What does "hedging" mean in treasury management?

In treasury management, "hedging" specifically refers to the use of financial instruments to mitigate risk associated with fluctuations in currency exchange rates, interest rates, or commodity prices. This practice is essential for organizations that want to protect themselves against potential losses that could arise from adverse movements in these financial variables.

For instance, a company that exports goods might hedge against currency risk by entering into a forward contract, which locks in exchange rates and protects against unfavorable shifts in currency values. Likewise, a firm with variable interest rate debt may use interest rate swaps to convert that debt to a fixed rate, thus safeguarding against potential interest rate increases.

The concept of hedging is fundamentally about risk management, enabling organizations to stabilize their cash flows and improve financial predictability. It is distinct from other financial strategies such as merely borrowing more funds, combining investments, or diversifying portfolios, all of which may contribute to a broader financial strategy but do not specifically address risk mitigation in the same targeted manner as hedging does.