What is anticipatory hedging?

ByMunyaradzi Mafaro

Anticipatory hedging allows companies and investors to protect themselves from possible future losses by making financial arrangements today before a risky situation arises.

The goal is to reduce the amount by which the value of something can change in the future. That “something” could be an asset (something valuable that is owned), a liability (a debt or financial obligation), or expected future income.

Why do anticipatory hedging?

Imagine a company thinking the US dollar will lose value compared to the Euro in the coming months. If a lot of the company’s income is in dollars, it could lose money overall when it converts those dollars into Euros.

To protect against this risk, the company could use anticipatory hedging. It could enter an agreement to convert its dollars into Euros at today’s exchange rate at some point in the future. This locks in the current rate. It doesn’t matter if the dollar loses value later on – the company is protected.

So, anticipatory hedging is all about reducing uncertainty. It makes future finances more predictable.

How anticipatory hedging works

There are different ways to set up an anticipatory hedge. A standard method is to use derivatives. Derivatives are financial contracts whose value is based on the expected future price of something else.

Using derivatives

Common derivatives used for hedging include:

  • Futures contracts: Agreements to buy or sell an asset at a specific future date and price
  • Forward contracts: Similar to futures, but more customized and traded over-the-counter
  • Options: The right (but not obligation) to buy or sell an asset at an agreed price on or before an agreed date
  • Swaps: Agreements between two parties to exchange future cash flows

Companies can offset their risks by carefully constructing derivatives that will gain value if the underlying asset loses value (and vice versa).

Long and short positions

Another anticipatory hedging approach is taking a long or short position in a risky asset.

If a company already owns an asset and is worried its value will fall, it could take a short position as a hedge. This means it borrows and sells the asset, planning to repurchase it later at a lower price. If the price does drop, the gains from the short position offset the losses on the company’s assets.

Conversely, if a company knows it will need to buy an asset in the future and is worried the price will increase, it could take a long position now as a hedge. It buys the asset today, so it doesn’t have to be purchased at a potentially higher price later. The long position locks in the current price.

When anticipatory hedging is used

Anticipatory hedging is commonly used by all kinds of institutions—manufacturers, service providers, financial firms, government entities, etc. It may help an organization manage its future financial exposures.

Managing foreign exchange risk

Managing foreign exchange risk is one of the most frequent uses of anticipatory hedging. Companies that operate internationally often receive income and pay expenses in various currencies.

If the exchange rates between these currencies fluctuate, it can dramatically impact the company’s profits and losses. Anticipatory hedging with currency derivatives helps reduce this uncertainty.

Smoothing commodity costs

Another common application is for companies that depend on commodities like oil, crops, metals, etc. Prices for these raw materials can be pretty volatile.

Companies can better plan their budgets and manage costs by locking prices with anticipatory hedges. Airlines often hedge fuel prices, food manufacturers hedge crops, construction firms hedge metals, etc.

Benefits and risks

When appropriately used, anticipatory hedging has some key benefits:

  • Reduces uncertainty and financial risk
  • Enables better financial planning and budgeting
  • Can help secure financing and boost creditworthiness
  • This may allow focus on core business rather than complex risk management

However, hedging is complex and can pose risks if not done carefully:

  • Hedging incurs upfront costs, which are lost if the risks don’t materialize as expected
  • Over-hedging can lead to significant losses if markets move in the opposite direction
  • Complicated hedges can be challenging to understand and adequately account for
  • Hedging focuses on specific known risks but doesn’t address risks we can’t anticipate

Munyaradzi Mafaro is a music enthusiast and he also likes to tackle topics of business, productivity, and the possibilities for growth in the digital world.