Hedging of risks with it became necessary to insure trade transactions and operations. It all started with the fact that in the Middle Ages merchants drew up special contracts with certain conditions that insured them in case of crop failure. In the XVI-XVII centuries, the first exchanges and futures (forward) contracts appeared, which allowed traders to find a counterparty in advance and determine the amount of possible profit, regardless of price fluctuations in the market. Despite the fact that trading in real goods with delivery on time appeared to reduce the risks of the seller and the buyer, there was still a risk that one of the parties would not fulfill the contract. With the growth of world trade in raw materials and food, the stocks of these goods also increased, which in turn led to an increase in the mass of capital, which is exposed to the risk of adverse price changes. As a result, there was an urgent need to insure transactions with real goods. Thus, special insurance tools against price risks were created, which are called risk hedging.
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In 1865, risk hedging began to be carried out with the help of futures contracts, which allowed traders to insure real transactions. Part of the resulting risk was assumed by speculators who were counting on a possible profit. For more than a hundred years, futures trading mechanisms have developed exclusively on the raw materials market. However, in the 1970s, which became a turning point for the world economy, the old system of stable exchange rates was replaced by a new one that provides for floating exchange rates. As a result, the active growth of international capital markets and the development of national stock markets began. Almost all companies have realized that they are more or less exposed to financial risk in the new conditions. There was a need to create risk management strategies, which eventually led to the staggering growth of financial market segments offering protection against risks.
In 1984, risk hedging began to be carried out with the help of options, which turned out to be less risky than futures. In 1982, exchange transactions began to be conducted with contracts that were based on price and stock indices.
The modern futures exchange has begun to perform such functions as transferring price risk, increasing the efficiency and liquidity of markets, identifying objective prices, increasing the flow of information, you can get acquainted with the world's largest futures exchanges by turnover.
Read more: Introduction to Forex hedging basics. Examples of hedging
The world's largest futures exchanges:
- USA - Chicago Board of Trade (CBOT or CBT)
- USA - Chicago Mercantile Exchange (CME)
- USA - Chicago Board Options Exchange (CBOE)
- Germany - EUREX (formerly DTB and SOFFEX)
- Great Britain - London International Financial Futures Exchange (LIFFE)
By the end of the twentieth century, OTC trading began to develop simultaneously with the exchange, where risk hedging had wider opportunities due to the use of specific instruments, including derivatives.
Thus, risk hedging has become a universal method of protecting buyers and sellers from a wide variety of risks, offering a wide range of financial instruments to any market participant.
Today, risk hedging is an operation that complements the usual commercial activities of commercial and industrial enterprises and consists in insuring against losses in the event of sharp changes in market prices.
Read more: What are futures: types, features, advantages and risks
Markets for financial instruments for hedging risks
The markets to which risk hedging is applied are distinguished by the form of organization of trading on exchange and over-the-counter.
The exchange market is a highly liquid and reliable market with standard exchange contracts (options, futures), which is controlled by the relevant exchange authorities.
The OTC market differs from the exchange market in that it offers the participant to manage risks through a wide range of funds (swaps, swap options, etc.).
Advantages and disadvantages of hedging instruments
Dignities of Exchange-traded instruments
1. High market liquidity
2. High reliability
3. Relatively low overhead costs when conducting a transaction
4. Availability
Dignities of OTC instruments
1. Taking into account the requirements of a particular customer regarding the type of goods, the size of the batch and the terms of delivery
2. Longer contract drafting period
3. There are no daily requirements for additional monetary security.
4. There are no positional limits and restrictions on market share.
5. Increased privacy.
Read more: Chicago Mercantile Exchange (CME): history, structure, advantages and features
Disadvantages of Exchange-traded instruments
1. Very strict restrictions on the type of goods, batch sizes, terms and delivery time.
2. Requirements for additional monetary security are issued daily after the quotation price is established.
3. Exchange-traded instruments are mostly liquid in a limited time range
Disadvantages of OTC instruments
1. Low liquidity
2. Relatively high overhead costs.
3. Significant restrictions on the minimum batch size.
4. Difficulties in finding a counterparty.
5. Risks of non-fulfillment of the obligation by the parties in the case of direct transactions.
Read more: What is OTC and what are its features
Futures as risk hedging instruments
Most often, risk hedging is carried out through the use of such instruments as futures and options.
A futures contract is a right and obligation to buy and sell an asset at a specified time in the future on terms that are agreed at a given time and at a price that is determined by the parties when making a transaction. Futures are used for such assets as commodities, currencies, raw materials, stock indices, securities, and interest rates.
Futures trading is characterized by the fictitious nature of transactions, in which the purchase and sale operation is performed, as a rule, in the absence of an exchange of goods. Note that no more than 2% of the total number of transactions are made by the delivery of a real asset.
Futures trading, as a hedging of risks, is conducted taking into account the fact that when selling a futures contract, it is assumed that it will be necessary to subsequently buy out a similar futures contract, i.e. in the same amount and for the same asset, in other words, to close an open position for sale. If a buy position was opened (a futures contract was purchased), then the contact is sold to close the position. If the position was not closed within the established time frame, the transaction participant undertakes to deliver or accept the asset in full.
By hedging risks in this way, the participant of the transaction makes a guaranteed deposit when opening a position, the so-called initial margin, which is equal to 2-20% of the contract value. Also, in the event of an unfavorable price change in the amount of up to 70-75% of the initial margin, the transaction participant will need to provide additional cash collateral.
Let's consider examples 1 and 2, which clearly describe the hedging of risks through futures contracts.
Example 1, where the hedging of the risks of the rise in the price of raw materials is carried out by buying futures contracts.
Let's say there is a gasoline manufacturing company that concluded a forward deal for 1,000 barrels of gasoline at a price of $35 per barrel in January with the delivery of goods in March. At the same time, the purchase of oil for the production of this batch of gasoline will take place only in March. The company is satisfied with the current price of oil at $18 per barrel, but there are fears that the price of oil will rise by the time gasoline is delivered, which will lead to losses. In this regard, the company hedges risks by buying futures for 1,000 barrels of oil at a price of $18.5 per barrel in January. If in March the price of oil rose to $21 per barrel on the real market, and to $21.5 per barrel on the futures market, then the company's losses on the real market will amount to $3,000 (18,000-21,000), while a profit of $3,000 (21,500 - 18,500) will be made on the futures contract. Thus, hedging risks through futures allowed us to compensate for losses on a transaction with a real commodity with a profit on a futures transaction.
On the other hand, if the oil price decreases by March, then there will be a profit on the real market, and a loss on the futures market, which, as in the first case, overlap each other. In other words, risk hedging allows the company to stay at the planned level.
Example 2, where the hedging of the risks of cheaper output is carried out by selling futures contracts.
Let's take the same company that sells gasoline. Let's say the current price of gasoline is $35 per barrel and the company is satisfied, but there is a risk that the price of gasoline will fall in three months. In this case, the risks are hedged by selling a futures contract at the current market price of $35.6 per barrel in the amount of 1000 barrels of gasoline. If in three months the price of gasoline falls to $33 per barrel, both on the real and futures markets, then there will be losses of $2,000 (33,000 – 35,000) on a transaction with a real commodity, while a profit of $2,600 (35,600 – 33,000) will be made on a transaction with futures. Thus, risk hedging will allow not only to cover possible losses, but also to get additional profit. If, on the contrary, the price of gasoline rises, say, to $36 per barrel in both markets, then a profit of $1,000 (36,000 – 35,000) will be made on the real market, and a loss of $400 (35,600 – 36,000) will be made on the futures market. However, even in this case, the company will receive additional profit.
Read more: Introduction to Forex hedging basics. Examples of hedging
Options as risk hedging instruments
Options as risk hedging instruments An option is a contract under which the seller, for a certain fee (premium), transfers to the buyer the right to buy or sell the asset that underlies it at a certain point in time and at a predetermined price. The asset for an option can be: options, futures contracts, securities, currency, interest rates, stock indices, goods.
The cost of purchasing an option is equal to the premium paid. No other collateral in the form of margin is used.
There is a buy option (call), in which the buyer of the option receives the right, but not the obligation, to buy an exchange asset, and a sell option (put), in which the buyer can, but is not obliged to sell this asset.
If the price change was unfavorable for the buyer of the option, then he can waive his right to buy and sell the asset that underlies the option. As a result, the maximum loss for the option buyer will be the amount of the premium paid, and the profit is not limited in size.
When compared with futures, options are less risky and costly. The fact is that futures contracts are used only when there is confidence in the forecast regarding the development of events in the market in the future, and since futures require mandatory execution, errors in forecasts are fraught with large losses. In this regard, it is more expedient to hedge risks with options.
Example 3, where hedging the risks of a rise in the price of raw materials is carried out by buying a call option.
Let's take an enterprise from Example 1. Let's say, instead of buying a futures contract for oil, a call option is purchased to purchase a futures contract for 1000 barrels of oil at an exercise price of $18.5 per barrel. The premium paid is $50.
If the price of oil has increased, the company executes its option, i.e. it buys an oil futures contract at a price of $18.5 per barrel, after which it immediately sells it at a new price of $21.5. As a result, the profit is $2950 (21500 – 18500 – 50). In the real market, the loss will be $3000, which is almost completely compensated by hedging the purchase of a call option.
If the oil price falls, the company refuses to exercise the option, i.e. the loss on it is $50 (the premium paid). In the real market, there is a profit of $1000.
As a result, hedging risks by buying a call option made it possible to minimize risks and get additional profit.
Example 4, where the hedging of the risks of cheaper products is carried out by buying a put option.
Let's consider the situation from Example 2. Let's say the company decided to hedge risks by buying a put option to sell a futures contract for 1,000 barrels of oil at an exercise price of $35.6 per barrel. The premium paid is $50.
In the event of a decrease in the price of gasoline, the company will execute the option and sell the futures contract at a price of $35.6 per barrel, after which it will immediately buy the futures contract at a price of$ 33 per barrel. As a result of hedging, a profit in the amount of $2500 (35600 – 33000 – 50). The loss on the real market will be 2000. Thus, the additional profit of the enterprise will be $550.
If the price of gasoline increases, then the option will not be exercised and the loss will be $50 (the premium paid). As a result, risk hedging will result in an additional profit of $950 (1000 - 50).
Costs and risk hedging strategy
The costs of hedging risks are relatively small in comparison with the losses that arise in the event of refusal of the hedge.
A hedging strategy is understood as a set of hedging instruments and methods of using them to reduce price risks. All hedge strategies are based on the parallel movement of the price on the real market and the futures price, which as a result allows you to compensate for losses on the market of real goods on the futures market.
There are two main types of hedging-a long hedge (buyer's hedge) and a short hedge (seller's hedge).
Buyer's hedge is used by entrepreneurs to reduce the risk of rising prices for goods that are planned to be purchased in the future.
The seller's hedge is used to reduce the risks from falling prices for a product that is planned to be sold in the future.
Risks inherent in risk hedging
There are also some risks inherent in hedging risks. Among them, the basic risk is distinguished, which is associated with the non-parallel movement of asset prices in the real and futures markets, i.e. it is associated with the variability of the basis. It appears due to the fact that the urgent and cash markets have slightly different laws of supply and demand. However, the price on the futures and real markets do not differ significantly, since in this case there are arbitrage opportunities that are almost immediately neutralized due to the high liquidity of the futures market.
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What does risk hedging provide?
Despite the fact that hedging risks has some costs, and companies may face numerous difficulties when developing a hedge strategy, the role of hedging is very high in ensuring stable development.
So, risk hedging:
- allows you to significantly reduce the price risk associated with the purchase of raw materials and the supply of finished products;
- frees up the company's resources, minimizes risk, increases capital, reduces the cost of using funds and stabilizes income;
- it does not face the usual business operations, while providing constant protection, without requiring to change the inventory policy or draw up long-term forward contracts;
- facilitates the attraction of credit resources.
Thus, the use of various financial hedging instruments has become an integral part of the economic activities of many large companies in the world practice.
Practical steps towards successful risk hedging
Step 1. The probability and magnitude of losses from unfavorable price changes in the market are determined.
Step 2. The possibility of insurance against such losses through financial hedging instruments is determined.
Step 3. The hedging costs are determined depending on which financial instruments will be used.
Step 4. The value of possible losses in case of refusal of hedging is compared. It is worth giving up a hedge only if the expected losses are less than the costs for it.
Step 5. A hedging strategy is developed taking into account the type of asset to be insured, the insurance period, the costs acceptable to the company for hedging, and a specific market.
Step 6. The effectiveness of hedging operations is determined according to the main activity of the company.