How Companies Use Derivatives to Hedge Risk

The fluctuation of market prices may cause companies to incur losses. Some common examples of this are:

•  A manufacturing organization could incur a loss if they buy raw materials in the future and the price of these raw materials goes up.
•  An organization exporting products may receive payments for products in foreign currencies, and if the value of that foreign currency decreases, the organization could lose a portion of its profits due to that decrease.
•  Many organizations also have loans that will incur higher rates if the cost of borrowing money increases.

In order to cover their potential losses from market price fluctuations or uncertainty companies use derivative instruments as a hedge against future increases in price. This risk management technique is referred to as hedging.

Common Hedging Strategies Using Derivatives

1.Hedging Against Currency Risk.

Internationally operating businesses typically conduct business transactions using multiple currencies, and fluctuating exchange rates may cause a decrease in the amount of profit that is received.

•  To protect against currency exchange rate fluctuations, many companies enter into forward contracts or options to purchase foreign currencies at a specified rate on a specified date.

For example:

An Indian exporter who expects to receive payment for goods in U.S. dollars (USD) will enter into a currency forward contract to lock in their rate of payment, which means the rate of exchange for USD will remain stable regardless of the exchange rate fluctuation.

2.Hedging Against Commodity Price Risk.

Businesses in industries such as manufacturing, energy, and agriculture rely on obtaining the physical basis of their products to produce their finished products, and the price of such commodities will fluctuate based on supply and demand.

•  Many businesses in these industries will use futures or options to lock in prices of commodities.

For example:

An airline concerned about potential increases in fuel prices may enter into an oil futures contract to lock in their future cost of jet fuel.

3.Hedging Against Interest Rate Risk.

Companies that have variable-rate loans (loans where the rate of interest may change) may incur a higher cost of capital if the interest rate rises.

Interest Rate Swaps can help companies lower their monthly variable payment to a fixed amount.

A company can also use Interest Rate Swaps to create an easier forecast for its cash flow and avoid rising interest rates.

Advantages of Hedging with Derivatives

•  Reduces the uncertainty of finance due to variance in rates.
•  Provides consistency in future revenues.
•  Helps with budgeting and financial forecasting.
•  Limits the amount of loss due to volatile markets.

A Company cannot completely eliminate their risks when hedgelike derivatives, but they can use these hedges to control their potential losses.

Real Example:

A coffee export company located in Malappuram is expecting to receive payment for their business in USD in six months. If the USD exchange rate falls before the payments comes in, the value of their income will be less in INR.

To hedge against that potential risk, they purchase a currency forward contract to fix the exchange rate for buying USD at the time of payment.

The purchase of the forward contract demonstrates how good planning and hedging have helped to protect the profits of that coffee export company  and this is a central lesson taught in the top trading academy in Malappuram.

Learn More about the Sciences of Hedging and Risk Management

If you are serious about the financial markets, you should educate yourself on derivatives and hedging strategies. At NXT Institutions, considered by many locals as the best forex trading academy in Malappuram, we offer hands-on training for real-world examples of the usage of derivatives and the behaviour of global markets, so our students can learn to trade and hedge like experts.

• Learn how to apply derivatives in your daily life.
• Learn how to understand the way the world markets operate.
• Learn how to trade and hedge your position like a pro.

We will provide you with the best training, and the best chance to gain insight into how financial markets work. Our instructors are experienced and trained to provide you with a hands-on, interactive learning experience.

Join us at NXT Institutions and learn how to master the derivatives and risk management.