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hedging

Page history last edited by Brian D Butler 9 years, 6 months ago

 

 

 

 

 

 

 

Hedging

In International Business, and in International Finance markets ... hedging is the use of derivatives to reduce risk (of a company, investment, or portfolio).   You "hedge your bets" by taking an opposite bet in another direction on another asset.   If your afraid that your asset will lose value, then you want to buy another asset that gains value.

 

Table of Contents:


 

 

see also:  our discussion on risk management, and currency hedging

 

How hedging works:

 

What you essentially do is:

1.  Look at your asset and see how its price moves.  If your afraid that you might loose value if the price moves up / down...then..

2.  Buy another asset whose price moves in the opposite direction.

 

 

 

Risk Management

 When dealing with foreign exchange risk, you have a few choices as a business manager

  1. Operationally hedge - use operations in more than one country to balance your assets and liabilities so that currency is generated in revenues in the same country where liabilities are owed.   Another way to operationally hedge is to have operations in multiple countries, so that if one currency goes down, another will go up, etc.
  2. Avoid - you can try to avoid currency risk by passing along the risk-premium to your customers.  You can charge a risk premium, say for example 7% extra to all clients, and keep a fund ready for incase the currencies change, and then, that way...you will have money ready.  Its not a very good method, but some companies do it.
  3. Protect yourself - hedge - transfer the risk to someone else that is more willing / able to take on that risk... if there is someone that is willing to take on risk for a fee, then sell them that risk, and take the money now.  This is the essence of currency hedging .

 

 

Hedge funds

Hedge funds specialize in using derivatives, using the techniques shown below.  It is a form of asset management.  See more in our discussion on Hedge Funds here...

 

 

 

 

 

Various Hedging Strategies using options:

 

see more in our discussion about Options

 

 

 

learn more here:  http://www.amex.com/?href=/options/eductn/index_education.html

 

 

 

 

 

Long/ Short Hedging

1.  long hedge - you benefit if price goes up 

2.  short hedge - you benefit if price goes down  

 

              Forward     Type        when to use                                example

seller:       sells       short        if your hurt by price decrease     selling inventory

buyer:       buys       long        if your hurt by price increase       if purchasing for resale (and have fixed sales price)

 

 

 

 

Short Hedge

To "sell short" means the same thing as selling something in the futures market.  i.e. you are promising to sell an asset (stock, bond, physical good) to someone in the future at a specified price.  You might not even own that asset at the present time, but you can sell it forward (short it), which means that you will have to buy it sometime between now and then, so that you can sell it at the specified price.  So, if the price is fixed at which you will sell it in the future, what you are hoping is that the market price of that good will drop between now and that future date, so that you can buy it cheaply, and sell it at a higher price, making a profit.  Selling short is like betting on a price decrease (by selling a contract in the forward market). 

 

How to short hedge?

Sell in the futures market.  Sell a futures contract.

 

 

When to use a short hedge:

If you are hurt by a price decrease.  If, for example, you might have an asset that you don't want to loose in value, like inventory.  A short hedge reduces the risk of holding inventory. You reduce your inventory risk by selling futures contracts.  This is very common in business, and is used whenever someone either has, or anticipates receiving inventory.   You write a futures contract in order to "lock in" a future price for your good (this is short selling, meaning that you are protected from a drop in price).

 

 

 

Examples

Agricultural Example

Lets assume that you produce wheat, and you are afraid that the wheat might loose in value before you can bring it to market, then you could sell wheat (short) on the futures market. 

 

This is  different than writing forward contracts.  Instead, what you are selling is another asset (wheat contract) in the futures market.  So, if your physical wheat that you are growing increases in value, then the short futures contract will loose value.  But, if your physical wheat were to lose value, your futures contract would gain in value.  This is the idea of hedging...you buy another asset that moves in the opposite direction of your first asset...so the risk cancels each other out.  The idea is that by hedging, you should try to purchase / sell the exact right number of futures contracts to offset your risk of your physical asset. 

 

Financial Example:  Mortgages (short)

A very common example of short hedges may occur when a mortgage broker builds up an "inventory" of mortgages before selling them to an insurance company. This occurs when a mortgage banker first promises to his clients that he will deliver money in exchange for the promise (asset) that they will pay principal + interest for the next 30 years.  That, in and of itself, is like buying a forward contract, but dont focus on that right now.  First, think of it in a simplified manner...he will receive an asset in 60 days, and he plans on reselling that asset to someone else.  That, in its essence, is just like an inventory example shown above (like having an expected inventory of mortgages). 

 

The broker would be worried that a raise in interest rates could decrease the value of his inventory of mortgages.  (note that mortgages, like all bond, decrease in value when interest rates rise).   A decrease in the value of his inventory would hurt him because he wouldnt be able to sell the inventory for as high of a price as he would like.  That would mean making less money, or even taking a loss (if the inventory were to devalue too much).  This risk is something that most mortgage brokers are unwilling to take.

 

Again, the solution will be to sell (short) futures contracts.  But, in this case he will not find mortgage for trade on a futures market, so he will look for another asset that behaves similarly to his asset.  The most common asset to use is the Treasury Bonds, which also decreases in value when interest rates rise (and increase in value when interest rates fall).  This Treasury Bond will act as a proxy for his mortgages.

 

He sells Treasury Bonds in the futures markets, which means that he is short on Tbonds.  If the price were to fall, he would make money.  Hopefully enough to offset the loss he will face on his mortgages.

 

Summary:

 

If he is afraid that his mortgages will lose value, then he wants to sell them short in the futures market.  But, since mortgages don't trade, he instead sells Treasury Bonds short in the futures market.  That way, if interest rates rise, although he will lose money on his mortgages (inventory before he sells them to a bank), he will make off-setting money on the treasury bonds.  If he carefully plans the right number of treasury bonds to purchase, he should be able to (almost) completely insulate himself from interest rate risk. 

 

Risk is therefore offset by an offsetting transaction in the futures market.  The only thing to watch for is that the two assets might not have identical reactions to changes in interest rates, becasue of differences in maturity time, and a less than perfect correlation between the two assets.  The hedging is only really perfect if there is perfect correlation.  

 

 

 

Long Hedge

To have a long hedge is the same thing as saying that you are planning on buying something in the futures market, at a set price...so you are betting that the price will go up.   If you were speculating, then this would be your only position.  But because we are talking about hedging, then this is not your only move, but instead is your second move...in opposite motion, and is used to cancel out some risk of your underlying asset.  If you are afraid that a price increase might hurt you (in your regular business), then you would purchase a futures contracts to offset that risk.  If the prices did indeed increase, then your underlying asset would lose value, but your futures contract would increase in value...offsetting each other (if you bought the right futures contracts at the right volume).  

 

How to long hedge?

Buy in the futures market.  Buy a futures contract.

 

 

When to use a Long hedge:

If you are hurt by a price increase

 

 

 

Examples

Oil Example

You have agreed to sell a fixed amount of oil at a fixed price at some time in the future.  You then go to the market and find supplies, but if the supply price increases, you might end up losing money.  This risk can be hedged by buying futures contracts.    He takes a long position in the futures market.  Betting on a price increase.  which means that his contract will be more valuable if the price of oil in the market actually increases.  So, when it comes time to actually purchase the oil in the market (to resell to the client), if that price of oil has increase, then he will lose money on the physical goods, but make money on the futures contracts, netting out to zero (no risk of price change).  If the price of oil falls, then his long futures contract is worth less, but he makes up the difference in the physical market.  Again, the hedge involves purchasing a second asset that moves in opposite direction as your underlying asset, thereby eliminating risk.  

 

Financial Example:  Mortgages (long)

A mortgage broker should use a long hedge if they are hurt by price increases.  In order to hedge your potential losses on your primary asset (which looses money when prices go up), you purchase a second asset that earns money when prices go up. 

 

In the mortgage broker business, what scenario could occur where he would be hurt if the mortgage prices went up?

 

Imagine a case where the broker would have already sold the mortgages to an insurance company (or bank) at a fixed price, and then he goes out into the market looking for clients.  If they write a mortgage contract, then that contract becomes his asset that he resells to the insurance company (at the fixed price).  The trouble could come into the picture if the interest rates change between the time he arranges the fixed price with the insurance company, and the time he buys the contracts from the individuals. 

 

If interest rates fall, the mortgages will be more expense (for him to buy).   He will want to protect against a fall in interest rates buy buying another asset that would increase in value itself if the interest rates would fall....thereby offsetting his losses on his mortgages.  In this case, he would buy Treasury Bonds in the futures market.   If interest rates were to fall between now and then, his TBond futures would become more valuable, but his mortgages would become less.  If he correctly purchased the right number of Tbonds, he should offset most of this risk.  

 

Risk is therefore offset by an offsetting transaction in the futures market.  The only thing to watch for is that the two assets might not have identical reactions to changes in interest rates, because of differences in maturity time, and a less than perfect correlation between the two assets.  The hedging is only really perfect if there is perfect correlation.  

 

 

 

 

 

 

Using Credit default swaps to manage credit risk

 

 

Credit Default Swap (CDS) market can be used to manage credit risk without necessitating the sale of the underlying cash bond. Owners of a corporate bond can protect themselves from default risk by purchasing a credit default swap on that reference entity.

 

 

 

 

 

 

 

 

Definition of "hedging" from Wikipedia

 

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis," where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).

 

Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.

 

 

 

 

 

 

Example of a financial hedge

(from wikipedia)

 

A stock trader believes that the stock price of FOO, Inc., will rise over the next month, due to this company's new and efficient method of producing widgets. He wants to buy FOO shares to profit from their expected price increase. But FOO is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the FOO shares were underpriced, the trade would be a speculation.

 

Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of FOO's direct competitor, BAR. If the trader were able to short sell an asset whose price had a mathematically defined relation with FOO's stock price (for example a call option on FOO shares) the trade might be essentially riskless and be called an arbitrage. But since some risk remains in the trade, it is said to be "hedged."

 

The first day the trader's portfolio is:

  • Long 1000 shares of FOO at $1 each
  • Short 500 shares of BAR at $2 each

 

(Notice that the trader has sold short the same value of shares.)

 

On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. FOO, however, because it is a stronger company, goes up by 10%, while BAR goes up by just 5%:

 

  • Long 1000 shares of FOO at $1.10 each — $100 profit
  • Short 500 shares of BAR at $2.10 each — $50 loss

 

(In a short position, the investor loses money when the price goes up.)

 

The trader might regret the hedge on day two, since it reduced the profits on the FOO position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash -- 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since FOO is the better company, it suffers less than BAR:

 

Value of long position (FOO):

  • Day 1 — $1000
  • Day 2 — $1100
  • Day 3 — $550 => $450 loss

 

Value of short position (BAR):

  • Day 1 — $1000
  • Day 2 — $1050
  • Day 3 — $525

 

Without the hedge, the trader would have lost $450. But the hedge - the short sale of BAR - gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

 

 

 

Hedging currency risk

Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.

 

For example, labor costs are such that much of the simple commoditized manufacturing in the global economy today goes on in China and South-East Asia (Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of doing business in foreign countries, so many businesses are moving manufacturing operations overseas. But the benefits of doing this have to be weighted also against currency risk.

 

If the cost of manufacturing goods in another country is denominated in a currency other than the one that the finished goods will be sold for, there is the risk that changes in the values of each currency will reduce profit or produce a loss. Currency hedging is akin to insurance that limits the impact of foreign exchange risk.

 

Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the "Major Eight" (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the "Benchmark Currencies", and expands to include several others by virtue of liquidity.

 

Currency hedging, like many other forms of financial hedging, can be done in two primary ways: with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).

 

Example:

 

The financial investor may be a Hedge Fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency.

 

The hedge fund can separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by "hedging" out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events.

 

As with other types of financial products, hedging may allow economic activity to take place that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be "too expensive" if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.

 

 

Hedging equity & equity futures

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, you short futures when you buy equity. Or long futures when you short stock.

 

There are many ways to hedge, and one is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures. Buy 10000 GBP worth of Vodafone and short 10000 worth of FTSE futures.

 

Another method to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone is 2, then for a 10000 GBP long position in Vodafone you will hedge with a 20000 GBP equivalent short position in the FTSE futures (the Index that Vodafone trades in).

 

 

 

Futures hedging

If you primarily trade in futures, you hedge your futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. So if you are long futures in your trade you can hedge by shorting synthetics, and vice versa.

 

 

 

Contract for differences

A Contract for Differences (CfD) is a two way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. For instance, consider a deal between an electricity producer and an electricity retailer who both trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price.

 

In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.

 

 

 

Links

 

 

External Links

 

 

 

 

Related concepts

Forwards
A contracted agreement specifying an amount of currency to be delivered, at an exchange rate decided on the date of contract.
Forward Rate Agreement
A contract agreement specifying an interest rate amount to be settled, at a pre-determined interest rate on the date of the contract. This is also known as FRAs.
Currency option
A contract that gives the owner the right but not the obligation to take (call option) or deliver (put option) a specified amount of currency, at an exchange rate decided at the date of purchase.
Non-Deliverable Forwards (NDF)
A strictly risk-transfer financial product similar to a Forward Rate Agreement, but only used where monetary policy restrictions on the currency in question limit the free flow and conversion of capital. NDFs are, as the name suggests, not delivered, but rather, these are settled in a reference currency, usually USD or EUR, where the parties exchange the gain or loss that the NDF instrument yields, and if the buyer of the controlled currency truly needs that hard currency, he can take the reference payout and go to the government in question and convert the USD or EUR payout. The insurance effect is the same, it's just that the supply of insured currency is restricted and controlled by government. See Capital Control.
Currency correlation
Risk management
Currency swap
FX swap
Interest rate swap
Basis swap
Quanto swap
Diff swap
Interest rate parity and Covered Interest Arbitrage
The simple concept that two similar investments in two different currencies ought to yield the same return. If the two similar investments are not at face value offering the same interest rate return, the difference should conceptually be made up by changes in the exchange rate over the life of the investment. IRP basically gives you the math to calculate a projected or implied forward rate of exchange. This calculated rate is not and cannot be considered a prediction or forecast, but rather is the arbitrage-free calculation for what the exchange rate is implied to be in order for it to be impossible to make a free profit by converting money to one currency, investing it for a period, then converting back and making more money than if you had invested in the same opportunity in the original currency.
Distributed Funds Transfer Hedge (DFT-hedge)


 

 

 

 

Books about FX trading from Amazon.com

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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