Question:
I don't quite understand the point of doing business if an entity is just going to enter a hedge on its investment. I appreciate that if there are adverse price movements, then the hedge would mitigate this loss, which is very useful. However, on the other hand, if any gains on an investment are wiped out when an entity's price movements are favourable, then what's the point in hedging in the first place?Answer:
The answer is hidden in your question. The company hedges to mitigate risk, to guard against excessive downturns in profit. It “pays” for this risk protection by potentially foregoing some profit. There is of course a risk-return tradeoff.
Hedging serves as a means of minimizing losses. The economic rationale is that the marginal value of an extra dollar is lower at high profit levels than at lower profit levels. In other words, the profit that is wiped out by unanticipated economic downturns hurt a company much more than limits which hedging places on profits. Additionally, hedging allows a firm to continue funding its investments by protecting its funds in times of market volatility, and this creates value for the firm. Firms which hedge are shown to have higher market valuation as well as higher return on invested capital, particularly over a longer time horizon.
