Hedge relationship (finance)
Imagine you have a piggy bank where you save your pocket money. Sometimes you may want to buy a toy that costs $10, but you only have $5. To make sure you have enough money to buy the toy, you can ask your parents for an allowance in advance, or you could borrow money from your friend.
In finance, people and companies also face similar problems. They may have some investments or assets that they want to protect from any changes in the market, such as the price of goods or exchange rates. For example, a company may have a factory in another country, and they need to pay their workers in that country in their local currency. If the currency exchange rate suddenly changes, it could affect how much the company needs to pay, and they could lose money.
To avoid such risks, companies use what is called a hedge relationship. A hedge is like a backup plan that helps companies protect themselves from any unexpected changes in the market. Just like borrowing money from your friend, companies can also borrow money from banks or other financial institutions to protect their investments from fluctuations in the market.
For example, if a company has to pay $500,000 for a delivery of goods in six months, they can enter into a hedge agreement with a financial institution. The institution may give the company a loan of $500,000 with a fixed interest rate, and in return, the company will pay back the loan at the end of six months, no matter what happens to the market price.
This way, the company is protected from any sudden changes in the market that could have affected the cost of the goods they were purchasing. It's like having a piggy bank that always has enough money to buy the toy you want, no matter what happens to the price.
In finance, people and companies also face similar problems. They may have some investments or assets that they want to protect from any changes in the market, such as the price of goods or exchange rates. For example, a company may have a factory in another country, and they need to pay their workers in that country in their local currency. If the currency exchange rate suddenly changes, it could affect how much the company needs to pay, and they could lose money.
To avoid such risks, companies use what is called a hedge relationship. A hedge is like a backup plan that helps companies protect themselves from any unexpected changes in the market. Just like borrowing money from your friend, companies can also borrow money from banks or other financial institutions to protect their investments from fluctuations in the market.
For example, if a company has to pay $500,000 for a delivery of goods in six months, they can enter into a hedge agreement with a financial institution. The institution may give the company a loan of $500,000 with a fixed interest rate, and in return, the company will pay back the loan at the end of six months, no matter what happens to the market price.
This way, the company is protected from any sudden changes in the market that could have affected the cost of the goods they were purchasing. It's like having a piggy bank that always has enough money to buy the toy you want, no matter what happens to the price.