The trick is to find the hedge ratio or delta that is the number of units of one asset that is
needed to offset changes in the value of the other asset. Sometimes the best solution is to
look at how the prices of the two assets have moved together in the past. On other
occasions a little theory can help to set up the hedge. For example, the effect of a change
in interest rates on an assets value depends on the assets durations. If two assets have the
same duration, they will be equally affected by fluctuations in interest rates. Once you
have set up the hedge, you can take a long vacation, confident that the firm is well
protected. However, some hedges, such as those that match duration’s, are dynamic. As
time passes and prices change, you need to rebalance your position to maintain the hedge.
Firms use a number of tools to hedge:
- Futures contracts are advance orders to buy or sell an asset. The price is fixed
today, but the final payment does not occur until the delivery date. The futures
markets allow firms to place advance orders for dozens of different commodities,
securities and currencies. - Futures contracts are highly standardized and are traded in huge volumes on the
futures exchanges. Instead of buying or selling a standardized futures contract,
you may be able to arrange a tailor- made contract with a bank. These tailor made
futures contracts are called forward contracts. Firms regularly protect themselves
against exchange rate changes by buying or selling forward currency contracts.
Forward rate agreements (FRAs) provide protection against interest rate changes. - It is also possible to construct homemade forward contracts. For example, if you
borrow for two years and at the same time lend for one year, you have effectively
taken out a forward loan. - In recent years firms have entered into a variety of swap arrangements. For
examples a firm may arrange for the bank to make all the future payments on its
dollar debt in exchange for paying the bank the cost of servicing a euro loan.
Instead of using derivatives for hedging some companies have decided that speculation is
more fun, and this has sometimes got then into serious trouble.
(Source: Book on Corporate Finance – Professor Brealey.I.Myrer)