Hedging and Derivatives

Definition: 

Hedging is the process of mitigating risk exposure to fluctuations in the spot rate for interest rates, exchange rates and commodity prices. 

• Natural hedging: Establishing physical offshore subsidiaries, arranging to receive payments / receipts in same currency. No risk of transferring funds between currencies.

• Derivatives: Financial instruments that derive their value from the underlying asset used to mitigate risks of future changes in exchange rates. 

  • Forward-exchange contracts (futures) lock in a currency value for a future date of exchange (locking out beneficial movements in exchange rate); 

  • Options contracts grant the right but not the obligation to exchange at contracted rate (if spot rate is more beneficial); 

  • SWAP contracts  are an agreement to reverse a currency transaction for the same value of currency at a future date (receipt and repayment of debt).