Blog
Q&A: What is hedging?
1st June 2009
Hedging is the process of protecting oneself against risk.
Hedging is trying to reduce uncertainty by buying (or selling) something in a futures market. So an airline might hedge against volatile aviation fuel prices by buying the fuel it thinks it will need ahead of time - say 6 months before. Say that it buys the oil now at $55 per barrel for delivery in 6 months .... that price is fixed. Ofcourse the price might decline to $40 and so the airline will take a hit - it is committed to buying at the hedged price. But the price might also reach $80 in which case the airline has made a good move, by hedging it has lowered uncertainty and reduced its costs.
Virgin Atlantic recently announced better than expected profits partly because of successful hedging of the global price of oil.
Take another example, a company who owes money to an overseas company may want to hedge against the risk that the exchange rate moves against them. They could do this by taking out a future contract for the purchase of foreign exchange at a fixed future rate
Geoff Riley
Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.