Q&A: What is hedging?

Hedging helps businesses to manage risks

Budget airline Ryanair has revealed that it will be unhedged for the next year.

Recently pub group Mitchells and Butlers announced losses of £274m due to a failed hedge.

It may be a strange term, but it is a business strategy that is far from the garden.

Why hedge?

Hedging is typically used by a business to protect it from sudden and unexpected increases in the cost of raw materials. Or to protect against rises in interest rates and inflation, or currency fluctuations.

Often, if a business is in a risky market, or under the influence of factors beyond its control, hedging can help avoid future troubles.

For example, airlines can choose to hedge against volatile fuel prices.

A hedge can therefore reduce or even cancel out a costly negative influence.

How does it work?

At its simplest form, hedging is a means of insurance and protection against a business risk.

The most typical method by which a company places a hedge is taking out a "futures contract".

This agrees a set price for something, such as a raw material, which will remain for a determined period of time.

For example, a bread-maker could make a hedge to buy wheat for a set price into the future, avoiding the risk that a crop failure in the intervening period could drive up wheat prices.

If the price goes up, the business still only has to pay the agreed price, not more. However, if the price then falls, it could be a costly move.

If it is so good, why not always do it?

If a business is big, secure and profitable enough to handle any market volatility there is no point in starting to hedge.

In fact, to begin to hedge would incur costs, and is therefore ideally avoidable.

Furthermore, without careful management, it can be disastrous.

Pub group Mitchells and Butlers (M&B) revealed last week that it had lost £274m through a hedge connected to a failed attempt to spin off property assets.

M&B had set up a hedge to protect the venture against changes in interest rates and inflation.

Yet at the last minute, the banks declined to back the venture, leaving M&B to take big losses from the cost of pulling out of the hedge.