What is hedging in simple words? Example of a hedge. Currency hedging

In modern economic terminology, you can meet many beautiful, but incomprehensible words. For example, "hedging." What is it? In simple words, not everyone can answer this question. However, on closer examination, it turns out that such a term can be used to determine insurance of market transactions, although a bit specific.

Hedging - what is it in simple words

So, let's deal with it. 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 sense of "defend", that is, try to reduce the 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 in the future the terms of the transaction will not change 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 of the transaction insure their risks from the possible fluctuation of rates in the foreign exchange market and, as a consequence, changes in the market price of the goods. Participants in market relations that hedge transactions, that is, insure their risks, are called hedgers.

How it happens

If it is still not very clear, you can try to simplify even more. To understand what a hedge is, the easiest way is to use a small example. As you know, the price of agricultural products in any country depends, in part, on weather conditions, and on how good the harvest will be. Therefore, conducting a sowing campaign, it is very difficult to predict what will be the price of products 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, some of the crops may die, because of which the cost of grain will grow many times. 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 the contract. Based on the terms of the transaction, the farmer will be obliged to sell, and the client will buy the harvest at the price that was prescribed in the contract, regardless of what price is on the market at the moment.

Here comes the moment when it becomes most clear what a hedge is. In this case, several variants of the situation development are possible:

• The price of the harvest in the market is more expensive than the one prescribed in the contract - in this case the producer, of course, is unhappy, because he could get more benefits;
• The market price is less than the price specified in the contract - in this case, the buyer is already in 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 before they occur. However, such positioning does not preclude the possibility of a loss.

Methods and objectives, currency hedge

On the other hand, it can be said that hedging risk - insurance against a variety of adverse changes in the foreign exchange market, minimizing losses associated with fluctuations in the exchange rate. That is, not only a specific commodity can be hedged, but also financial assets that are already available and planned for acquisition.

It should also be said that the correct currency hedging is not aimed at obtaining the maximum additional income, as it may seem at first. Its main task is to minimize risks, while many companies deliberately refuse an additional chance to quickly increase their capital: the exporter, for example, could play at a lowering rate, and the producer - at an increase in the market value of the goods. But common sense suggests that it is much better to lose superprofits than to lose everything altogether.

There are 3 main ways to save your foreign exchange reserves:

1. Application of contracts (urgent) for the purchase of currency. In this case, fluctuations in the exchange rate will not affect your losses in any way, nor will they bring profit. The purchase of currency will be strictly under the terms of the contract.
2. Entering into the contract protective clauses. Such items are usually bilateral and mean that when 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 contract. Sometimes, however, it happens that protective clauses concern only one side, then the other remains unprotected, and currency hedging is recognized as one-sided.
3. Variations with bank interest. For example, if in 3 months you need a currency for settlements, and there are assumptions that the rate will change in a larger direction, it will be logical to exchange money at the existing rate and put them on deposit. Most likely, the bank interest from the deposit will allow to level the fluctuations of the rate, and if the forecast does not justify, there will be a chance even to earn a little.

Thus, it can be said that hedging is an example of how your deposits are protected against a probable fluctuation in 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 talking about various tools, it should be noted that understanding the question "what is hedging" is primarily for the purpose of the operation being conducted, and not in the means used. So, the hedger conducts a transaction in order to reduce the probable risk of changing the value of the goods, the speculator is quite consciously going to such a risk, while expecting to receive only a favorable result.

Probably the most difficult task is to choose the hedging instrument correctly, which can be divided into 2 large categories:

• OTC, represented by swaps and forward contracts; Such transactions are concluded between the parties directly or through the intermediary of a specialist dealer;
• Exchange hedging instruments, which include options and futures; In this case, the trade takes place at special venues - exchanges, and any transaction concluded there, ends up being trilateral; The Clearing House of a particular exchange acts as a third party, which is the guarantor for the parties to fulfill the contract of obligations;

Both these and other methods of hedging risks have their own 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 as the goods of a food group: sugar, meat, cocoa, cereals , etc., and industrial - gas, precious metals, oil, others.

The main advantages of exchange trading are:

• Maximum availability - in our century of advanced technologies, trading on the exchange can be conducted from virtually any corner of the planet;
• Significant liquidity - you can open and close trading positions at any time at your discretion;
• Reliability - it is ensured by the presence in each transaction of the interests of the clearing house of the exchange, which acts as guarantor;
• Rather low transaction costs.

Of course, there were some drawbacks - perhaps the most basic ones are quite strict restrictions on the terms of trade: the type of goods, their quantity, delivery times, 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 trades take maximum account of the customer's wishes, you can control the volume of the lot and the delivery time yourself - this is perhaps the biggest but almost the only plus.

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

• Complexity with the selection of a counterparty - this issue you now have to deal with on your own;
• A high risk of non-fulfillment by any of the parties of their obligations - there is no guarantee in the form of an exchange administration in this case;
• Low liquidity - at the dissolution of a previously concluded transaction, you are under considerable financial costs;
• Considerable overhead;
• Long term - some hedging methods can cover periods of several years, as the variation margin requirements here are not applicable.

In order not to be mistaken with the choice of a hedging instrument, it is necessary to conduct the most complete analysis of the probable prospects and features of one or another method. In this case, it is necessary to take into account the economic features and prospects of the industry, as well as many other factors. Now let's take a closer look at the most popular hedging tools.

Forward

This term refers to a transaction that has a certain period of time at which the parties agree on the delivery of a specific product (financial asset) for some agreed date in the future, while the price of the goods is fixed at the time of the transaction. What does this mean in practice?

For example, a certain company expects to purchase a euro for a dollar from the bank, but not on the day of signing the contract, 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 to euro exchange rate will be 1.3, then the firm will receive tangible savings - 10 cents on the dollar, which at a contract value of, for example, in a million, will help save $ 100 thousand. In the event that during this time the exchange rate drops to 1.1, the same amount will go to the loss to the enterprise, and it will no longer be possible to cancel the deal, since the forward contract is an obligation.

Moreover, there are some more unpleasant moments:

• Since such a contract is not provided by the clearing house of the stock exchange, one of the parties may simply refuse to execute it upon the occurrence of unfavorable conditions for it;
• Such a contract is based on mutual trust, which significantly narrows the range 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 undertakes after a while to buy (sell) the indicated quantity of goods or financial assets - shares, other securities - at a fixed base price. Simply put, this is a contract for future delivery, but futures is an exchange product, which means that its parameters are standardized.

Hedging with futures contracts freezes the price of future delivery of the asset (goods), while if the spot price (the price of selling goods on the real market, for real money and on condition of immediate delivery) decreases, the lost profit is compensated by the profit from the sale of fixed-term contracts. On the other hand, there is no way to use the growth of spot prices, 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, which maintains open-term positions in working order, so to speak, is a kind of guarantee. In case of rapid growth of the spot price, you may need additional financial injections.

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

Hedger, using futures deals, insures them with those transactions that are carried out on the market of this (real) commodity. For a speculator, a futures contract is only an opportunity to generate income. Here there is a game on the price difference, and not on buying and selling an asset, because a real product does not exist in nature. Therefore, all losses or incomes of a speculator in the futures market are nothing more than the final result of his operations.

Insurance options

One of the most popular instruments for influencing the risk component of contracts is hedging options, let's talk about them in more detail:

Put option:

• The holder of the American put option has the full right (however, is not obligated) to implement a futures contract at a fixed strike price at any time;
• Acquiring such an option, the seller of the commodity asset fixes the minimum selling price, while retaining the right to take advantage of favorable price changes;
• If the futures price falls below the option execution price, the owner sells it (fulfills), thereby compensating losses in the real market;
• When the price increases, he may refuse to execute the option and sell the goods at their most profitable value.

The main difference from futures is the fact that when buying an option a certain premium is provided, which burns in case of refusal to execute. Thus, the put option can be compared with the usual traditional insurance - in case of an unfavorable development of events (in the insurance case), the option holder receives a premium, and under normal conditions it disappears.

Call option:

• The holder of such an option is entitled (but not obligated) at any time to purchase a futures contract at the fixed execution price, that is, if the futures price is more fixed, the option may be exercised;
• For the seller the opposite is true - for the premium received when selling the option, he undertakes to sell the futures contract at the strike price at the buyer's first request.

At the same time, there is a guarantee deposit similar to that used for futures transactions (futures sales). The peculiarity of a call option is that it compensates for the reduction in the value of a commodity asset by an amount not exceeding the premium received by the seller.

Types and strategies of hedging

Speaking about this kind of insurance of risks, it is worthwhile to understand that, since in any trading operation there are at least two parties, then the types of hedging can be divided into:

• Hedge of the investor (buyer);
• Vendor hedge.

The first is necessary to reduce the investor's risks associated with the probable increase in the value of the proposed purchase. In this case, the best options for hedging the price fluctuation will be:

• Put option sale;
• Purchase of a futures contract or call option.

In the second case, the situation is diametrically opposite - the seller needs to protect himself from the fall in the market price of the goods. Accordingly, the hedge methods here will be reversed:

• Sale of futures;
• Buying put;
• Call option sale.

Under the strategy should be understood as a set 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 price of the commodity change almost in parallel. This gives an opportunity to reimburse the losses incurred in the futures market from the sale of a real product.

The difference between the price determined by the counterparty for a real product, and the price of a futures contract is taken as a "basis". Its real value is determined by such parameters as the difference in the quality of goods, the real level of interest rates, the cost and storage conditions of the goods. If storage is associated with additional costs, the basis will be positive (oil, gas, non-ferrous metals), and in cases where possession of the goods before it is transferred to the buyer brings additional income (for example, precious metals), will become negative. It is worthwhile to understand that its value is not constant and often decreases as the futures contract expires. However, if a real (sudden) demand for a real product suddenly arises, the market can move to a state where real prices will become much larger 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 heal by hedging.