What is hedging and how does it work – Examples

Hedging

Hedging is a tool that every investor should be familiar with. We tell you what the essence of the method is, who participates in it and when it needs to be used..

The basic principle

The word “hedge” is derived from the English hedge, which means “insurance” or “protection”. This is one way to protect yourself from unnecessary market risks. It works according to a simple principle:

• The investor receives a guarantee of the preservation of the price of the asset in case of changing market conditions.

• Investor agrees that if the market grows, he will receive a profit less than the maximum.

One of the hedging participants acquires the opportunity to buy or sell the asset in the future under conditions that are agreed in advance.

Let’s take an example of apples. Suppose the standard price for 1 ton of them for sales in September is 30,000 rubles. But this figure is changing:

• In a good season, a large harvest from all producers. The market has a high offer. Accordingly, the price falls.

• In a weak season, farms receive less yield. Due to low supply, the price per ton of apples rises.

Manufacturers do not know what the season will be, and want to protect themselves from risks. They buy a forward contract for the sale of apples at a price of 30,000 rubles per ton.

Then the following happens:

• The season turned out to be good – everyone has a big harvest. The market price of a ton fell to 25,000 rubles. The farm gives 20 tons under a contract for 600,000 rubles. If sold at a market price, it would receive 500,000. Hedging gains – 100,000.

• The season turned out to be bad. The market price of a ton rose to 35,000. The farm executes the contract and receives 600,000 rubles instead of 700,000. In this case, the second party to the contract wins from the hedge – the buyer.

Potential profit or loss due to market changes are not always equivalent. Therefore, hedging requires a serious approach to calculating and understanding the factors that affect the state of affairs.

Who and how is involved in hedging

A participant who protects against risks when hedging is called a hedger, and his counterparty is a business partner, another hedger. He also insures himself, but in the opposite direction.

Hedging instruments are any assets, even those that are not yet in the portfolio, but are planned for acquisition:

• currency;
• precious metals;
• property and consumer goods;
• securities;
• loan rates;
• commodities and energy.

In addition, a hedging contract also acts as a financial asset that you can sell or buy..

Example. The investor buys 100 shares of the company at a price of 800 rubles per share and hopes that the price will rise. But he knows that due to a number of difficultly predictable factors, the price may fall. Therefore, it acquires an option to sell the same 100 shares at 800 rubles in 6 months. The option provides an opportunity, but does not oblige to make a deal at this cost.

When buying an option, he will pay an option premium. This is the amount that the buyer is guaranteed to receive if the investor does not begin to implement the transaction.

Six months later, there are two options:

• Shares rose. The investor waives the option and makes a profit from the price increase.

• Shares fell. The investor exercises the option and sells shares at 800 rubles, minimizing losses.

The bottom line is risk optimization. The investor receives protection from a major loss if the situation is negative. When planning a hedge, you need to consider operating expenses (premiums on options and commissions).

Types of hedging

Hedging differs in the type of contract. They can be stock (futures or options) or over-the-counter (forward or over-the-counter).

Exchange contracts

Exchange contracts are opened on exchanges and, in addition to counterparties, there is a third party in them – the regulator. It ensures that contractual obligations are met. Stock options and futures are independent assets that can also be sold or bought. Here’s how they differ:

• Futures oblige counterparties to execute a transaction on pre-agreed conditions.

• The option gives the right to buy or sell exchange commodities on pre-agreed conditions. In this case, only one of the participants in the transaction will be required to fulfill it. It depends on the type of option:

• Call – call option. Gives the right to buy an asset at an agreed price. The seller will be required to sell it..

• Put – put option for sale. Grants the right to sell the asset at an agreed price. The buyer will be required to buy it..

Advantages of exchange contracts: contract security, the ability to use assets in other transactions, quick search of a counterparty. Cons: the exchange puts forward stringent requirements for operations, limits the choice of assets.

OTC Contracts

Over-the-counter options and forwards are transactions concluded outside of the exchange, through intermediaries or directly. They occur rarely, are not regulated by a third party, and are not independent assets, that is, they cannot participate in sales transactions. Forward is an over-the-counter futures counterpart.

The advantage of such contracts is the greatest flexibility in the terms of the contract – no one restricts counterparties in choosing assets, terms, prices and other provisions. True, there are significant shortcomings: a high risk of default, low liquidity (it is difficult to find a counterparty on your own), more significant costs are possible.

If desired, the parties involved in the transaction, the hedge covers it in whole or in part. The second option applies when the risks are relatively small. Partial hedge costs less.

Hedge Contract Combination

Experienced players combine hedging instruments with each other, developing the least risky strategy.

Consider this with an example of a store purchasing apples. He plans to buy 30 tons of apples in September at a price of 30,000 rubles per ton, but fears that prices will rise in the event of a poor harvest. In order to protect itself from risks, but also not to lose the benefit from a possible increase in value, the store concludes two transactions:

• Futures for the purchase of 30 tons of apples for 900,000 rubles. Mandatory transaction.

• Option to sell 30 tons of apples for 900,000 rubles. You can refuse this transaction..

The option insures the store against futures losses. Here’s how it works:

• The price rose to 40 rubles per ton. The store fulfills futures obligations and buys apples below the current market price.

• The price dropped to 20 rubles per ton. The store fulfills futures obligations (buys for 900,000), then implements an option (sells for 900,000). Now you can buy a batch at a favorable current price.

In both cases, the profit of the enterprise will be equal to profit from the sale minus the costs of securing transactions.

Conclusion

Hedging is a delicate tool, which is not worth approaching without painstaking calculations. It protects against risk, but not from loss. Errors in planning lead to a situation in which the investor will receive either a modest plus or a significant minus. If you still do not have much experience in managing cash, securities and other assets, it is better to take the time to further study the field and prefer the traditional portfolio diversification.

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