Secured hedge agreements: Overview, definition, and example
What are secured hedge agreements?
Secured hedge agreements are financial contracts in which one party (usually a borrower or investor) uses a hedge—such as derivatives or other financial instruments—to protect against risks related to fluctuations in asset values or interest rates, while securing the agreement with collateral. The collateral provides additional security to the counterparty, ensuring that in case of default, they can recover their losses by claiming the collateral. These agreements are commonly used by businesses or financial institutions to manage risk, such as fluctuations in commodity prices, foreign exchange rates, or interest rates.
For example, a company might enter into a secured hedge agreement to protect itself against future changes in the price of oil. In this agreement, the company could offer collateral like real estate or other assets to secure the hedge.
Why are secured hedge agreements important?
Secured hedge agreements are important because they provide a way to manage financial risk while also offering protection to the party providing the hedge. For the party entering the hedge, it helps to mitigate potential losses from market fluctuations by locking in favorable prices or rates. The collateral backing the agreement adds an extra layer of protection for the counterparty, reducing the risk of financial loss in case the hedging party fails to meet their obligations.
For businesses, these agreements are crucial for reducing uncertainty, especially in industries that are highly sensitive to market volatility, such as commodities, energy, or finance. The use of secured collateral in these agreements provides reassurance to the other party that they will have a way to recover funds if the hedge does not perform as expected.
Understanding secured hedge agreements through an example
Imagine an airline company that wants to protect itself against rising fuel prices. The airline enters into a secured hedge agreement with a financial institution. The hedge agreement locks in a fixed price for fuel over the next year, but the airline provides collateral in the form of company-owned aircraft. If the airline fails to meet its obligations under the agreement, the financial institution can claim the collateral to cover any potential losses.
In another example, a multinational company that operates in multiple countries may use a secured hedge agreement to manage foreign exchange rate risks. The company enters into a currency hedge contract with a bank, providing collateral in the form of marketable securities. If the value of the currency moves unfavorably, the hedge will protect the company, and if the company defaults, the bank can claim the securities as compensation.
An example of a secured hedge agreement clause
Here’s how a secured hedge agreement clause might appear in a contract:
“The Hedge Agreement is secured by the Borrower’s assets, including but not limited to [describe collateral]. In the event of default or failure to meet obligations under this agreement, the Lender shall have the right to claim and liquidate the secured collateral to recover any losses incurred due to the Hedge’s performance.”
Conclusion
Secured hedge agreements are used to manage financial risk, particularly in volatile markets, while providing added security through collateral. These agreements help businesses lock in prices or rates to protect against market fluctuations, and the collateral provides a safety net for the counterparty. For businesses or investors dealing with significant risks, secured hedge agreements offer a way to safeguard against unexpected market changes and provide confidence in their financial strategy.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.