What is a Hedging Instrument?

A hedging instrument is a designated financial instrument whose fair value or related cash flows should offset changes in the fair value or cash flows of a designated hedged item. A hedged item is an asset, liability, commitment, highly probable transaction, or investment in a foreign operation that exposes an entity to changes in fair value or cash flows, and is designated as being hedged.

Examples of Hedging Instruments

Here are several common examples of hedging instruments:

Forward contract. A contract between two parties to buy or sell an asset at a specified price on a future date.
Futures contract. A standardized contract that is traded on an exchange, to buy or sell an asset at a predetermined price at a specific future date.
Option. A financial derivative that gives the holder the right, but not the obligation, to buy (call option) or sell (put option) an asset at a specific price before or on a specific date.
Swap. A contract to exchange cash flows or financial instruments between two parties. Examples are interest rate swaps and currency swaps.
Short selling. This involves selling a borrowed asset with the expectation that its price will decline, allowing it to be repurchased later at a lower price. It is a hedge against potential losses in a long position.

These instruments are chosen based on the nature of the risk, the specific market, and the user’s risk tolerance.

Cost-Effectiveness of a Hedging Instrument

Many businesses do not use hedging instruments, because their cost may exceed the benefit to be gained from their use. This is most commonly the case when the risk being hedged against has a high probability of occurrence, which increases the cost of the hedge.