Hedging is concerned with minimizing risk in order to protect the individual or the business from unanticipated losses. If an individual insures his business against fire, then he is dealing in a hedge. Check this link to know more about challenges faced by Insurance companies. Hedging involves the strategy wherein the individuals buy securities that are negatively correlated to his assets. If an automobile manufacturer wants to hedge, then he would buy a futures contract of steel at an agreed price. He would gain if prices of steel increase in future but he would lose if these prices go down.
Guide to Successful Hedging:
Hedging is fairly complex and involves the investment of time and energy in strategizing the trade-off subject to future inconsistencies. Following are some of the strategies you should keep in mind while hedging:
Don’t hedge Silos:
Often, companies consider the aggregate risk of the enterprise as a whole rather than nominal risks of isolated (siloed) businesses. This approach increases risk exposure of the business. This is a big issue, especially in multi-business organizations. Net economic exposure includes indirect risks which may occupy a significant percentage of the total risk exposure of the company. For instance, when a wheat dealer hedged his supply costs, the hedge rightly protected him when the labor costs increased. This helped the wheat dealer compete in the market without raising prices. Sometimes net economic exposure may be lower than the nominal risks. Thus, it is important to evaluate the company’s right economic exposure. Natural discrepancies are also evaluated so that hedging costs do not increase.
Hedge only Key Aspects:
Large companies sometimes hedge irrelevant components rather than the focal points. For instance, an aluminum company hedged its exposure to natural gas for years rather than aluminum itself. Companies need to understand whether the risk exposure of an aspect is significantly large. If the cash flow is able to substantiate the cash needs of the aspect, then one does not require hedging.
Well developed Risk Profile :
Companies should have a well-researched risk profile. It should include the threats to the organization, probabilities of failures and the outline of indirect costs. Additionally, one should mention the level of disruption each threat might pose. A compliance division for the same should exist. Independent auditors can identify the risks and address them before they become issues. Failure to comply with the standards can cause long-term damage to the company. For example, if a drug company does not conduct thorough drug tests, then it may face legal and monetary charges. This can cause a fall in the company’s reputation.
While considering hedging, businesses need to understand that market movement are very unpredictable. One needs to create an optimum risk profile in order to minimize the risks to the business. An effective risk mitigating strategy can help a business concentrate its efforts towards expansion and growth.Add to favorites