To Hedge Or Not To Hedge…?
January 24, 2010 4 Comments
Hedging is trying to reduce the risk in the commodity price fluctuation. A factory may need raw material to produce widgets. The raw material could be imported from different country using different currency. The price of the material and the currency can change during the year. The factory can cut the risk of price fluctuation by buying the foreign currency now, or buy the full amount of raw material and store it in the warehouse. By this action the factory would secure the raw material at the market value now and continue its production at the calculated material price. The change in future prices should not affect its production or profit margin. This is called hedging and can save the company from unnecessary lose due to price fluctuation.
Currency hedging is required to manage the volatility in foreign exchange rate. Daimler-Benz (DB) reported its largest market loss in its 109 year history because of the dollar exchange rate change (Stulz, 2001). The lost was caused by Daimler-Benz management decision of not hedging although one of Daimler-Benz‘s subsidiaries has 16 billion Deutsch Marks in dollars that decreased 14% in value against the Deutsch Mark (Stulz, 2001).
I thought of adding some useful definitions to impress you! Forward currency markets enable the companies to lock the buying and selling exchange rate by a contract agreement, usually with a bank, specifying the amount of currency, at and exchange rate on the date of contract (Madura, 2003). Forward markets have contracts tailored to the company’s need and delivery date: these contracts are self-regulated contract without security deposit (Madura, 2003). Future market contracts have standardized size and delivery date and require small security deposit.
Many companies were hedging before the last rescission hit the world market. They bought foreign currencies or stocked raw materials for their industry. What do you think happened to those companies? Should they hedge now since the world market is picking up?
Madura, J. (2003). International financial Management (7th ed.). Mason, Ohio: South-Western.
Stulz, R. (2001). Rethinking risk management. In The new corporate finance: where theory meets practice (pp. 411-27). New York: McGraw-Hill Irwin.