Question

Hedging activities are necessary for all businesses to do. Do you agree with this statement?
Discuss.

Answer 1

Yes.Hedging is an important part of doing business. When investing in a company you expose your money to risks of fluctuations in many financial prices - foreign exchange rates, interest rates, commodity prices (oil and so on) and equity prices.

If a company makes sweet treats, the price of sugar is going to be watched closely. If a business relies on a fleet of lorries to move goods, then the price of petrol is key. More often than not, though, in today's global business world, the killer movers are currencies.

Foreign Exchange (FX) is by far the largest market in the world, dwarfing the size of stock and bond markets. The daily trading volume in FX markets is about $5 trillion (£4 trillion) - that's about four times more than all the trading in companies listed on the FTSE 100 for a whole year.

"It is often a good idea for companies to use hedging to protect themselves from swings in the exchange rate of a foreign country they are investing in," says Jasper Lawler, a markets analyst at CMC Markets.

The impact of changes to market prices can have a devastating effect on profits, so companies will seek to shield the sensitivities of their core business.

"Companies hedge for a variety of reasons, but they all come down the same thing," says Karlien Porré, a partner in Deloitte's global treasury advisory services practice. "They want to protect their financial results - for example cash or profits."

The main risk in hedging is getting it wrong. Companies need to be in tune with their wider supply chain so as not to hedge at the wrong time or for too long.

A London shop selling goods bought from Europe may fix an exchange price for a long time if using a consistent supplier over the course of a year. But if the company switches suppliers regularly in search of the best prices, it will also need to keep a close eye on the rate at which they are exchanging money.

Failing to keep all sections of the business as well as senior management and shareholders informed on hedges is another potential pitfall.

Everyone needs to understand that you stand to lose as well as gain.