Question

1. Discuss the arguments in favour and against the use of hedging strategies. (Note: provide some examples to support your discussion).

Answer 1

Hedging can be very useful in order to manage financial risk and uncertainty about the future. Hedging strategies can be used to mitigate currency risk, which has become a major issue in today's global business environment or commodity price risk, which helps manufacturers and traders lock in price today for a future transaction. For example, consider a global firm that has operations in many different countries. This firm needs to convert its profits earned in a foreign country to its domestic currency. Now, considering how volatile exchange rates can be, hedging is very useful for this kind of a firm to lock in an exchange rate today, in order to manage future exchange rate volatility. Also, consider the example of a corn producer. The producer expects to harvest and sell his crop 6 months down the line but is concerned that prices may fall in the future. Using hedging strategies, this guy can lock in a price for his harvest today, even if the transaction is going to happen 6 months from now. So, hedging can be very useful for people and firms trying to manage risk.

the arguments against hedging is that first of all hedging has costs involved. This means that any profit that the corn producer, mentioned above, will make will be less than what he might have made without hedging. And this is intuitive as well, if you take on less risk, you are gonna have to do with lesser return. Another argument is that it requires skill and time and may not be a suitable strategy for short term traders and other short term market participants.