Definition of Hedging Techniques

Introduction

A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization.

A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of over-the-counter and derivative products, and futures contracts.

Public futures markets were established in the 19th century to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.

Hedging means that making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.

An example of a hedge would be if you owned a stock, then sold a futures contract stating that you will sell your stock at a set price, therefore avoiding market fluctuations. Investors use this strategy when they are unsure of what the market will do. A perfect hedge reduces your risk to nothing (except for the cost of the hedge).

Hedging with Forwards

Hedging refers to managing risk to an extent that it is bearable. In international trade and dealings foreign exchange plays an important role. Fluctuations in foreign exchange rates can have significant implications on business decisions and outcomes. Many international trade and business dealings are shelved or become unworthy due to significant exchange rate risk embedded in them. Historically, the foremost instrument used for managing exchange rate risk is the forward rate. Forward rates are custom agreements between two parties to fix the exchange rate for a future transaction. This simple arrangement easily eliminates exchange rate risk, however, it has some shortcomings, particularly the difficulty in getting a counter party who would agree to fix the future rate for the amount and at the time period in question. In Malaysia many businesses are not even aware that some banks do provide forward rate arrangements as a service to their customers. By entering into a forward rate agreement with a bank, the businessman simply transfers the risk to the bank, which will now have to bear this risk. Of course, the bank, in turn, may have to make some other arrangement to manage this risk. Forward contracts are somewhat less familiar, probably because no formal trading facility, building or even regulating body exists.

An Example of Hedging Using Forward Agreement

Assume that a Malaysian construction company, ABC Corporation just won a bid to build a stretch of road in India. Now is July and the contract signed for 10,000,000 rupees, would be paid for in September. This amount is consistent with ABC’s minimum revenue of RM1,000,000 at the exchange rate of RM0.10 per rupee. Nonetheless, fluctuating exchange rates could end with a possible depreciation of rupees and thus render the project unworthy. ABC, therefore, enters into a forward contract with the First Bank of India to fix the exchange rate at RM0.10 per rupee. The forward contract is a legal agreement and, therefore, constitutes obligations on both sides. The First Bank may have to find a counter party for this transaction — either a party that wants to hedge against an appreciation of 10,000,000 rupees expiring at the same time or a party that wishes to speculate on an upward trend in rupees. If the bank itself plays the counter party, then the risk would be borne by the bank. The existence of speculators increases the probability of finding a counter party. By entering into a forward contract ABC is guaranteed of an exchange rate of RM0.10 per rupee in the future, irrespective of what happens to the spot rupee exchange rate. If the rupee were to actually depreciate, ABC would then be protected. However, if it were to appreciate, then ABC would have to forego this favourable movement and hence bear some implied losses. Even though a favourable movement could be lost, ABC still proceeds with the hedging since it knows that a “guaranteed” exchange rate of RM0.10 per rupee is consistent with a profitable venture.

Hedging with Futures

The futures market came into existence as an answer for the shortcomings inherent in the forward market. The futures market solves some of the shortcomings of the forward market, particularly the need and the difficulty in finding a counter party. A currency futures contract is an agreement between two parties to buy or sell a particular currency at a future date, at a particular exchange rate that is fixed or agreed upon upfront. This sounds a lot like the forward contract.

In fact, the futures contract is similar to the forward contract but is much more liquid. It is liquid because it is traded in an organized exchange — i.e. the futures market. Futures contracts are standardized contracts and thus are bought and sold just like shares in a stock market. The futures contract is also a legal contract just like the forward, however, the obligation can be ‘removed’ prior to the expiry of the contract by making an opposite transaction, i.e. if one had purchased a futures contract then one may exit by selling the same contract. When hedging with futures, if the risk is an appreciation in value, then one needs to buy futures, whereas if the risk is a depreciation then one needs to sell futures.

Consider our earlier example, instead of using forwards, ABC could have thus sold rupee futures to hedge against a rupee depreciation. Let’s assume accordingly that ABC sold rupee futures at the rate RM 0.10 per rupee. Hence the size of the contract is RM 1,000,000. Now assume that the rupee depreciates to RM 0.07 per rupee — the very thing ABC was afraid of (See Table ). ABC would then close the futures contract by buying back the contract at this new rate. Note that in essence ABC bought the contract for RM0.07 and sold it for RM0.10. This gives a futures profit of RM 300,000 [(RM0.10-RM0.07) x 10,000,000].

However, in the spot market ABC gets only RM 700,000 when it exchanges the 10,000,000 rupees at RM0.07. The total cash flow, however, is maintained at RM 1,000,000 (RM700,000 from spot and RM300,000 profit from futures). With perfect hedging the cash flow would always be RM1 million no matter what happens to the exchange rate in the spot market. One advantage of using futures for hedging is that ABC can release itself from the futures obligation by buying back the contract anytime before the expiry of the contract. To enter into a futures contract a trader, however, needs to pay a deposit (called an initial margin) first.

Then his position will be tracked on a daily basis so much so that whenever his account makes a loss for the day, the trader will receive a margin call (also known as variation margin), requiring him to pay up the losses.

Liquid and central market. Since futures contracts are traded on a Standardized Features of the Futures Contract and Liquidity

Unlike the forward contract, the futures contract has a number of features that have been standardized. These standard features increase the liquidity in the market, i.e. increase the number of transactions that match in terms of size and expiration. In the practical world, traders are faced with diverse conditions that need diverse actions (like the need to hedge different amounts of currency at different points of time in the future) such that matching transactions can be difficult. By standardizing the contract sizes (i.e. the amount) and the expiry dates, these different needs can be matched to some degree, even though not perfectly perhaps. Some of the standardized features include the expiry date, contract month, contract size, position limits (i.e. the number of contracts a party can buy or sell) and price limit (i.e. the maximum daily price movements allowed). Nevertheless, these standardized features introduce some hedging imperfections. In our earlier example, assuming the size of each rupee futures contract to be 2,000,000, then 5 contracts need to be sold for a contract size of 10,000,000 rupees. However, if the size of each contract is 3,000,000 for instance, then only 3 contracts can be sold, leaving 1,000,000 rupees unhedged. Therefore, with standardization, some part of the spot position can go unhedged. Some advantages and disadvantages of hedging using futures are summarized below:

Advantages of the Futures Contract

central market, this increases liquidity. There are many market participants and hence one may easily buy or sell futures contracts. The problem of double coincidence of wants that could exist in the forward market is greatly reduced. A trader who has taken a position in the futures market can easily make an opposite transaction and thereby close his or her position. However, such easy exit is not a feature of the forward market.

Leverage. Leverage is brought about by the futures market’s margin system, where a trader takes on a larger position with only a small initial deposit. If the futures contract with a value of RM1,000,000 requires an initial margin of only RM100,000, then a one per cent change in the futures price (i.e. RM10,000) would bring about a 10 per cent change relative to the trader’s initial outlay. This amplification of profits (or losses) is called leverage. Leverage allows the trader to hedge much bigger amounts with smaller outlays.

Positions can be easily closed out. As mentioned earlier, positions taken in the futures market can be easily closed out by making opposite transactions. If a trader had sold 5 rupee futures contracts expiring in December, then the trader could close that position by buying 5 December rupee futures. In hedging, such closing-out of positions is done close to the expected physical spot transactions. Profits or losses from futures would offset the opposite losses or profits from the spot transaction. Nevertheless, such offsetting may not be perfect due to the imperfections brought about by the standardized features of the futures contract.

Convergence. As the futures contract approaches expiration, its price and the spot price would tend to converge. On the day of expiration both prices should be equal. Convergence is brought about by the activities of arbitrageurs who would move in to profit if price disparities were to exist between the futures and the spot, i.e. buying in the cheaper market and selling in the higher priced one.

Disadvantages of the Futures Contract

Legal obligation. The futures contract, just like the forward contract, is a legal obligation. Being a legal obligation it can sometimes pose problems. For example, if futures are used for hedging a project that is still in the bidding process, the futures position can turn into a speculative position in the event the bidding turns out unsuccessful.

Standardizedfeatures. Since the futures contract has some of its features standardized like the contract size, expiry date, etc., perfect hedging may be impossible. Since over-hedging is also not advisable, some part of the spot transactions will, therefore, have to go unhedged.

Initial and daily variation margins. This is a unique feature of the futures contract. A trader who wishes to take a position in the futures market must first pay an initial margin or deposit. This deposit will be returned when the trader closes his or her position. Also, the futures contract is marked to market, i.e. its position is tracked on a daily basis and the trader would be required to pay up variation margins in the event of daily losses. The initial and daily variation margins can pose a significant cash flow burden on traders or hedgers.

Forego favourable movements. In hedging using futures, any losses or profits in the spot transaction would be offset by profits or losses from the futures transaction. Consider our earlier example where ABC sold rupee futures to protect against a rupee depreciation. However, if the rupee were to appreciate, then ABC would have to forego such favourable movements.

The above shortcomings of the futures contract, particularly it being a legal obligation, with margin requirements and the need to forego favourable movements, prompted the development and establishment of the options markets that deal in more flexible instruments, i.e. the options contracts.

Hedging using Options

A currency option may be defined as a contract between two parties — a buyer and a seller — whereby the buyer of the option has the right but not the obligation, to buy or sell a specified currency at a specified exchange rate, at or before a specified date, from the seller of the option. While the buyer of an option enjoys a right but not an obligation, the seller of the option, nevertheless, has an obligation in the event the buyer exercises the given right.

There are two types of options:

Call option — gives the buyer the right to buy a specified currency at a specified exchange rate, at or before a specified date.

Put option — gives the buyer the right to sell a specified currency at a specified exchange rate, at or before a specified date.

The seller of the option, of course, needs to be compensated for giving the right. The compensation is called the price or the premium of the option. The seller thus has an obligation in the event the right is exercised by the buyer.

For example, assume that a trader buys a September RM0.10 rupee call option for RM0.01. This means that the trader has the right to buy rupees for RM0.10 per rupee at any time until the contract expires in September. The trader pays a premium of RM0.01 for this right. The RM0.10 is called the strike price or the exercise price.

If the rupee appreciates over RM0.10 anytime before expiry, the trader may exercise his right and buy it for only RM0.10 per rupee. If, however, the rupee were to depreciate below RM0.10, the trader may just let the contract expire without taking any action since he is not obligated to buy it at RM0.10. In this case, if he needs physical rupee, he may just buy it in the spot market at the new lower rate.

In hedging using options, calls are used if the risk is an upward trend in price, while puts are used if the risk is a downward trend. In our ABC example, since the risk is a depreciation of rupees, ABC would need to buy put options on rupees. If rupees were to depreciate at the time ABC receives its rupee revenue, then ABC would exercise its right and thereby effectively obtain a higher exchange rate.

If, however, rupees were to appreciate instead, ABC would then just let the contract expire and exchange its rupees in the spot market at the higher exchange rate. Therefore, the options market allows traders to enjoy unlimited favourable movements while limiting losses. This feature is unique to options, unlike the forward or futures contracts where the trader has to forego favourable movements and there are also no limits to losses.

Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. When a firm bids for a project overseas, which involves foreign exchange risk, the options market allows it to quote its bid price and at the same time protect itself from the exchange rate fluctuations in the event the bid is won. In the case of hedging with forwards or futures, the firm would be automatically placed in a speculative position in the event of an unsuccessful bid, without any limit to its downside losses.

An Example of Hedging with Put Options

Consider our ABC Corp. example. Instead of already having won the contract in question, let’s, however, assume that it is in the process of bidding for it — as is the common case in real life. ABC wants a minimum acceptable revenue of RM1,000,000 after hedging costs, but ABC need to quote a bid price now. In this instance, ABC would face the exchange rate risk only upon winning the bid. Options fare better as a hedging tool here compared with forwards or futures due to the uncertainty in getting the contract. Assume that it is now July and the results of the bidding will be known only in September, and that the following September options quotes are available today:

RM0.10 call @ RM0.002

RM0.10 put @ RM0.001

Assume that the size of each rupee contract is 2,000,000 rupees. The following is how ABC could make its hedging strategy:

First, it needs to decide whether to buy puts or calls. Since ABC would receive rupees in the future if it won the contract, its risk is a depreciation of rupees. Therefore, it should buy puts.

What should the bid amount be? To answer this question we need to compute the effective exchange rate after incorporating the price of put, i.e. RM0.10 minus RM0.001 which equals RM0.099. Now the bid amount is computed as RM1,000,000/ RM0.099, which equals 10,101,010 rupees.

How many put contracts should it buy? To answer this, just take the bid amount and divide by the contract size, i.e. 10,101,010/2,000,000 equals 5.05. Since fractions of contracts are not allowed and we don’t over-hedge, 5 contracts are sufficient, with some portion going unhedged. However, if we want to guarantee a minimum revenue of RM1,000,000, we cannot tolerate any imperfections in the hedging. Therefore, in this example we should go for 6 contracts.

What is the cost of hedging? The cost of hedging is computed as follows: 6 contracts x 2,000,000 per contract x RM0.001 equals RM12,000. This cost of hedging is the maximum loss possible with options.

In September, ABC would have known the outcome of the bid and by then the spot rupee rate might have appreciated or depreciated. Let’s look at two scenarios where the rupee appreciates to RM0.20 in one and depreciates to RM0.05 per rupee in the other. Table shows the four outcomes possible and their cash flow implications.

The above example illustrates how options can be used to guarantee a minimum cash flow on contingent claims. In the case the bid is won, a minimum cash flow of RM1,000,000 is guaranteed while allowing one to still enjoy a favourable movement if that does take place. If the bid is lost, the maximum loss possible is the premium paid.

An example for hedging with the call option is when a firm bids to buy a property (e.g. land) in another country. Say, a company bids to buy a piece of land in Indonesia to plant oil palm trees. Assume that the bidding is in Indonesian rupiahs. Here the risk would be an appreciation of the rupiah. Therefore, buying call options on the rupiah would be the suitable hedging strategy.

If one analyzes it carefully, the options market is simply an organized insurance market. One pays a premium to protect oneself from potential losses while allowing one to enjoy potential benefits. An analogy, for example, is when one buys car insurance, by paying the premium. If the car gets into an accident one gets compensated by the insurance company for the losses incurred. However, if no accident happens, one loses the premium paid. If no accident happens but the value of the car appreciates in the secondhand market, then one gets to enjoy the upward trend in price. An options market plays a similar role.

In the case of options, however, the seller of an option plays the role akin to an insurance company.

Advantages and Disadvantages of Hedging using Options

The advantages of options over forwards and futures are basically the limited downside risk and the flexibility and variety of strategies made possible. Also in options there is neither the initial margin nor the daily variation margin since the position is not marked to market. This relieves traders from potential cash flow problems.

Options are, however, more expensive because they are much more flexible compared to forwards or futures. The option price is, therefore, probably its disadvantage.