What is Hedging?
Hedging is like an insurance when you decide to hedge, you are insuring yourself against a negative event. In finance, It is used as risk management tool to reduce financial risks. It involves reduction of financial risk by passing that risk to someone else.
If a company wants to remove translation risk, it is possible to hedge this type of risk internally by following ways
Invoice in home currency
If a US company trades with a UK company and accepts invoices (of sale) in US dollar only then it partly removes currency risk.
Leading and lagging
Leading is making payment before it is due and lagging is delaying a payment for as long as possible. This is effective if a company has strong view about future currency exchange rate movements.
Matching and netting
Matching involves matching assets and liabilities in the same currency, financing foreign investment with the foreign loan would reduce the exposure to exchange rate risk. In netting, companies pay their foreign liabilities from their foreign receipts to remove the translation risk.
In countertrade, companies trade by exchanging goods of equivalent value to reduce the exposure of currency risk.
Normally in multinational groups, the cross-border payments are managed through the multilateral netting. In which net receipts and payments is paid to each individual subsidiary in desired currency. The multilateral netting function can be outsourced to the third party or managed through central treasury function.
A forward contract is an agreement to buy or sell a specific amount of foreign currency or financial instrument at a given future date using agreed forward rate.
Money market hedge
The money requires for the transaction is exchanged with current spot rate, and is then deposited/ borrow on the money market to ensure to the amount required for the future transaction.
Why use hedging?
- It provides certainty in cash flows which will help in budgeting process
- Management might have more investment opportunities after reduction of risk
- If a company has hedging policies, risk-averse managers would consider it attractive for working
Argument against hedging
- Investors own diversified stocks in stock market, thus further hedging may harm their interests
- Transaction cost associated with hedging can be significant
- A company might not have enough expertise for use of derivative instruments