Question

Which of the following is an example of hedging?

	A.	Kodak uses silver to make film. They "lock in" the price of silver so that they know what their costs will be going forward.
	B.	Delta airlines biggest cost is jet fuel. They "lock in" the price of oil so that their fuels costs will not increase.
	C.	Marathon Oil does a great deal of business with Saudi Arabia. The U.S. dollar is worth 3.75 riyals (the currency in Saudi Arabia). If this rate fluctuates it can make a big difference to Marathon's profits. Marathon "locks in" this exchange rate.
	D.	All three of the above scenarios are examples of hedging.

Answer 1

D.	All three of the above scenarios are examples of hedging.

Hedging is a method of reducing the risk that a company is exposed to during the normal course of doing business. Companies want to reduce this risk and want to know clear certain costs for their business so that their profits don't take a big hit due to unexpected situations.

In Case 1. Kodak locks in the price of silver so that in case the prices soar in the future, it can maintain the price level of its products constant, else due to higher input costs, Prices need to be increased to stay profitable and this may lead to a reduction in sales.

In Cas 2. similarly, Delta airlines want to maintain prices as expected, else with rising fuel costs, the airline will be stressed to increase flight fares which may threaten the business and make consumers go to other airlines.

In Case 3. when a company does business in multiple countries and earns revenue in different currencies, it makes sense to hedge against unfavourable currency fluctuations so that the profits are not hit.

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