Companies use hedging to minimize the impact of potentially negative financial events on their business—such as unexpected spikes in value of foreign currency or the price of the raw materials they use to make their products.
For example, a coffee company depends on a regular, predictable supply of coffee beans. To protect itself against a possible increase in coffee bean prices, the company could enter into a futures contract that would allow it to buy beans at a specific price on a particular date. That contract is a hedge.
If the price of coffee beans climbs above the price in the futures contract, the company will save money and the hedge will have paid off. If the price of beans falls, the company will lose money because it has to pay the contract price. The difference essentially becomes a “fee” the company has chosen to pay for the sake of price certainty.
As this example shows:
- Hedging does not prevent a negative event from happening, it just lessens the blow.
- You need to pay for the benefit, whether you receive one or not.
- Sometimes you benefit from what you spent, sometimes you don’t.