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What is Hedging? Best Practices in 2024
Technology
Demetris Makrides
Senior Business Development Manager
Vitaly Makarenko
Chief Commercial Officer
In the financial world, investments always imply some risks no matter how aggressive a chosen strategy is. Professional investors adhere to diverse insurance policies that offset possible losses. Hedging falls into the category of such insurance policies.
What is Hedging in Finance?
The best way to understand what hedging means lies in drawing a parallel with insurance. When a person wants to protect his property from force-major factors, he makes an agreement with a certain insurance company. On the one hand, you face some extra expenses. On the other hand, insurance payments cover all your losses in case of force majeure. As such, possible risks are minimized.
When talking about the financial market, everything is more complicated. One cannot just make an agreement with an insurance company to cover losses.
Hedging helps investors to balance by opening an order in the opposite direction. Such an option makes it possible to level out price fluctuations. Hedging is effective enough to protect different assets:
- currencies;
- stocks;
- commodities;
- metals, etc.
How Does Hedging Work?
The use of one instrument to minimize possible risks connected to another instrument lies in the ground of hedging. In most cases, traders and investors reduce risks with the help of derivatives. Let’s give some examples of how hedging works.
A gasoline producer buys oil, planning to produce gasoline within 3 months and then sell it. Meanwhile, during the next 3 months, oil prices may drop down and cause losses; which is why a producer enters into a forward contract for the gasoline supply with the expiration date in three months. On the other hand, a producer may open a “Put” option to both minimize risks linked to the possible price decrease and get additional profit when oil prices grow.
A Japanese company supplies goods to the United States and gets payments in USD. Dollars are then converted to JPY. To hedge the risks of the JPY/USD exchange rate increase, the company buys JPY/USD futures.
Texas gets 25% of local taxes from oil production and refining companies. When world oil prices decrease, the state receives reduced taxes. The hedging program implemented in Texas helped the state stabilize cash flows under different market conditions.
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Basic Principles of Hedging
Such an approach to minimizing risks is based upon the following principles:
- An effective hedging program doesn’t aim to exclude risks at all. The core goal lies in transforming risks from the category of unacceptable to acceptable ones.
- When thinking about hedging, a company or an investor needs to evaluate possible losses that may happen without hedging. When those losses are insignificant, the benefits of hedging implementation are questionable.
- Like any other financial activity, a hedging program requires a system of strict inner rules and stages.
As such, hedging is not an investor’s lifeline in all market situations. You need to understand which risks should be minimized and which ones should be carried out.
Hedging Instruments
First and foremost, when talking about hedging, take into account the goal, not the means. The same instruments are used by both hedgers and traders. The first ones apply instruments to reduce risks from possible price movements. Traders carry those risks consciously betting on beneficial results.
All the hedging instruments are divided into two groups: exchange and OTC instruments.
Exchange-traded Hedging Instruments
The category of exchange-traded hedging instruments is mostly represented by futures and options. Those instruments are available on exchanges; which is why, the Exchange Clearing House guarantees that both buyers and sellers fulfill their obligations.
The pros of exchange-traded hedging instruments:
- Such instruments are characterized by the highest liquidity and investors may buy and sell assets at a market price within the shortest terms.
- Deals are protected by the Exchange Clearing House.
- Because of up-to-date technologies traders and investors access trading platforms from any part of the globe.
The cons of exchange-traded hedging instruments:
- Exchanges imply restrictions related to lot sizes, conditions, and delivery time.
- Buyers and sellers pay exchange commissions and fees.
OTC (Over the Counter) Hedging Instruments
OTC instruments that are used for hedging are primarily forward contracts and swaps. The two parties make such deals either directly or through dealers.
The pros of OTC hedging instruments:
- Investors get instruments that take into account product type, volumes, and delivery conditions.
- Commissions and fees either do not exist or are minimal as the two parties decide on all the conditions directly.
The cons of exchange-traded hedging instruments:
- Overhead costs are rather high.
- Investors face significant restrictions related to a minimum lot size.
- Sometimes it is difficult to find a counterparty.
Thus, all the instruments used in hedging have their pros and cons. Investors need to find the best option depending on particular conditions.
Hedging Strategies
Under the term of “hedging strategy,” a set of tools and methods is commonly understood. All the strategies are based upon the parallel movement of spot and futures prices. Investors get an opportunity to apply derivatives as “insurance mechanisms.”
Let’s dive deeper into the main hedging strategies.
Hedging by Futures Contracts
The strategy requires the selling of futures contracts. The volume of futures contracts should correspond to the hedged lot of real assets.
What should be taken into account?
- Investors who sell futures contracts can evaluate the prime cost of assets with great certainty.
- Prices in the derivatives market provide investors with acceptable profit.
Hedging with the help of futures contracts fixes the price of assets that will be supplied in the future. If an asset’s price on the spot market decreases, the investor receives compensation from the derivative instruments. On the other hand, when a price goes higher on the spot market, investors do not get extra profits as they need to cover losses from futures contracts.
Hedging by Put Options
The Put option enables its holder to sell the underlying asset at a fixed price (the option’s strike price) within the expiration period. On the other hand, an owner of such an option is not obliged to use his right. He decides on his option whether to sell the underlying asset or not.
Through buying a put option investors fix the minimum selling price. When an asset’s price rises on the spot market, investors just pay rewards refusing their right to sell an asset. In case of a price drop, investors activate their right to sell an asset at a fixed price that is higher than on the spot market.
Hedging by Call Options
The strategy works in the same way as the previous one but instead of put options investors purchase call options that give the right to buy the underlying asset at a fixed price.
When an asset’s price goes higher, holders use their right to purchase an asset. If the price drops down, investors pay rewards and reject their right to buy an asset.
Other Hedging Instruments
There are many other hedging tools based on put and call options. For instance, one sells put options and buys call options using rewards. The selection of hedging instruments depends on the detailed analysis of a hedger’s business needs, the overall economic conditions, and future opportunities in the industry.
Hurdles and Pitfalls of Hedging
Hedging is not something that helps investors offset risks under any market conditions. There are some hurdles and pitfalls related to this approach:
- Hedging of long-term positions is more complicated as investors cannot find long-term derivative instruments that are liquid enough. The roll-over strategy is used in this case. First, investors buy options with shorter expiration dates. As the expiration date comes closer, investors sell an option and buy another one with a longer expiration.
- Sometimes investors cannot select an exchange-traded commodity that fully corresponds to a real asset used in spot transactions. In such a case, they need to make a profound analysis to determine which assets are as close to real ones as possible.
- A price change may affect sales volumes and lead to a situation when a hedged position is fewer or higher than a spot one. In both situations, investors face higher risks. The best solution lies in dynamic hedging (for instance, delta hedging).
What is Delta Hedging and How it Works?
Delta hedging is a strategy that helps investors manage the risk of an option’s price change in response to the price change of an underlying asset. Delta shows how much an option’s price will change when an underlying asset’s price goes higher or lower. As such, delta hedging lies in the constant changing of option volumes to maintain a certain delta coefficient.
For instance, a Delta coefficient is equal to zero when the underlying asset stays at the same price level. When its price moves higher or lower, the coefficient undergoes some changes as well. To maintain balance, an investor needs to readjust his position. When an underlying asset’s price goes higher, investors buy more lots. In case of a price drop, one should sell some lots.
Expenses Related to Hedging
The main difference between hedging and other trading strategies lies in that hedging aims to minimize risks, not to get extra profits; which is why, it involves additional expenses. What are those costs?
- When a hedger makes a deal, he transfers some part of the risk to the counterparty (another hedger or a trader). Counterparties take on additional risks and expect to get rewards. For instance, a hedger pays for buying an option no matter whether he will use his right to buy/sell assets or not.
- All the deals are subjects of fees and imply bid and ask prices.
- Trading platforms charge security deposits to ensure that both parties will fulfill their obligations. The security deposit usually varies from 2% to 20% of the overall volume of the hedged position.
- One more expense item hedgers need to take into account is funding. Holders of futures positions pay funding when the price moves towards the chosen direction. In the case of the opposite movement, hedgers get funding on their balances.
The above-mentioned expenses may affect your hedged positions; which is why you need to take those rewards, fees, and funding costs into account.
Risks Related to Hedging Strategies
The hedging itself is an instrument that minimizes risks; meanwhile, the existing approaches are not able to exclude the dependence on the incorrect price movement. Furthermore, an insufficiently developed hedging strategy may increase risks.
The main type of risk that appears in hedging lies in differences between the price movements of real assets and the corresponding derivative instruments. The prices of real assets and derivatives usually move in parallel and cannot differ essentially, but some basic risk always remains.
Another risk type implies administrative limits on maximum daily fluctuations of futures prices. Such restrictions are set by some exchanges. When a hedger needs to close his position during strong price movements of a real asset the difference between spot and derivative prices is quite large.
One more risk type is related to unpredictable legislative changes – i.e., duties, excises, etc.
What Do Hedgers Get?
When talking about hedging strategies, investors and companies experience the following benefits:
- Hedging significantly reduces price risks associated with the uncertainty of future financial flows, interest rates, and exchange rates.
- A well-planned hedging strategy reduces both risks and expenses. Hedging helps companies switch their focus towards aspects where a company has competitive advantages.
Bottom Line: Is Hedging a Must-Have for Investments?
When talking about investment and business processes, investors or companies may be ready to take on one risk and protect themselves from other risks. In such a situation, hedging sounds like a perfect instrument.
Hedging functions like an insurance program on financial markets. Meanwhile, the hedged position does not mean that investors or companies will not face losses. There are some expenses and risks related to hedging, and the wrong strategy may lead to even higher risks instead of minimizing them.
