What is hedging

Description

Definition and examples.

Hedging is the use of one instrument to reduce the risk associated with the adverse effect of market factors on the price of another associated with the first instrument or on the cash flows generated by it.
The hedged asset may be a commodity or financial asset that is on hand or planned to be purchased or produced. The hedging instrument is chosen so that adverse changes in the price of the hedged asset or associated cash flows are offset by changes in the relevant parameters of the hedging asset.

Here are some examples:

1. A gasoline producer buys oil and plans to sell the gasoline produced from it in 3 months. However, he fears that during this time, oil prices (and, with them, gasoline prices) will fall, which will lead to a shortfall in profits and possibly even losses. To reduce the risk, he enters into a forward contract for the supply of gasoline with a maturity date of 3 months.
2. In the previous example, the gasoline producer insured itself against a decrease in oil prices; however, at the same time, it lost the opportunity to receive additional profit from a possible increase in them. Instead of selling the forward contract, he could buy a put option on a gasoline futures contract with a maturity of 3 months (or a little more). An option of this type gives its owner the right to sell the goods at a predetermined price or refuse the transaction. Having spent some money today, the gasoline producer has fixed the minimum delivery price, retaining the ability to sell gasoline at a higher price if the market conditions are favorable for it.
3. A European firm plans to take a dollar loan from a bank for 3 months at a rate of LIBOR + 3% in 6 months. To reduce the risk of an increase in the cost of servicing it when interest rates rise, it sells on the CME exchange a futures contract for a three-month eurodollar deposit with a maturity in 6 months (the futures price, in this case, is defined as 100% – the deposit rate, therefore, with an increase in interest rates profitable is a “short” position in the derivatives market, i.e., sale).
4. The US investor includes 30-year fixed-coupon US Treasury bonds in the conservative portion of his portfolio. In order to protect the real returns on these bonds from the effects of inflation, he portfolios bonds with fixed interest coupons and par values ​​indexed to the current rate of inflation (CPI-U).
5. A Japanese firm delivers a product to the US and receives payment for it in dollars, which it then converts into yen. To hedge the risk of a rise in the yen against the dollar, the firm buys JPY/USD futures).
6. 6. 25% of Texas’s local taxes come from oil-producing and refining companies. When world oil prices fall, tax revenues are reduced. In order to stabilize future cash flows, the state administration has developed a hedging program for the future sale price of oil (this is a real-life example).
As can be seen from the above examples, hedging can be used to reduce the risk of losses associated with changes in both commodity prices and other market factors (exchange rates, interest rates). In the future, however, we will focus on the hedging of commodity items.

Sources of price risk.

Before answering the key question “to hedge or not to hedge”, a company must assess its exposure to price risk. This exposure occurs when the following conditions are met:
1. Prices for inputs (services) or outputs are not constant.
2. The Company cannot set prices for raw materials (services) at its discretion.
3. The company cannot freely set prices for output products while maintaining the volume of sales (in physical terms).
Now, let’s dwell on the main sources of risk associated with possible price changes:
1. Unsold stocks of finished products.
2. Non-produced products or future harvest.
3. Concluded forward contracts.

Basic hedging instruments.

Before talking about specific instruments, it should be noted that when we use the term “hedging”, we mean, first of all, the purpose of the transaction, and not the means used. The same instruments are used by both the hedger and the speculator; the only difference is their purpose. The hedger enters into a trade in order to reduce the risk associated with a possible price movement; the speculator deliberately takes this risk, counting on a favorable outcome.
Depending on the form of organization of trade, all hedging instruments can be divided into exchange and over-the-counter.
OTC hedging instruments are primarily forward contracts and commodity swaps. Transactions of these types are concluded directly between counterparties or through the mediation of a dealer (for example, a swap dealer).
Exchange hedging instruments are commodity futures and options on them. These instruments are traded on specialized trading platforms (exchanges). The essential point here is that one of the parties in each purchase and sale transaction is the clearing house of the exchange, which guarantees the fulfillment of both the seller’s and the buyer’s obligations. The main requirement for exchanging commodities is the possibility of their standardization. The standardized goods include, first of all, oil and oil products, gas, non-ferrous and precious metals, and food products (cereals, meat, sugar, cocoa, etc.).
Now, let’s briefly list the main advantages and disadvantages of exchange and over-the-counter hedging instruments:
OTC instruments:
Advantages
• to the maximum extent, take into account the requirements of a particular client for the type of goods, lot size, and delivery conditions
Disadvantages
• low liquidity – termination of a previously concluded transaction is usually associated with significant material costs
• relatively high overhead costs
• significant restrictions on the minimum lot size
• search difficulties counterparty;
• in the case of direct transactions between the seller and the buyer, there is a risk that the parties will not fulfill their obligations.
 

Exchange instruments:

Advantages
• high liquidity of the market (position can be opened and liquidated at any time)
• high reliability – the clearing house of the exchange acts as a counterparty for each transaction
• relatively low overhead costs for the transaction
• availability – using telecommunications, trading on most exchanges can be conducted from anywhere in the world
Disadvantages
• very strict restrictions on the type of goods, lot sizes, conditions, and delivery time

Futures price.

The use of futures exchange instruments for hedging transactions with real goods is based on the fact that the futures price of the goods and its price on the spot market change to a large extent in parallel. If this were not the case, then there would be the possibility of arbitrage between the cash and futures markets.
For example, if the futures price significantly exceeds the spot price, then there is the following possibility:
1. Take a loan
2. Buy a consignment of goods on the spot market
3. Sell the futures contract on the futures market
4. Upon closing the futures contract, deliver the real goods
5. Pay off the loan.
Thus, the difference between the futures price and the spot price reflects such factors as the cost of debt capital (i.e., the current level of interest rates) and the cost of holding this type of commodity. This difference is called the basis. The basis can be either positive (for commodities that are costly to maintain, such as oil and non-ferrous metals) or negative (for value-added commodities by holding before delivery, such as precious metals).
The basis value is not constant; it is subject to both systematic and random changes. The general pattern is a decrease in the absolute value of the basis with the approaching delivery time for a futures contract.
It should be noted that in the presence of a rushed demand for a cash commodity, the market can go into an “inverted” state when cash prices exceed futures prices, and this excess can be quite significant.

Hedging strategies.

A hedging strategy is a set of specific hedging instruments and how they are used to mitigate price risks.
All hedging strategies are based on the parallel movement of the spot price and the futures price, the result of which is the ability to recover on the derivatives market the losses incurred on the real commodity market. However, as we have already noted, this similarity is not perfect. Basis volatility entails residual risk that cannot be eliminated by hedging.
There are 2 main types of hedging – the buyer’s hedge and the seller’s hedge.
The buyer’s hedge is used when an entrepreneur plans to buy a consignment of goods in the future and seeks to reduce the risk associated with a possible increase in its price. The basic methods of hedging the future purchase price of a commodity are buying a futures contract on the futures market, buying a call option, or selling a put option.
The seller’s hedge is used in the opposite situation, i.e., if necessary, to limit the risks associated with a possible decrease in the price of the goods. Ways of such hedging are the sale of a futures contract, the purchase of a put option, or the sale of a call option.

Let’s consider the main methods of hedging using the seller’s hedge as an example.

1. Hedging by selling futures contracts.

This strategy consists of selling futures contracts in the futures market in an amount corresponding to the volume of the hedged batch of real goods (full hedge) or less (partial hedge).
A deal on the derivatives market is usually concluded at a point in time when
1. the seller can predict with a high degree of certainty the cost of the sold consignment of goods
2. the prices on the derivatives market have formed, providing an acceptable profit.
For example, suppose a gasoline manufacturer wants to hedge its future selling price, and the cost of refining oil can be estimated at the time of its purchase. In that case, the hedge is entered at the same moment, i.e., open positions in the futures market.
Hedging with futures contracts fixes the price of future delivery of a commodity; at the same time, in the event of a drop in prices on the spot market, the lost profit will be compensated by the income from the sold futures contracts (if the futures price drops, the traded futures makes a profit). However, the other side of the coin is the impossibility of taking advantage of rising prices in the real market – additional profit in the “spot” market, in this case, will be “eaten” by losses on sold futures.
Another disadvantage of this hedging method is the need to constantly maintain a certain amount of collateral for open futures positions. When the spot price for a real product falls, maintaining the minimum margin is not a critical condition because, in this case, the seller’s exchange account is replenished with a variation margin on the sold futures contracts; however, as the spot price rises (and the futures price rises with it), the variation margin on open futures positions is removed from the exchange account, and additional funds may be required.

2. Hedging by buying a put option.

The holder of an American put option has the right (but not the obligation) to sell the futures contract at a fixed price (the strike price of the option) at any time. Having bought an option of this type, the seller of the goods sets the minimum selling price while retaining the opportunity to take advantage of the price increase that is favorable for him. When the futures price drops below the strike price of the option, the owner executes it (or sells it), compensating for losses in the real commodity market; when the price rises, he waives his right to exercise the option and sells the commodity at the highest possible price. However, unlike a futures contract, when buying an option, a premium is paid, which disappears when the option is canceled.
The purchased option does not require a guarantee.
Thus, hedging by buying a put option is similar to traditional insurance: the insured receives compensation in the event of an unfavorable development of events for him (in the event of an insured event). It loses the insurance premium in the normal development of the situation.

3. Hedging by selling a call option.

The holder of an American call option has the right (but not the obligation) to buy the futures contract at a fixed price (strike price) at any time. Thus, the owner of an option can exercise it if the current futures price is greater than the strike price. For the option seller, the situation is reversed – for the premium received when selling the option, he assumes the obligation to sell, at the request of the option buyer, a futures contract at the strike price.
The margin for a sold call option is calculated similarly to the margin for a traded futures contract. Thus, the two strategies are largely similar; their difference lies in the fact that the premium received by the seller of the option limits his income on the urgent position; as a result, the written option compensates for the decrease in the price of the commodity by an amount no greater than the premium received by it.

4. Other hedging instruments.

A significant number of other options-based hedging methods have been developed (for example, selling a call option and using the resulting premium to buy a put option with a lower strike price and a call option with a higher strike price).
The choice of specific hedging instruments should be made only after a detailed analysis of the needs of the hedger’s business, the economic situation and prospects of the industry, and the economy as a whole.
The simplest in terms of implementation is the full short-term hedging of a single batch of goods. In this case, the hedger opens a position on the futures market, the volume of which corresponds as closely as possible to the volume of a lot of real goods sold, and the term of the futures contract is chosen close to the term of the real transaction. Positions on the futures market are closed at the moment of execution of the transaction on the spot market.

However, the real needs of the business cannot always be satisfied with such a simple scheme.

1. If it is necessary to hedge long-term transactions (more than 1 year), it is usually not possible to select a futures contract with an appropriate maturity and sufficient liquidity. In this case, resort to a practice called “roll” (roll-over). It consists of the fact that first, a position is opened on a closer contract (for example, with a maturity in 6 months), and as liquidity improves for longer delivery dates, positions are closed in the near months, and positions are opened in distant ones.
2. It is also more difficult to hedge with a continuous or close-to-continuous production cycle. In this case, there are always open positions on the derivatives market with different delivery times. Managing such an ever-changing “cash-term” position can be a daunting task.
3. It is not always possible to select an exchange commodity that exactly corresponds to the object of a real transaction. In these cases, additional analysis is required to determine which commodity, or perhaps a group of commodities, is best suited to hedge a commodity’s position in the real market.
4. In some cases, when prices change, the potential sales volumes also change. At the same time, the above hedging schemes turn out to be ineffective because there is a situation of “under-hedging” (the hedge volume is less than the real position volume) or “over-hedging” (the hedge volume is greater than the real position volume). In both situations, the risk increases. The way out is dynamic hedging, when there is a constant analysis of the compliance of the size of the urgent position with the situation in the real market and, if necessary, changing this size.

Hedging cost.

The main difference between hedging and other types of operations is that its purpose is not to extract additional profit but to reduce the risk of potential losses.
Because there is almost always a price to pay for risk reduction, hedging usually involves additional costs (in the form of direct costs and lost profits). Here are a few sources of these costs:
• By entering into a trade, the hedger transfers part of the risk to the counterparty; such a counterparty can be another hedger (also reducing his risk) or a speculator whose goal is to close a position in the future at a more favorable price for himself. Thus, the speculator takes on additional risk, for which he receives compensation in the form of real money (for example, when selling an option) or the possibility of receiving it in the future (in the case of a futures contract).
• The second reason for the cost of hedging is that any transaction entered into involves costs in the form of commission payments and the difference between the purchase and sale prices.
• Another cost item in hedging with exchange-traded instruments is the security deposit charged by the exchange to ensure that participants in the transaction fulfill their obligations. The amount of this deposit usually ranges from 2% to 20% of the volume of the hedged position and is determined primarily by the price volatility of the underlying commodity. Collateral is required only for those term instruments for which their owner has or may have certain obligations, i.e., for futures and sold options.
• Finally, another source of hedging costs is the variation margin calculated daily on futures and, in some cases, option positions. Variation margin is removed from the hedger’s exchange account if the futures price moves against his futures positions (i.e., towards his real market position) and credited to the account if the futures price moves the other way. It is in the form of a variation margin that the hedger compensates for its possible losses in the real commodity market. However, it must be taken into account that the movement of funds on the urgent part of the transaction usually precedes the movement of funds on its cash part.
• For example, in the case of hedging with futures contracts, if the hedger incurs losses in the real market and makes a profit in the derivatives market, then he receives a variation margin on open futures before fixing losses in the real market (i.e., the situation is favorable for him). However, in the opposite case (loss on futures contracts and profit on the spot market), the hedger also pays the variation margin before making a profit on the actual delivery of the goods, which can increase the cost of hedging.

The risk associated with a hedged position.

The purpose of hedging is to reduce price risk. However, it is usually not possible to eliminate dependence on an unfavorable price movement in the real asset market. Moreover, an insufficiently developed hedging strategy can increase the company’s exposure to price risk.
The main type of risk inherent in hedging is the risk associated with the non-parallel movement of the price of a real asset and the corresponding forward instrument (in other words, with the volatility of the basis). Basis risk is present because of the somewhat different operation of the law of supply and demand in the cash and futures markets. The prices of the real and futures markets cannot differ too much because. At the same time, arbitrage opportunities arise, which, due to the high liquidity of the derivatives market, are almost immediately reduced to nothing. However, some basic risks always remain.
Another source of basic risk is administrative restrictions on the maximum daily fluctuations in the futures price set by some exchanges. The presence of such rules can lead to the fact that if term positions need to be closed during strong movements in the price of a real asset, the difference between the futures price and the spot price can be quite large.
Another type of risk that hedging is powerless to deal with is the systemic risk associated with unpredictable changes in legislation, the introduction of duties and excises, etc., and so on. Moreover, in these cases, hedging can only make matters worse, as open-term positions do not give the exporter the opportunity to reduce the negative impact of these actions by reducing the volume of deliveries.

Basic principles of hedging.

1. An effective hedging program does not aim to eliminate risk; it is designed to transform risk from unacceptable to acceptable forms. The goal of hedging is to achieve an optimal risk structure, i.e., the balance between the benefits of hedging and its cost.
2. When deciding on hedging, it is important to assess the amount of potential losses that the company may incur in case of refusal to hedge. If the potential losses are insignificant (for example, they have little effect on the firm’s income), the benefits of hedging may be less than the costs of its implementation; in this case, the company should refrain from hedging.
3. Like any other financial activity, a hedging program requires the development of an internal system of rules and procedures.
4. The effectiveness of a hedge can only be assessed in the context of (it makes no sense to talk about the profitability of a hedging operation or the losses on a hedging operation in isolation from the main activity in the spot market)
What the hedge provides.
Despite the costs associated with hedging and the many challenges a company may face in developing and implementing a hedging strategy, it plays an important role in sustainable development:
• There is a significant reduction in the price risk associated with the purchase of raw materials and the supply of finished products; Hedging interest rates and exchange rates reduces the uncertainties of future cash flows and enables more efficient financial management. As a result, fluctuations in profits are reduced, and production controllability is improved.
• A well-designed hedging program reduces both risk and cost. Hedging frees up company resources and helps management focus on aspects of the business where the company has a competitive advantage while minimizing non-central risks. Ultimately, hedging increases capital, reducing the cost of using funds and stabilizing returns.
• The hedge does not interfere with normal business transactions and allows for ongoing price protection without the need to change inventory policies or enter into long-term forward contracts.
• In many cases, a hedge makes it easier to raise credit: banks value hedged collateral at a higher rate; the same applies to contracts for the supply of finished products.
Once again, we note that hedging does not aim to increase profits as its immediate task; the source of profit is the main production activity.

Practical steps.

In order to use futures instruments for hedging price risk, a company must take the following steps:
1. Select a trading platform and a futures contract traded on it that best suits its needs. At this step, additional analysis is required since there is not always a fixed-term contract that fully corresponds to the object of the commodity transaction. In this case, it is necessary to choose one of the available futures, the dynamics of price changes which most closely matches the dynamics of the price of a real product.
2. Select a clearing company (a company that controls the movement of funds and guarantees the fulfillment of obligations under transactions) accredited on the relevant exchange, as well as an exchange broker who will execute trading orders.
3. Fill out standard forms and sign service contracts.
4. Open an account with a clearing company and transfer a certain amount of funds to it, which is used as security for the fulfillment of obligations on open positions (usually about 10% of the planned transaction amount). Many exchanges and clearing companies set a minimum amount of funds that must be credited to a trading account upon opening it (usually $10,000).
5. Develop a hedging strategy.

Hedging of basic commodities.

Oil and oil products.

The bulk of trading in futures contracts for oil and oil products is concentrated on two exchanges – in London at the International Petroleum Exchange (IPE – International Petroleum Exchange) and at the New York Mercantile Exchange (NYMEX – New York Mercantile Exchange).
NYMEX.
Futures and options on futures for the following petroleum products are traded on the NYMEX:
• light crude oil (Light Sweet)
• fuel oil
• unleaded gasoline
Trading volumes for 1997-1998 are shown in the following table:

Contract
Futures Options Volume (mln tons)
Crude oil 28,964,383 7,476,904 4,900
Fuel oil 8,619,979 828,494 1,350
Unleaded gasoline 7,880,645,754,812 1,000
Note.
When converting volume indicators into weight indicators, the following coefficients were used:
Crude oil – 7.33 bar/t.
Fuel oil – 7.0 bar/t.
Petrol – 8.5 bar/t.

1. Crude oil.

The volume of world trade in crude oil exceeds the volume of trade in any other commodity. The NYMEX trades futures and options for light crude oil (low sulfur). It is the world’s most liquid futures contract. Due to its high trading volume and market transparency, it is used as one of the world’s main benchmarks for oil prices.
The NYMEX trades futures contracts and options on futures contracts of the American type (the option holder can exercise it at any time before the closing of the corresponding futures contract).
The object of supply: in addition to ‘Light Sweet’ oil, other grades of oil (including “Brent”) can also be supplied under the contract with discounts (or surcharges) specified in the specification.
Futures contract volume: 1000 barrels.
Trading Hours: 9:45 – 15:10 (main session), 16:00 – 08:00 (e-trading)
Delivery Months: 36 monthly futures contracts traded simultaneously (each month for the next 3 years) and long-term futures (3, 4, 5, 6, and 7 years old)). The main trading volumes are usually concentrated on the three closest contracts. Options – 12 consecutive months, as well as 18, 24, and 36 months with expiration in June and December).
Price change step: 1 cent/barrel ($10/contract)
Maximum price movement per day: for the nearest two futures contracts – $15/barrel ($15,000/contract), no limits are set for options.
Security deposit: $1620/contract

2. Unleaded gasoline.

The NYMEX trades futures contracts and options on American-style futures contracts.
Delivery object: unleaded gasoline.
Futures contract volume: 42,000 gallons (1,000 barrels).
Trading Hours: 9:45 AM – 3:10 PM (main session), 4:00 PM – 8:00 AM (e-trading)
Delivery Months: 18 monthly futures contracts are traded simultaneously. The main trading volumes are usually concentrated on the three closest contracts—options – for 12 consecutive months.
Price change step: 0.01 cents/gallon (4.2 dollars/contract)
Maximum price movement per day: for the nearest two futures contracts – 40 cents/gallon (16,000 dollars/contract), no limits are set for options.
Security deposit: 1620 USD/contract

3. Fuel oil.

Fuel oil is the second largest fraction of oil (after gasoline). Initially, the NYMEX futures market participants were mainly large wholesalers and consumers of fuel oil. Still, in recent years, consumers and manufacturers of diesel and aviation fuel have become more involved in trading (prices for these goods on the world market are usually set based on the futures price of fuel oil on the NYMEX with a stable premium).
The NYMEX trades futures contracts and options on American-style futures contracts.
Delivery object: fuel oil (heating oil N2).
Futures contract volume: 42,000 gallons (1,000 barrels).
Trading hours: 9:45 – 15:10 (main session), 16:00 – 8:00 (e-commerce)
Delivery Months: 18 monthly futures contracts are traded simultaneously. The main trading volumes are usually concentrated on the three closest contracts. Options – 12 consecutive months.
Price change step: 0.01 cents/gallon (4.2 dollars/contract)
Maximum price movement per day: for the nearest two futures contracts – 40 cents/gallon (16,000 dollars/contract), no limits are set for options.
Security deposit: 1620 USD/contract

International Petroleum Exchange
IPE trades futures and options for North Sea Brent oil and diesel fuel.
Trading volumes for the period from April 1, 1998 to March 31, 1999 are shown in the following table:

Contract
Futures Options Volume (mln tons)
Crude oil 13,988,556 365,930 1,958
Diesel fuel 5,276,713 93,436,716

The trading organization in London is generally similar to New York, but there are some differences:
• Trading hours: 10:00 – 20:15 GMT (7:00 – 17:15 MSK)
• There are no restrictions on daily price fluctuations on IPE, which makes it easier to enter and exit the hedge during strong price movements;
• if the position is not closed at the close of trading under the contract, it can be settled in cash (without the need to make or take delivery of the real goods)
• options on futures are margined, i.e., write-off and accrual of variation margin is carried out according to the same rules as for futures (at the same time, of course, the fundamental rule is observed – the maximum margin written off on a purchased option cannot exceed that paid for premium) • security
deposit under both contracts – $1600

1. CJSC “LUKOIL-Perm”. The impetus for hedging for the company was the fall in crude oil prices in the second quarter of 1996 from $22 to $18 per barrel, on the one hand, and the crisis in the sale of petroleum products on the domestic market, on the other. The first experience of hedging was the sale on January 15, 1997, of 30 contracts for fuel oil (Heating Oil) on the NYMEX, which hedged 10% of exports of petroleum products. Since there is a significant time difference between IPE and NYMEX trading (5 hours), the company moved trading to London. At the same time, hedging of crude oil supplies began. During the period from January to July 1997, 7 transactions were made with futures contracts on IPE and NYMEX. The trading volume was 180 contracts for fuel oil, which is approximately equal to 20,000 tons, and 300 contracts for oil, which was 39,484 tons. According to the results of the whole period, the variation margin in the amount of 115,645 US dollars was received from operations with futures, which covered the loss on the spot market. The average duration of one transaction (the difference between opening and closing a position) is 8 days. The total duration of all transactions is 56 days, or 28% of the entire account maintenance period (197 days). Trading volumes, of course, are difficult to compare with the company’s export volumes. But this experience was the first, and it seems to have succeeded. Difficult to compare with the company’s export volumes. But this experience was the first, and it appears to have succeeded. Difficult to reach with the company’s export volumes. But this experience was the first, and it seems to have grown.

2. Another example of hedging is the experience of Texas. After the fall in oil prices in 1986 from $35 per barrel to $11, a situation developed in which the state treasury, a quarter dependent on revenues from oil duties, was almost empty, as the state could not collect the expected amount (the size of the lost duties amounted to $3.5 billion). In order to prevent such a situation from happening again in the future, a program of hedging tax revenues was developed using options. All trades were made on NYMEX. The operation began in September 1991, and a price of $21.5 per barrel was chosen for hedging (during the hedging period (of 2 years), the price level varied from $22.6 to $13.91 per barrel). The hedging program was designed in such a way that the minimum price of oil was fixed ($21.5 per barrel), and when oil prices rose, the state received additional profits. This technique allowed the state government to obtain a stable income for two years, with significant fluctuations in oil prices.