Corporate Hedging
Sometimes, corporations or individuals want to avoid exposure to changes in the value of certain assets. For example, an American corporation may have sold some product to a German corporation for payment in Euros in six months. But the U.S. corporation may prefer to lock in the value of the Euro payment to be received in order to avoid the uncertainties of the exchange rate. After all, it needs to purchase its inputs in U.S. dollars today.
This can be done by hedging the exchange rate risk. The idea is to purchase a financial security that goes up by $1 in value if the product payment in Euros goes down by $1 in value (and vice-versa). For example, if there is a call option that increases in value by $0.33 if the Euro increases in value by $1, then the firm needs to sell three of these call options to neutralize its exposure. If the Euro goes up by $1, then the underlying contract payments will go up by $1 and the three call options will go down by $0.33 · 3. Conversely, if the Euro goes down by $1, then the underlying contract payments will go down by $1 and the three call options will go up by $0.33 · 3. Corporate hedging of uncertainties has become very common. The idea behind hedging is closely related to the idea of derivative securities: that is, a hedge ratio determines how many financial securities are required to neutralize the effect of changes in the value of an underlying asset.