Hedging and insurance

Hedging is the process of transferring risk to another party and protecting your own organisation from that risk.

When organisations decide to hedge, they are protecting themselves against the consequences of a negative event. This doesn’t prevent a negative event from happening, but if it does happen, and the organisation is properly hedged, the impact of the event is reduced.

Hedging may either take the form of insuring against adverse market prices or other events, or fixing the price of a market variable or other uncertain event, often via a derivative. For example, someone who buys house insurance hedges themselves against fires or break-ins.

Hedging principles

Effective hedging means the hedging instrument gains or loses value in a way closely related, but in the opposite direction, to the underlying exposure being hedged. To achieve a perfect hedge, the risk being hedged, and the hedging instrument should move in value by exactly equal amounts in opposite directions, to offset exactly.

Hedging oil price

ABC plc is a manufacturer that relies heavily on the use of oil in the production process.

It takes out a hedging instrument that protects the company from any adverse movements (i.e. increases) in the oil price. It enters into an agreement that ensures overall the net cost of oil is USD80 per barrel of oil.

If the oil price rises to USD100 (i.e. a USD20 rise) the hedging instrument will pay exactly USD20 to the manufacturer thus offsetting the increased cost of oil. The net cost would therefore be USD80.

If the oil price falls to USD60, ABC plc will pay USD20 to the hedging instrument provider, thus fixing the net cost at USD80 per barrel.

How far ahead to hedge

Choosing the period of how far ahead to hedge can be challenging. One approach is to match the future period of the hedge with the period in the future for which forecasted financial information is available. This choice is sometimes known as the ‘time horizon’ for risk management.

Whatever choice is made, it is important to ensure that the choice does not mean that hedging becomes inappropriate speculation, which would be the case if the hedge related to uncertain future cashflows. Such hedging creates additional risks and complexities.

Hedging and speculation

Hedging can be contrasted with speculation. Speculation is the intentional establishment or maintenance of an exposure with the aim of profiting from favourable price movements. For example, a speculator might bet on a stock market rise. If the market falls, the speculator loses. Speculation increases risk, therefore for this reason most corporate risk management policies prohibit speculation. Speculators can be viewed as risk-takers, whereas hedgers are risk-averse.