In modern economic terminology, you can find many beautiful, but incomprehensible words. For example, hedging. What is it? In simple words, not everyone can answer this question. However, upon closer examination, it turns out that insurance of market operations can be defined by such a term, although a little specific.
Hedging - what are these simple words
So let's get it right. This word came to us from England (hedge) and in direct translation means a fence, a fence, and as a verb it is used in the meaning of “defend”, that is, try to reduce probable losses or avoid them altogether. And what is hedging in the modern world? We can say that this is an agreement between the seller and the buyer that the terms of the transaction will not change in the future, and the goods will be sold at a certain (fixed) price. Thus, knowing in advance the exact price at which the goods will be purchased, the participants in the transaction insure their risks against possible fluctuations in the foreign exchange market and, as a consequence, changes in the market price of the goods. Market participants involved in hedging transactions, that is, insuring their risks, are called hedgers.
How does it happen
If it’s still not very clear, you can try to simplify even more. Understanding what hedging is best done with a small example. As you know, the price of agricultural products in any country depends on weather conditions and how good the crop will be. Therefore, conducting a sowing campaign, it is very difficult to predict what the price of products will be in the fall. If the weather conditions are favorable, there will be a lot of grain, then the price will not be too high, but if there is a drought or, on the contrary, too frequent rains, then part of the crops may die, because of which the cost of grain will increase many times.
In order to protect themselves from the vagaries of nature, regular partners can conclude a special contract, fixing a certain price in it guided by the market situation at the time of conclusion of the contract. Based on the terms of the transaction, the farmer will be obliged to sell, and the client will buy the crop at the price that was specified in the contract, regardless of what price is currently on the market.
And here comes the moment when it becomes most clear what hedging is. In this case, several options for the development of the situation are likely:
- the price of the crop on the market is more expensive than the one prescribed in the contract - in this case, the producer, of course, is dissatisfied, because he could get more benefits;
- market price is less than specified in the contract - in this case, the buyer is already the loser, because he incurs additional costs;
- the price indicated in the contract at the market level - in this situation both are satisfied.
It turns out that hedging is an example of how you can profitably realize your assets even before they appear. However, such positioning does not exclude the possibility of a loss.
Ways and goals, currency hedge
On the other hand, we can say that risk hedging is insurance against various adverse changes in the foreign exchange market, minimizing losses associated with exchange rate fluctuations. That is, not only a specific product can be hedged, but also financial assets, both existing and planned for acquisition.
It is also worth saying that the correct currency hedging does not aim to receive the maximum additional income, as it might seem at the beginning. Its main task is to minimize risks, while many companies consciously refuse the additional chance to quickly increase their capital: for example, an exporter could play to lower the exchange rate, and a producer to increase the market value of the goods. But common sense tells us that it is much better to lose superprofits than to lose everything.
There are 3 main ways to maintain your foreign exchange reserve:
- Application of contracts (urgent) for the purchase of foreign currency. In this case, exchange rate fluctuations will not affect your losses in any way, nor will they bring any income. Currency purchase will occur strictly according to the terms of the contract.
- The introduction of protective clauses in the contract. Such items are usually bilateral and mean that if the exchange rate changes at the time of the transaction, the probable losses, as well as the benefits, are divided equally between the parties to the agreement. Sometimes, however, it happens that protective clauses concern only one side, then the other remains unprotected, and currency hedging is recognized as one-sided.
- Variations with bank interest. For example, if after 3 months you need a currency for calculations, and there are assumptions that the rate will change, it will be logical to exchange money at the existing rate and put it on deposit. Most likely, the bank percentage of the deposit will allow you to level out fluctuations in the exchange rate, and if the forecast does not materialize, there will be a chance to even earn a little.
Thus, we can say that hedging is an example of how your deposits are protected from the likely fluctuation of the interest rate.
Methods and Tools
Most often, the same methods of work are used by both hedgers and ordinary speculators, but do not confuse these two concepts.
Before discussing various instruments, it should be noted that the understanding of the question “what is hedging” is primarily for the purposes of the operation, and not in the means used. So, a hedger conducts a transaction in order to reduce the likely risk from a change in the value of the goods, while the speculator consciously takes such a risk, while hoping to get only a favorable result.
Probably the most difficult task is the right choice of a hedging instrument, which can conditionally be divided into 2 large categories:
- OTC represented by swaps and forward contracts; such transactions are concluded between the parties directly or through a specialist dealer;
- exchange hedging instruments, which include options and futures; in this case, trading takes place on special platforms - exchanges, and any transaction concluded there, as a result, turns out to be trilateral; the third party is the Clearing House of a particular exchange, which is the guarantor of the fulfillment by the parties of the contract of their obligations;
Both of these risk hedging methods have both advantages and disadvantages. Let's talk about them in more detail.
Exchange
The main requirement for goods on the exchange is the ability to standardize them. It can be both products of the food group: sugar, meat, cocoa,
crops , etc., and industrial products - gas, precious metals, oil, and others.
The main advantages of exchange trading are:
- maximum availability - in our age of advanced technologies, trading on the stock exchange can be conducted from almost anywhere in the world;
- significant liquidity - you can open and close trading positions at any time at your own discretion;
- reliability - it ensures the presence in each transaction of the interests of the clearing house of the exchange, which acts as a guarantor;
- fairly low transaction costs.
Of course, there were some shortcomings - perhaps the most basic can be called quite stringent restrictions on the terms of trade: the type of product, its quantity, delivery time and so on - everything is under control.
OTC
Such requirements are almost completely absent if you are trading on your own or with the participation of a dealer. OTC trading takes into account the wishes of the client as much as possible, you yourself can control the volume of the lot and the delivery time - perhaps this is the biggest, but almost the only plus.
Now about the shortcomings. There are much more of them, as you know:
- difficulties with selecting a counterparty - now you have to deal with this issue yourself;
- high risk of non-fulfillment by either side of its obligations - there is no guarantee in the form of an exchange administration in this case;
- low liquidity - if you terminate a previously concluded transaction, you are facing decent financial costs;
- considerable overhead costs;
- Long validity period - some hedging methods may cover periods of several years, since the requirements for variation margin are not applicable here.
In order not to be mistaken with the choice of a hedging instrument, it is necessary to conduct the most comprehensive analysis of the likely prospects and characteristics of a particular method. At the same time, it is necessary to take into account the economic characteristics and prospects of the industry, as well as many other factors. Now let's take a closer look at the most popular hedging instruments.
Forward
This term refers to a transaction that has a specified period in which the parties agree to supply a specific product (financial asset) at a specified date in the future, while the price of the product is fixed at the time of the transaction. What does this mean in practice?
For example, a certain company intends to purchase Euros from the bank for dollars, but not on the day the contract is signed, but, say, in 2 months. At the same time, it is immediately fixed that the rate is $ 1.2 per euro. If in two months the dollar / euro exchange rate will be 1.3, then the company will receive tangible savings of 10 cents per dollar, which, with the cost of the contract, for example, in a million, will save $ 100 thousand. If during this time the rate drops to 1.1, the same amount will be at a loss to the enterprise, and it is no longer possible to cancel the transaction, since the forward contract is an obligation.
Moreover, there are some more unpleasant moments:
- since such an agreement is not provided by the clearing house of the exchange, one of the parties may simply refuse to execute it upon unfavorable conditions for it;
- such a contract is based on mutual trust, which significantly narrows the circle of potential partners;
- if the forward contract is concluded with the participation of a certain intermediary (dealer), then expenses, overheads and commissions increase substantially.
Futures
Such a transaction means that the investor commits itself to buy (sell) a specified amount of goods or financial assets — shares, other securities — at a fixed base price after some time. Simply put, this is a contract for future delivery, but futures are an exchange product, which means its parameters are standardized.
Hedging by
futures contracts freezes the price of the future delivery of the asset (product), while if the spot price (the selling price of the goods on the real market, for real money and subject to immediate delivery) decreases, the lost profit is compensated by the profit from the sale of futures contracts. On the other hand, there is no way to use the growth of spot prices, the additional profit in this case will be offset by losses from the sale of futures.
Another drawback of futures hedging is the need to introduce a variation margin that maintains open urgent positions in working condition, so to speak, is a kind of guarantee collateral. In the event of a rapid increase in spot prices, you may need additional financial injections.
In a sense, hedging futures is very similar to ordinary speculation, but there is a difference, and this is very fundamental.
A hedger, using futures transactions, insures them with those operations that he conducts in the market for this (real) product. For a speculator, a futures contract is just an opportunity to generate income. There is a game on the price difference, and not on the purchase and sale of an asset, because a real product does not exist in nature. Therefore, all the losses or profits of a speculator in the futures market are nothing but the final result of his operations.
Options insurance
One of the most popular instruments for influencing the risk component of contracts is options hedging, let's talk about them in more detail:
Put option:
- the holder of an American option of the put type has the full right (however, is not obliged) at any time to implement a futures contract at a fixed strike price;
- by purchasing such an option, the seller of the commodity asset fixes the minimum selling price, while retaining the right to take advantage of a favorable price change for it;
- if the futures price falls below the exercise price of the option, the owner sells it (exercises), thereby compensating for losses in the real market;
- when the price increases, he may refuse to exercise the option and sell the goods at the most favorable cost to himself.
The main difference from the futures is the fact that when buying an option a certain premium is provided, which burns down in case of refusal to exercise. Thus, the put option can be compared with the traditional insurance familiar to us - in case of adverse events (insured event), the option holder receives a premium, and under normal conditions, it disappears.
Call type option:
- the holder of such an option is entitled (but not required) at any time to acquire a futures contract at a fixed strike price, that is, if the futures price is higher than the fixed price, the option can be exercised;
- for the seller, the opposite is true - for the premium received from the sale of the option, he undertakes to sell at the first request of the buyer a futures contract at the strike price.
At the same time, there is a guarantee deposit similar to that used in futures transactions (futures sale). A feature of a call type option is that it compensates for a decrease in the value of a commodity asset by an amount not exceeding the premium received by the seller.
Hedge Types and Strategies
Speaking about this type of risk insurance, it is worthwhile to understand that since at least two parties are present in any trading operation, hedging types can be divided into:
- hedge of investor (buyer);
- hedge of the supplier (seller).
The first is necessary to reduce the investor's risks associated with the likely increase in the value of the proposed purchase. In this case, the best options for hedging price fluctuations will be:
- sale of put option;
- acquisition of a futures contract or call option.
In the second case, the situation is diametrically opposite - the seller needs to protect himself from falling market prices for the goods. Accordingly, the hedge methods here will be the opposite:
- futures sale;
- purchase of put option;
- call option sale.
Under the strategy should be understood a certain combination of certain tools and the correctness of their application to achieve the desired result. As a rule, all hedging strategies are based on the fact that both the futures and spot prices of the goods change almost simultaneously. This makes it possible to reimburse in the derivatives market losses incurred from the sale of real goods.
The difference between the price determined by the counterparty to the real commodity and the price of the futures contract is taken as the “basis”. Its real value is determined by such parameters as the difference in the quality of goods, the real level of interest rates, cost and storage conditions of the goods. If storage involves additional costs, the basis will be positive (oil, gas, non-ferrous metals), and in cases where the possession of the goods before it is transferred to the buyer brings additional income (for example, precious metals), it will become negative. It should be understood that its value is not constant and most often decreases as the term of the futures contract approaches. However, if there is an increased (rush) demand for real goods, the market can go into a state where real prices will become much more than futures.
Thus, in practice, even the best strategy does not always work — there are real risks associated with abrupt changes in the “basis”, which are almost impossible to level with hedging.