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INTRODUCTION: There are a variety of reasons why retail and institutional investors may have substantial undiversified exposures

to single stocks. For instance, an investor may hold stock options that are currently deep in the money but for which selling is not permitted for a prescribed period. Or, a fund manager may have a large exposure to a stock that he does not want to close out. In all of these cases, the investor may desire to hedge, rather than sell, his/her shares as protection against price falls. Hedging is mitigation plan to reduce risks. The best way to understand hedging is to think of it as insurance. When people decide to hedge, they are insuring themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced. So, it occurs almost everywhere, and we see it everyday. For example, if you buy house insurance, you are hedging yourself against fires, break-ins or other unforeseen disasters. Risk is an essential yet precarious element of investing. Regardless of what kind of investor one aims to be, having a basic knowledge of hedging strategies will lead to better awareness of how investors and companies work to protect them.

Besides protecting an investor from various types of risk.DEFINITION: Hedging is a risk management strategy used in limiting or offsetting probability of loss from fluctuations in the prices of commodities. . The investor still likes the stock and its prospects looking forward but is concerned about the correction that could accompany such a strong move. Thus. it is believed that hedging makes the market run more efficiently. he or she will be able to guarantee a sale price of $50 no matter what happens to the stock over the next three months. Instead of selling the shares. If the investor buys the put option with an exercise price of $50 and an expiry day three months in the future. The investor simply pays the option premium. the investor can buy a single put option. which gives him or her right to sell 100 shares of the company at the exercise price before the expiry date. Basically. It has grown to encompass all areas of finance and business. or securities. Suppose that an investor has 100 shares in a company and that the company's stock has made a strong move from $25 to $50 over the last year. which essentially provides some insurance from downside risk. currencies. every investment has some form of a hedge. One clear example of this is when an investor purchases put options on a stock to minimize downside risk. home and business from uncertainty. in short hedging means a valid strategy that can help protect your portfolio.

. metals. such as a loan or a bond. which include agricultural products. CREDIT RISK: The risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks. but an unwanted risk for commercial traders. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps. INTEREST RATE RISK: The risk that the relative value of an interest-bearing liability. an early market developed between banks and traders that involved selling obligations at a discounted rate. and energy products. will worsen due to an interest rate increase. CURRENCY RISK (FOREIGN EXCHANGE RISK HEDGING): It is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure. Those types of risks include: COMMODITY RISK: The risk that arises from potential movements in the value of commodity contracts.RISKS THAT CAN BE HEDGED: There are varying types of risk that can be protected against with a hedge.

.EQUITY RISK: The risk that one's investments will depreciate because of stock market dynamics causing one to lose money. VOLATILITY RISK: It is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency. VOLUMETRIC RISK: The risk that a customer demands more or less of a product than expected.

Price risk exists because of uncertainty about future price levels. Thus the focus of any discussion of hedging is on ways to reduce price risk. QUANTITY RISK: It is the risk where we are uncertain a bout quantity that will be sold or bought at some future date. . we view price risk in our subsequent discussion as the variability in a firm’s net revenue due to unanticipated changes in the prices of the firm’s output and/or inputs. As an operational concept. in many instances being able to control this risk is the difference between success and failure. While reducing or even eliminating price risk may not in all cases be sufficient.RISKS THAT CANNOT BE HEDGED: PRICE RISK: It is the risk of a decline in the value of a security or a portfolio.

. since the cash price is 3. In order to be a perfect hedge.Future Pricet Basis. A common example of a near-perfect hedge would be an investor using a combination of held stock and opposing options positions to self-insure against any loss in the stock position. this is commonly quoted as 3. on July 1.HEDGING FUNDAMENTALS: Understanding basis risk is fundamental to hedging.T= Cash Pricet . In this case. the New York heating oil cash price was 41 cents per gallon. and the February 89 futures was-44. For example.48 cents “under” the February 89 futures price.48 under. A position undertaken by an Investor that would eliminate the risk of an existing position. Such a hedge is perfect hedge. As such. the basis will not change. The cost of this strategy is that it also limits the upside potential of the stock position. If futures and cash prices always change by the same amount. 1988. the perfect hedge is rarely found. The basis is said to be five percents higher (lower) than the future prices. since it eliminates all price risk. or a position that eliminates all market risk from a portfolio. any loss (gain) in the value of the futures position. a position would need to have a 100% inverse correlation to the initial position.48 cents. if the magnitudes (in units) of the cash and futures are identical. which is defined above is usually quoted as a premium or discount: the cash price as a premium or discount to the future price. Basist.

If the basis ends up weaker than expected (i. . in the market. the net selling price will be higher than originally thought. When the initial trade is the sale of a futures contract. The farmer would hedge harvest soybean prices by selling November futures on May 1. if a producer expects to sell corn next November.e. and the futures broker’s commission derive the expected cash price in October. For example.SHORT HEDGE OR HEDGING A SALES PRICE: A producer who expects to sell something in the cash market later can protect the future cash market price by selling a futures contract for the identical commodity now. Adjusting the May 1 futures price for the expected basis in October. This is also called as a short hedge.ii so in many cases a futures hedge will not correspond to the exact same number of bushels that are to be sold in the cash market. and a grain farmer wants to protect the price received for October harvested soybeans. Once a futures hedge has been initiated. The seller has sold a commitment to make delivery of a commodity. Each contract is for 5000 bushels of corn. the producer’s actual net selling price will be lower than thought when the hedge was initiated. the cash price is lower relative to futures than anticipated). the seller is said to be “short”. the producer has exchanged market price risk for basis risk. The only thing that can affect the final outcome of a hedged position is a change in basis relative to expected basis Example 1: Short Hedge or Hedging a Sales Price.50 per bushel. Recall from Chapter 2 that basis risk is the risk that the futures and cash prices do not end up with the same relationship that was initially anticipated. November soybean futures contracts are trading for $6.. he/she could sell a Decemberi corn futures contract. Assume it is May 1. If the basis is stronger than expected (cash price higher relative to futures than initially anticipated).

50 CONCLUSION: The net selling price of a hedged cash commodity will not change regardless of whether prices rise or fall over the hedge period as long as the basis is accurately forecast.09 Basis Expected to be -$0.40 May 1 $6.50 + (-$0. price risk has been traded for basis risk.40) $.Date Futures Market Grain farmer sells 3 November soybean futures contracts Cash Market Establishes an expected October selling price of $6.) = $6. .015 (Futures + Basis Comm. Once a commodity is hedged. It is critical to have as accurate an expectation of basis as possible in order to minimize the possibility of receiving a net selling price that is less than the expected selling price.

e. the seller is said to be “long”. the difference between the June cash corn price July futures price in June). if basis has been forecast accurately.e. contracts for the delivery of corn next July). This is also called as a long hedge. and the expected basis in June (i. the net purchase price originally established by the hedge becomes the effective price paid for the cash commodity..000 bushels of corn to be bought in the cash market in June by buying 3 July corn futures contracts (i. generating a profit in the futures position. This profit is used to offset the increased price of the cash commodity. but futures prices are also rising.000 bushels of corn to be bought in June and used as feed next summer. The one difference is that a purchase hedge is initiated by buying a futures contract. a dairy farmer effectively locks in the price he/she will pay for corn for the summer feeding period. . In the example here. When the initial trade is the purchase of a futures contract. By hedging in a specific corn futures contract month. the farmer can hedge 15. the cash commodity to be purchased later is becoming more expensive.LONG HEDGE OR HEDGING A PURCHASE PRICE: The mechanics of hedging a commodity to be purchased in the cash market at a later date are similar to the sales hedge described above. in the market. As prices rise. The important information for the farmer is the current futures price for July delivery.. The seller has sold a commitment to take delivery of a commodity. and. Assume it is November 1 and a dairy producer would like to lock in a purchase price for 15.

50 $2.15 + $.01 (Futures + Basis + Comm. The expected June purchase price is derived by adjusting the July futures price traded on November 1 for the expected basis in June and the futures broker’s commission.10 -$0.15 Nov 1 .36 Expected to be -$0. The farmer would need to purchase 3 July corn contracts to hedge June corn purchases.) $2.15 under July contract. Assume it is November 1 and a dairy farmer wants to lock in the purchase price for 15.Example 2: Long Hedge or Hedging a Purchase Price. Basis Date Futures Market Cash Market Dairy farmer buys July Establishes an corn contracts expected June purchase price of $2.000 bushels of corn to be bought in June. The expected basis in June is $0.

If . EXAMPLE OF HEDGE RATIO: 1. 2. A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.000 in foreign equity.HEDGE RATIO: 1. The hedge ratio that minimizes risk (HR*) is defined as: (HR*)= Q*f/Q*c Where Q*f is the quantity of futures that minimizes the risk. The hedge ratio is important for investors in futures contracts.75. for example a 300.5 (50 / 100).000 gallon gasoline short futures position is taken to hedge a 400. A general definition of a hedge ratio (HR) is: (HR)=Qf/Qc Where Qf is the quantity of the commodity represented by the futures position and Qc is the quantity of the cash commodity that is being hedged. This means that 50% of your equity position is sheltered from exchange rate risk. Say you are holding $10. as it will help to identify and minimize basis risk.00 gasoline cash position. 2. The HR equals 0. To understand how the value of this ratio is determined.000 worth of the equity with a currency position. your hedge ratio is 0. which exposes you to currency risk. A ratio comparing the value of futures contracts purchased or sold to the value of the cash commodity being hedged. consider the following: . If you hedge $5.

. If the change in the value of the hedged position is set equal to zero then ∆ CP*Qc=∆FP*Q*f And ∆CP/∆FP = Q*f/ Qc This ratio can be used to determine the number of futures contract with which to be hedge. Both Qc and Q*f are assumed to be constant for the life of the hedge. Our earlier equation for the minimum-risk hedge ratio (HR) can be restated as Q*f= Qc*∆CP/∆FP Or as Q*f= Qc*HR* But Q*f=NFC* Qfc Where NFC* is the number of futures contract that minimizes risk and Qfc is the quantity of the commodity represented by each futures contract. ∆FP is the change in the future prices. =∆CP is the change in the cash price.∆VH=∆CP*Qc .∆FP*Q*f Where ∆VH is the change in value of the total hedged position. Qc is the cash position. and Q*f is the futures position that minimizes risk. Thus. And NFC* Qfc = Qc*HR* NFC* = Qc/Qfc*HR* This is the general formula used to determine the number of futures contracts with which to hedge in order to achieve the minimumvariance hedges.

. a purchase hedge requires an initial deposit in a futures trading account.CONCLUSION: The net purchase price of a hedged cash commodity will not change regardless of whether prices rise or fall over the hedge period as long as the basis is accurately forecast. Once a commodity is hedged. and the net purchase price that was established with the hedge is being maintained. However. because the value of the buyer’s futures position is decreasing. It is critical to have as accurate an expectation of basis as possible in order to minimize the possibility of incurring a net purchase price that is greater than the expected purchase price. Just like the selling hedge. price risk has been traded for basis risk. The difference is that margin calls for a buyer occur as prices drop. and the account must be maintained as the futures positions are marked to market. this should not be viewed as a financial loss because falling prices mean the cash commodity that will eventually be bought is also decreasing in value.

margin calls result when the futures prices move above the price at which the hedger sold. hedgers who sold futures before a price rise would need to deposit additional money in their futures margin account in order to keep their hedged position. Futures contracts are marked to market daily. the total value of the futures contracts when the hedge is placed in September is $97. To insure against a default on a potential futures loss. If a hedger were to exit the futures market at a price above the initial selling price. Futures contracts are traded on margin. and generate a financial loss. This is what causes margin calls.500 ($6. a successful hedger must be able to finance the futures part of the hedge over the hedge period. however. For the example here. For a hedger who has sold futures contracts. or the requirement for futures traders to add to their futures margin account when prices move against their position. a margin account must be maintained. The total initial margin would be $3000. . assume the producer must post $1000 initial margin for each futures contract sold. This deposit is called as initial margin. prices will change and this has implications for the hedger’s futures trading account.50 per bushel * 5000 per contract * 3 contracts). Even though the hedger is a seller. and hedgers usually have lower initial margin requirements than futures speculators. he/she would buy the futures contract back at a price higher than it was sold for. For the example above. In the meantime.TRADING MECHANICS: In addition to accurate basis expectations. The sales price being established through the hedged position will not be realized until the soybeans are sold in the cash market and the futures position eliminated. This means both buyers and sellers of futures contracts must post an amount of money with their futures broker as an insurance bond against defaulting on any loses that may be generated in the futures account. This means that all futures profits and losses must be settled each day. The margin call simply brings the value of their performance bond back to the initial margin level. Margins vary by broker and market conditions.

However.Usually a small loss is allowed before a margin call occurs. Grain contracts require physical delivery at contract expiration. many realize that it is in their best interest to have the price of a commodity whose proceeds will be used to service a production or business loan protected against adverse price movements. Majority of the contracts in the market will be closed out prior to the actual delivery dates by taking offsetting positions. thus any hedger who did not buy back a futures hedge would be required to deliver soybeans against a futures contract sale. meaning a producer could not simply deliver the cash soybeans her or she was growing into the futures market. a hedger who sold futures contracts initially would buy those contracts back before the contracts expire in order to offset the hedged position. and they are willing to help customers with hedging programs. Only few contracts will be delivered in accordance with the delivery process. a margin call during the hedge period should not be considered a loss since it is associated with a more valuable cash commodity. . One solution to this problem is to work with an agricultural lender who can provide a line of credit to facilitate the hedge activity. For a hedger. For this example. Once the value of the hedgers futures account reaches the maintenance margin. Under most circumstances. However. and the net expected selling price at the end of the hedge period has not changed. it can still create cash flow problems if the hedger is not sufficiently capitalized to make the margin calls before the cash commodity is ready for sale. the soybeans would have to have already been graded and certified for delivery against a futures contract commitment. an additional deposit must be made to the futures account to bring its value back to the initial margin or the futures position cannot be maintained. The point at which a margin call is initiated is called the maintenance margin. assume the maintenance margin is $750 per contract. The hedger’s futures position could then deteriorate by a total of $250 (or 5 cents per bushel) before an additional deposit to the futures account would be required. While all lenders do not provide this service.

6. you are basing your hedge on currency. So partial hedging is not true hedging either. Increase debt capacity 5. Prevent market fluctuations from interfering with the business 2. WHY SHOULD INVESTORS OPT FOR HEDGING? Here are sum points why an investor should hedge: 1. 5. Hedging is only possible if you know your exposure – so the first Step is to define and measure exposure. This is not true hedging. Goal is to prevent market fluctuations from interfering with the Business. 2. Hedging is also only possible if the institution understands how Effective are the instruments of hedging – forwards. although less so. Like in case of currency it allows the firm to have more earnings stability and more optimal leverage. so it is unhedged. Secure cash for investments 3. . Partial hedging is also speculative. Hedging should not be based on predictions. futures.HEDGING OBJECTIVES: These are some objectives with which investors hedge: 1. 3. Selective hedging is not really hedging – since you have to decide when to hedge. swaps and options. Predictions. Reduce potential costs of financial distress 4. A 50% hedge means that the other 50% is exposed to market risk. 4.

Don’t forget that hedging insulates you from subsequent major price changes – both downward and upward.TEN DON’TS IN HEDGING: 1. Don’t view futures markets as an outlet for delivery of your crop. 8. Don’t hedge if you can’t meet additional margin calls. . Don’t lift your hedge before you buy or sell your commodity in the cash market. 6. Don’t think of futures markets as a way to get higher prices. Don’t combine hedging and speculating. 2. 9. 7. 3. Don’t expect hedging to be panacea for poor management. 10. Don’t ask your broker to make management decisions for you. 5. Don’t hedge unless you “know” your “basis”. 4. Don’t enter the futures market until you understand how to use it.


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