HEDGING PURPOSES OF DERIVATIVE INSTRUMENTS

HEDGING PURPOSES OF DERIVATIVE INSTRUMENTS

In the previous article, https://bit.ly/3wR8YoP, a general introduction to the world of derivative financial instruments was provided: among their various purposes of use previously mentioned, it is appropriate to elaborate on the one related to hedging, given its importance in the financial world. 

Indeed, those dedicated to hedging, hedgers, have the difficult task of using the derivatives market to reduce corporate exposures to particular risks, such as oil price movements, exchange rate fluctuations, stock market exposure, and so on. A perfect hedge consists of a hedging transaction that would completely eliminate the risks to which the company is exposed: of course, the above is almost impossible to implement in reality, so hedging strategies are aimed at reducing risk as much as possible. Hedging can be static, involving no time adjustments, or dynamic, in which constant adjustment and monitoring of parameters takes place: in both cases there are multiple possible strategies to implement, which require exceedingly thorough mathematical-statistical-financial notions. With this in mind, we would like to give examples here of the simplest to implement and most common hedges related to static hedging. 


HEDGING WITH FUTURES AND FORWARDS

The derivatives that are most commonly used for static hedging are futures and forwards contracts: as reported in the previous article, one of the differences between the two instruments lies in the fact that the former provide for daily settlement, while the latter at expiration. It follows that, by using a futures, what is known as "tailing the hedge" should take place: the marking-to-market mechanism of futures involves monitoring the standard deviation of the spot and futures price and their correlation coefficient, thus considering not the relationship that exists between daily price changes, but rather the relationship between the respective daily rates of change, assuming day-to-day hedging mechanisms. However, since these parameters return in practice very small differences on the optimal number of futures contracts to be traded daily, they are often ignored: therefore, in hedging-related operational practice, this difference between futures and forwards is essentially zeroed out, considering in both cases an adjusted position at expiration


BASIC PRINCIPLES: SHORT AND LONG STATIC HEDGES

When the company decides to use futures or forwards contracts to hedge against a risk, it aims to take a single position that neutralizes it as much as possible:

  • short hedge is when exposure to the underlying asset results in a profit when the asset price rises and a loss when it falls. These hedges are ideal when the hedger owns an asset that he assumes he will sell in the future or does not own it at the moment, such as when the underlying is a commodity, but at the same time he is certain to come into possession of it and then sell it again; 

Example The U.S. company is an exporter of machinery to Europe and against the exported equipment it will receive €1,000,000 in 3 months' time; as a result, it is exposed to exchange rate risk: in the next 3 months it will earn a profit if the euro appreciates against the dollar, while it will suffer a loss if it depreciates. In order to neutralize this risk, the corporate hedger will have to open a short futures position, which will therefore result in a loss if the euro appreciates against the dollar and a profit if it depreciates, so as to offset the export-related operational risk by paying only the amount of the derivative.

 

  • on the other hand, a long hedge is when the exposure to the underlying asset generates a profit when the asset price falls and a loss when it rises; in this case, such a hedge is ideal when the hedger wants to lock in the price to date of a particular asset that he will have to buy.

Example The Italian company is in the jewelry business: in 6 months' time it will need to procure 10,000 grams of gold to be processed in its workshop. The spot price of gold is €55 per gram, while the 6-month futures price is €35 per gram; as a result, the corporate hedger can hedge this exposure by purchasing 4 6-month futures, which call for the delivery of 2,500 grams of gold each: the strategy has the effect of locking in the price of gold near the price forecast. Assuming that at the expiration of the 6 months the spot price of gold is instead €40 per gram, the entrepreneur will earn from the futures contracts 10,000 x (€40 - €35) = €50,000, while for gold he will pay 10,000 x €40 = €400,000: the total cost of the transaction will be €400,000 - €50,000 = €350,000, or €35 per gram. Alternatively, assuming that the spot price at the 6-month maturity is 20€, the company will lose for futures contracts 10,000 x (35€ - 20€) = 150,000€, while it will buy gold for 10,000 x 20€ = 200,000€, again having a total cost of 200,000€ + 150,000€ = 350,000€. In conclusion, it therefore seems clear how convenient it is for the company to try to lock in the price of gold, preferring to buy to date on the futures market rather than on the spot market: if it had bought directly on the spot market it would have paid 10,000 x 55€ = 550,000€, rather than approximately 350,000€, or 35€ per gram, thus also avoiding the costs of storage for 6 months, until further processing.


BASIS RISK.

The factors acting on the hedge go to affect what is known as "basis risk," defined as the difference between the spot price of the asset being hedged and the futures price of the contract used for hedging. If the asset being hedged coincided with the asset underlying the futures, the basis should be zero at maturity and very small near that date: however, as time passes, the spot and futures price change, conceivably differently, so the basis before maturity may be positive or negative. Specifically:

  • when the spot price increases more than the futures price the basis increases (strengthening of basis), vice versa otherwise (weakening of basis);
  • this creates an improvement or worsening of the hedger's position. For example, considering a short hedge, if the base strengthens unexpectedly, the hedge improves, while it worsens otherwise; for the long hedge the opposite is true.

The hedges considered so far have obvious simplifications for the purposes of exposition, which, however, may not always occur in practice; in fact, a key factor influencing hedging is the choice of contract to be used, especially in relation to the underlying asset and the time factor of delivery: in the cases set out above, the underlying asset was the same, so obviously hedging is easier; otherwise, so-called "cross hedging," i.e., cross hedging of the underlying assets, should take place, which is much more complex and articulated. The same goes for the delivery date: it usually cannot always be known, so it is a good rule to choose a delivery month close to the maturity of the hedge but further away in time. Obviously, the basis risk increases if the assets are different and if the time distance between the expiration of the hedge and the delivery month of the underlying increases.

 

Edited by: Antonio Russo, Chartered Accountant and Statutory Auditor

You can download the article in PDF here

For more information:

antoniorusso@valoreassociati.it

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