An introduction to hedging in HSC Busines Studies

For HSC Business Studies, we don’t need to be hedging experts; we don’t need to solve hedging for big companies. All we have to do is understand the fundamentals and provide an example to demonstrate hedging in action. Try and keep it as simple as possible.

This is an intro to the idea of hedging. It’s not too detailed but aims to get you on the right track in trying to understand this complicated area.

Where does this sit in the syllabus?

Hedging is part of the Finance topic in the HSC Business Studies course. It is a strategy and is part of the set of Global Financial Management strategies.

What is hedging in HSC Business Studies?

As a strategy, hedging is a way for a business to minimise risk.

Let’s think about this from an individual’s perspective. I look out the window and it looks like it might rain. I consult my weather app and there’s a 50% chance it might rain.

If I’m thinking about my risk of being rained on, I can reduce my risk to zero by staying indoors. But I’ve got things to do. I need to leave the house. So, I can reduce my risk by venturing outside, accepting it might rain, but taking an umbrella.

The hedge is the umbrella.

Obviously a business cannot carry an ‘umbrella’ that will protect against all possible outcomes. Instead, businesses use a number of different methods.

An example to demonstrate hedging

One risk for international businesses is currency fluctuations.

Let’s think about Qantas. Qantas earns its revenue in Australian dollars. It pays wages in Australian dollars and has many expenses in Australian dollars.

Qantas, however, has expenses in other currencies too.

Australian companies do not manufacture planes. If Qantas needs a new plane, it has to go to the US or Europe to buy this. And these companies DO NOT accept Australian dollars.

Instead, Qantas has to change some of its Australian dollars into a foreign currency, like US dollars. The amount of US dollars for one Australian dollar depends on movements in exchange rates.

Let’s say that on 1 January 2023, Qantas will buy a plane from Boeing for $US3 million.

We are now in July 2022 and the Australian dollar is at parity with the US dollar. This means that one Australian dollar will buy one US dollar. The Australian dollar is pretty strong!

At this exchange rate, the cost of the plane for Qantas is $A3 million.

Let’s say we get to December 2022. Now, one Australian dollar only buys $US0.50. The Australian dollar is now WEAKER because it takes more Australian dollars to buy the same value of US dollar. (We say that the Australian dollar has depreciated against the US currency).

Now Qantas has a big problem. The plane still costs $US3 million. This has not changed. But what has changed is that $US3 million now equals $A6 million. Qantas’ expenses have now doubled because the value of the currency changed. This could be disastrous for Qantas if it doesn’t have enough money to cover the higher expenses.

But what does this have to do with hedging?

Qantas can prepare for this risk. It can hedge its currency risk.

Go back to July 2022. Qantas can buy some extra US dollars now, when it has parity with the Australian dollar, to have some extra US dollars in reserve in case the value changes.

So in July 2022, Qantas buys $US3 million worth of US dollars and it costs $A3 million.

Then, in December 2022, when the $A depreciates, Qantas doesn’t need to worry. It can pay for the plane using the US dollars it bought earlier. This means that the cost of the plane is $US3 million, which equates to $A3 million BECAUSE Qantas HEDGED and bought currency before it needed it.

What’s the risk of hedging?

Let’s say Qantas buys $US3 million worth of US dollars but then the Australian dollar appreciates. The risk is that the value of the plane will fall in Australian dollars and Qantas is left with a bunch of US dollars it doesn’t need.

So here’s how it could work. Let’s say $A1 now buys $US2. The plane worth $US3 million will now cost $A1.5 million. It is cheaper than Qantas originally thought. The risk is Qantas now has an extra $US1.5 million it doesn’t immediately need.

Hedging is a risk, but it can be a risk worth taking.