Personal Finance

Advantages and Disadvantages of Hedging in Finance

Many companies use hedges to reduce their risk levels in key areas of their operations. These hedges can pay off for companies in situations in which changing market conditions would otherwise have hurt their profits, but they also come with a cost. Let's take a closer look at the advantages and disadvantages of hedging.

Why hedge?

Hedges are particularly popular with companies that have exposure to certain markets, such as commodities or interest rates. For instance, airlines and railroads spend substantial amounts for fuel for their operations, and so hedging future fuel costs can protect them against a spike in the market price for energy products.

At the same time, commodity producers can open hedge positions that allow them to lock in fixed prices for their production in the future. If the price of that commodity goes down, then the hedge will protect the producer by rising in value to offset the commodity-price decline. Oil and gas exploration and production companies provide a useful example of this use of hedging, as some players in the oil-rich shale plays like the Bakken and Eagle Ford hedged their anticipated future production and therefore earned huge gains on their hedge positions because of the plunge in oil prices on the open market during late 2014 and 2015. Those companies that didn't hedge, on the other hand, face the full impact of the crude oil drop, and some are struggling to get the capital they need to keep operating.

The downside of hedging

The flip side of hedging is that when things don't go against a company, the hedge is at best unnecessary and at worst counterproductive. For instance, when energy prices fell sharply in 2014 and 2015, airlines that had hedged against their future fuel costs didn't benefit as much as those that were unhedged. Essentially, the hedge position worked as a contrary bet that didn't pan out, and so hedge-related losses offset at least some of the decline in operating expenses that resulted from cheaper fuel.

Moreover, some hedges are costly even if markets remain neutral. Like any insurance product, prices of hedges usually carry an upfront cost, and the hedging party typically has to count that cost against any profits from the position or add it to any losses.

Finally, some investors don't like it when companies have hedges. They want exposure to the risks of the industry and see hedging as an impediment to their own risk management as investors. Especially when hedging doesn't work out, investor pressure can lead to a company reversing course and removing hedges -- often at what proves to be the worst possible time.

Hedging is a tool that companies can use to set their risk level. It can turn out well or poorly for a company, but it serves a useful purpose regardless of how things work out in the end.

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