What is hedging in simple terms?

In modern economic terms, you can meet a lot of beautiful but incomprehensible words.For example, "hedging".What is it?In simple words, this question can not answer each.However, a closer look reveals that this term can determine the insurance market transactions, however, a little peculiar.

Hedging - it's simple words

So let's deal.Word of this came to us from England (hedge) and in the literal translation means of fences, and it is used as a verb meaning "to defend themselves", that is to try to reduce the likelihood of loss or to avoid them altogether.What is hedging in the modern world?We can say that this is an agreement between buyer and seller that in the future conditions of the transaction will not change, and the goods will be sold at a certain (fixed) price.Thus, knowing the exact price at which the goods will be purchased, participants in the transaction hedge their risks against possible fluctuations in the currency market and, as a result, changes in the market price of the goods.Market participants engaged in hedging transactions, ie insuring their risks, are called hedgers.

As it happens

If you are still not very clear, you can try to simplify even more.To understand what hedging is easiest on a small example.As you know, the price of agricultural products in any country depends on including the weather, and how good the harvest is.Therefore sowing campaign spending, it is very difficult to predict what will be the price of the products fall.If weather conditions are favorable, it will be a lot of grain, and the price is not too high, but if drought occurs or, conversely, too frequent rains, part of the crops can be lost, which is why the price of grain will grow many times over.To protect themselves from the vagaries of nature, constant partners may conclude a special agreement, fixing it in a price being guided by market conditions at the time of conclusion of the contract.On the basis of this transaction, the farmer will be required to sell and the customer to buy the harvest at a price that was spelled out in the contract no matter what the price appears on the market at the moment.

Here and there comes a point when it becomes more obvious that such hedging.In this case, several options are likely developments:

• price of the crop on the market more expensive prescribed in the contract - in this case, the manufacturer, of course, unhappy because he could get more benefits;
• market price is less than specified in the contract - in this case, the loser is already a buyer, because it carries additional costs;
• price indicated in the agreement at the level of the market - in this situation are both satisfied.

turns out that hedging - an example of how to implement profitable assets before they occur.However, such positioning does not exclude the probability of losing.

methods and goals, a currency hedge

On the other hand, we can say that hedge risk - insurance against a variety of adverse changes in the foreign exchange market to minimize losses related to exchange rate fluctuations.That is hedged may be not only a particular product, but the financial assets as existing and planned to purchase.

should also say that the correct currency hedging is not intended to obtain maximum additional income, as it may seem at first.Its main task is to minimize the risks, while many companies deliberately refuse additional chance to quickly increase their capital: the exporter, for example, could play on the slide course, and the manufacturer - to increase the market value of the goods.But common sense tells us that it is much better to lose excess profit than all lose everything.

There are 3 main ways to maintain its foreign exchange reserves:

1. Applications contracts (futures) for the purchase of currency.In this case, fluctuations in the exchange rate does not reflect on your loss, nor bring income.Purchase of foreign currency will be strictly according to the terms of the contract.
2. Adding to the safeguards agreement.Such items are usually bilateral and means that when you change the exchange rate at the time of the transaction probable losses, as well as the benefits are divided equally between the parties.Sometimes, though, it happens that the safeguard clause apply only to one side, then the other is unsecured, and foreign exchange hedges is recognized sided.
3. Variations with bank interest.For example, if after 3 months, you will need currency for settlement, and at the same time there are suggestions that the rate will change in a big way, it would be logical to exchange money at the current exchange rate and put them on deposit.Most likely, the bank will allow a percentage of the contribution level fluctuations, and if the forecasts were not justified, there will be little chance of even money.

Thus, we can say that the hedge - an example of how your deposits are protected against possible fluctuations in interest rates.

Methods and Tools

Most often the same methods of work used as hedgers and speculators usual, but do not confuse these two concepts.

Before talk about different instruments, it should be noted - understanding of the question "what is a hedge" is primarily for the purpose of an operation, and not the means employed.Thus, the hedger conducts a transaction in order to reduce the probability of the risk of changes in value of the goods, the speculator is consciously is such a risk, while expecting only get a favorable result.

Probably the biggest challenge is the right choice of the hedging instrument, which can be divided into 2 broad categories:

• OTC submitted swaps and forward contracts;such deals are concluded between the parties, directly or through a specialist - a dealer;
• exchange hedging instruments, which include options and futures;in this case the sale takes place in special venues - exchanges, with any deal, it concluded, the outcome is a trilateral;Third Party Clearing House serves a specific exchange, which is the guarantor of the parties to the contract commitments;

Both methods of hedging are both advantages and disadvantages.We'll talk more about them.

Stock

basic requirement for commodities on the stock exchange - the ability to standardize them.These can be of foodstuffs: sugar, meat, cocoa, cereal, and so on. G., Industrial and - gas, precious metals, oil and others.

main advantages of stock trading are:

• maximum availability - in this age of advanced technology trading on the stock exchange can be carried out from virtually any corner of the planet;
• significant liquidity - to open and close trading positions at any time in its sole discretion;
• reliability - it provides a presence in the interests of each transaction exchange clearinghouse, which acts as a guarantor;
• quite low costs of transaction.

course, not without its shortcomings - perhaps the most basic can be called fairly restrictive in terms of trade: type of product, its quantity, delivery time and so on - everything is under control.

OTC

Such requirements are almost entirely absent, if you are trading on their own or with the assistance of the dealer.OTC trades as possible take into account the wishes of the client, as you can control the amount of batch and date of delivery - perhaps this is the biggest, but virtually the only plus.

Now the drawbacks.They are, as you know, much more:

• difficulties with the selection of a company - this issue is now you have to deal with on their own;
• high risk of failure of any of the parties to their commitments - guarantees in the form of Exchange administration in this case there is no;
• low liquidity - at cancellation of the deal before you get any decent financial costs;
• considerable overheads;
• long duration - some methods of hedging may cover periods of several years, as the variation margin requirements do not apply here.

Not to be mistaken with the choice of the hedging instrument, it is necessary to conduct a full analysis of the most likely prospects and peculiarities of a particular method.It should certainly take into account the economic characteristics of the industry and prospects, as well as many other factors.Now let's take a closer look at the most popular hedging instruments.

Forward

That concept denotes the deal, which has a fixed term, in which the parties agree on the supply of particular goods (financial asset) at some specified date in the future, with the price of goods is fixed at the time of the transaction.What does this mean in practice?

For example, the company plans to buy some of the bank for dollars Eurocurrency, but not on the day of signing the contract, and, say, 2 months.This right is fixed, that rate is $ 1.2 per euro.If after two months the dollar to the euro will be 1.3, the firm will receive tangible savings - 10 cents on the dollar that the value of the contract, such as a million, will save $ 100,000.If during this time rate drops to 1.1, the same amount will go to the losses the company, and to cancel the deal is no longer possible, since the forward contract is an obligation.

Moreover, there are a few unpleasant moments:

• since such an agreement does not provide clearing house exchange, one party may simply give up its execution upon the occurrence of adverse conditions for it;
• a contract based on mutual trust, which significantly narrows the range of potential partners;
• if a forward contract is the participation of a certain broker (dealer), the costs grow significantly, overhead and commissions.

Futures

This deal means that the investor undertakes some time to buy (sell) signified the quantity of goods or financial assets - shares and other securities - fixed on the base price.Simply put - it is a contract for future delivery, but the futures exchange is a product, which means that its settings are standardized.

Hedging futures price freezes future delivery of an asset (goods), while if the spot price (price of the sale of goods in the real market, with real money, and provided immediate delivery) drop, the profit shortfall is offset by gains from the sale of futures contracts.On the other hand, there is no way to use the increase in the spot price, the additional profit in this case will be neutralized losses from the sale of futures.

Another drawback of futures hedging becomes a need for variation margin, which supports open term positions in working order, so to speak, is a kind of collateral.In the case of the rapid growth of the spot price, you may need additional capital injections.

In a sense, hedging futures is very similar to the usual speculation, but there is a difference here, and very fundamental.

Hedger using futures transactions, hedging of the operations conducted by the market of the (real) goods.For the speculator futures contract - this is just an opportunity to generate income.Here is the game on the difference in price and not on the purchase and sale of an asset, because of the real product does not exist in nature.Therefore, any losses or profits on the futures market speculator is nothing else as the final result of its operations.

insurance options

One of the most popular instruments of influence on the risk component of contracts is to hedge options, let's talk more about them:

option type put:

• Holder American option type put has the full right (but notobliged to) at any time to implement a futures contract at a fixed price of the option;
• acquiring a call option, the seller of commodity asset fixes the minimum selling price, while reserves the right to take advantage of favorable changes in prices for it;
• Falling futures prices below the cost of exercising the option, the owner sells it (takes), thereby offsetting the loss of the real market;
• with increasing prices, he may refuse to exercise the option and sell the goods at the best value for themselves.

The main difference from the futures contract is the fact that the purchase option provided for a premium, which is burned in the case of non-performance.Thus, the put options can be compared with the traditional insurance familiar to us - in the worst-case scenario (the insured event) the holder of an option receives a premium, and under normal conditions, it disappears.

option type call:

• holder of such option shall be entitled (but not obliged) to any temporary purchase a futures contract at a fixed exercise price, that is, if the futures price over a fixed, option can be exercised;
• for the seller is the opposite - for a premium received on the sale of an option, it is obliged to sell at the first request buyer futures contract at the strike price.

In this case there is a security deposit, similar to that used for futures transactions (sale of futures).A feature of the type of call option is that it compensates for the decrease in value of marketable assets for an amount not exceeding the premium received by the seller.

types and hedging strategies

Talking about this type of insurance risks should be understood that, as in any transaction there are at least two sides, and the types of hedging can be divided into:

• hedge investor (buyer);
• hedge provider (seller).

first necessary to reduce the risk of the investor associated with the likely increase in the cost of the proposed purchase.In this case, the best options for hedging price fluctuations will be:

• sale option put;
• purchase of a futures contract or an option call.

In the second case the situation is diametrically opposite - the seller is necessary to protect themselves from falling market prices for goods.Accordingly, there are ways to hedge the reverse:

• sale of futures;
• purchase option put;
• sale of an option call.

Under the strategy should be understood a certain set of specific tools and use them correctly to achieve the desired result.As a rule, all hedging strategy based on the fact that the futures and spot commodity price changed almost in parallel.This makes it possible to compensate the futures market losses incurred from the sale of real goods.

difference between the price determined by the counterparty to the actual product and the price of a futures contract is accepted as the "basis".Its real value is determined by such parameters as the difference in the quality of goods, the level of real interest rates, the cost and conditions of storage of the goods.If storage is subject to additional costs, the basis is positive (oil, gas, non-ferrous metals), and in cases where the ownership of the goods until its transfer to the buyer brings additional income (for example, precious metals) will be negative.It is understood that there is no value of its constant and often decreases as the term of the futures contract.However, if the real goods arise suddenly increased (speculative) demand, the market may go into such a state, when the real price will be much more futures.

Thus, in practice, even the best strategy does not always work - there are real risks associated with abrupt changes in the "basis", which is almost impossible to neutralize by means of hedging.