The Practice Of Hedging

"A Beginner's Guide to Hedging" This is a very simplistic article with a good introduction to hedging.


As the article states, I think it is easiest to think of hedging as insurance. Having insurance does not guarantee that a fire or flood will not happen to your home, but it will help mitigate the loss if one should occur.

The text discusses 5 benefits to hedging, they are as follows:

* decreases a firm's expected tax payments
There is an asymmetry between the tax treatment of gains and losses. Firms often lose more value form a pretax loss than they gain from a pretax gain.

* reduces the costs of financial distress
Firms that are subject to high financial distress costs have greater incentives to hedge.

* allows firms to better plan for their future capital needs while reducing their reliance on outside capital markets
Hedging can reduce the variability in cash flows, therefore increasing their ability to plan for internal investment capital.

* improves the design of management compensation and evaluate top executives more accurately
Executive compensation should be designed to expose managers to risks that they can control. Hedging can assist in this.

* improves the quality of the investment and operating decisions
Having a good understanding of the markets and using hedging as a planning tool will help managers improve the decisions they make.