Hedging Risks and Rewards

The path to getting rich is fraught with potential disaster. Hence, if a businessman wishes to get rich, he must resign himself to the possibility that, at any point whatsoever along the way, he can lose everything and find himself dirt poor. This is so because the fastest way to get rich is through investments, trading in high volume markets, and essentially attempting to start and run a business. The alternative is working hard and climbing up the corporate ladder, but this method takes time and often is not nearly as fruitful as the latter option.

Hence, there are several techniques that businessmen, investors and essentially people with a lot of money implement in order to minimize the risk of their trade. One of these techniques is called hedging. Hedging is essentially making double investments, one investment which will turn out to be the main investment and another, less risky investment intended to offset any potential losses incurred from the former, riskier investment. It involves minimizing the risk that one faces whilst conducting a business deal.

A major risk faced by businesses is foreign exchange risk. This especially occurs when the business is getting money from a foreign country, one that possesses a currency different from the base currency used by the business. There is risk involved in such transactions because currencies can often be volatile. If the value of the currency being received by the business drops, the business could end up losing a lot of money. Businesses employ hedging in this regard by fixing an exchange rate with the foreign client, and obligating this client to pay at the very same rate regardless of any drops in currency value.

Hedging is essentially a method whereby future income is secured. A good industry whose example can be taken is the mining industry. Mining involves the extraction of raw materials and the selling of these materials to clients that are usually businesses in their own right, companies that use these materials to manufacture products of their own.

The mining process costs a lot of money, but the value of the ore being mined is volatile. If the price of the ore drops significantly, the company doing the mining can end up losing money. Hence, companies employ hedging in these situations by securing future selling prices with their clients beforehand. This way, no matter what the current price of the ore is, the buyers would be obligated to buy the ore at the agreed price, thereby securing profit for the company.

However, a fact of the investment world is that profit increases proportionally to risk. Hence, when a company reduces the risks of its ventures, it is also reducing potential profit along with potential losses. For example, if the aforementioned mining company had not secured prices beforehand and the price of the ore they were extracting increased significantly, they would stand to gain a lot of money that they wouldn’t have otherwise if they had employed hedging.