Here, we look at what hedging is and discuss whether or not it is an advantageous venture for SMEs.
It’s no secret that there has been a lot of economic and political turmoil in regard to the global economy recently. This turmoil has led to extremely volatile currency markets, which has had an impact on virtually every aspect of the business world. While all businesses have been impacted by the current state of global economic and political affairs, the organisations that seem to have been hit the hardest are those that conduct business across borders, as well as small businesses.
Whereas large corporations have the ability to cope with the burden of the current state of economic and political affairs, small and medium enterprises (SMEs), including import-export companies, farmers and retailers are not. In fact, drastic shifts in the economy can be the difference between profitability and bankruptcy for SMEs.
Given the current state of the global economies, many small business owners are wondering if they should get involved in hedging. Here, we will have a look at what hedging is and discuss whether or not it is an advantageous venture for SMEs.
What is hedging?
Hedging refers to the process of making an investment to reduce the risk of negative price movements in an asset. For instance, if you own a stock in a certain company and you enter it into a futures contract, indicating that you will sell the stock at a set price, you will be able to avoid or moderate any fluctuations in the market. Investors utilise this strategy when they are not sure what the market will do. If done correctly, a hedge can reduce your risk to nothing (minus the cost of the transaction fees.)
Hedging can be done through a number of different tools, including:
The benefits of hedging
There are several benefits that hedging can offer an investor. The first and the most important benefit is that hedging can eliminate risks, and actually significantly reduce them. However, it should be said that hedging is not a 100 per cent guarantee; nevertheless, with the right guidance, it is certainly a way to significantly reduce risks.
Another benefit of hedging is that is can help to manage the costs that are related to commodities, including fuel and raw materials. As a result, the process of hedging creates a larger bottom line, thus increasing profitability.
Hedging on limited resources
If you think hedging is something that you would be interested in, but you have limited resources, don’t despair. There are strategies that can be put in place that will allow you to invest in a smaller percentage of the total amount that needs to be covered, which is done via leveraging, or ‘trade on margin’. In other words, the total necessary investment to cover £500,000, for example, may only be £5,000 based on a leverage quota.
While hedging can be advantageous, there are potential risks. For instance, if the market moves against you, there has to be enough money in your reserve fund to cover the margin payment if you end up having to close out of your position.
Hedging reduces the risks that are created as a result of a volatile global economy. Hedging can prove to be a beneficial move if you are an SME, as it can help to soften the hit that is brought about by when an SME is exposed to extreme external factors.
To determine if hedging is right for you, you should define your risk tolerance. If it turns out that hedging would be beneficial for your business, you’ll find that it could be the difference between profit and loss.