Hedging with derivatives is an extremely useful strategy in finance that is used to manage risk. Consider it an insurance policy for your investments or business, where you make a hedging investment with the intent to offset the potential for loss from unfavorable price movement in the market. Hedging with derivatives allows you to protect your portfolio or profit margins without having to sell the underlying asset.
What is Hedging?
Hedging is a risk management strategy that is executed to decrease or eliminate the risk of financial loss from price movement. In other words, hedging is accomplished by taking an offsetting position in a related security or financial instrument.
The intention of hedging is to eliminate uncertainty and, therefore, not to make money. As an example, a farmer may hedge the price of harvest in order to guarantee a revenue level, despite the market price on the date of harvest. Thus, the protective action of hedging is comparable to the purchase of insurance in that you pay a cost (premium or fee to execute a trade) to protect against potentially large financial loss, should the market price be substantially lower on the harvest date.
What are Derivatives?
Derivatives are financial contracts that derive their value from the performance or value of an underlying asset, index, or interest rate. Derivatives are important tools for effective Hedging.
Derivatives are special because you can trade the risk in an asset without ever having to buy or sell the asset itself.
The common types of derivatives are:
Futures Contracts: A standardized agreement to buy or sell an asset at a predetermined price on a predetermined future date.
Options Contracts: Provides the option to buy (call option) or sell (put option) the underlying asset at the price specified (strike price) on or before a specified date, along with the right to walk away from the trade without any obligations under the terms of the contract.
Forward Contracts: Similar to futures, but are private agreements between two parties. They also allow customization of the terms of agreements between the two parties.
Swaps: Are agreements that allow the two parties to exchange one cash flow for another. An example would be a pre-agreed-upon interest rate swap.
If you are looking to develop a basic understanding of this market, there are a number of useful resources to tap into. For example, Stock Market Online Courses is a place to get started to get an understanding, and how to start trading in the Derivatives market in India would also be very useful.
For specific knowledge, the Derivative Market Dealers Module or NISM Series VIII SEBI Certification would be a good place to get started.
How Derivatives Hedge Risk?
Derivatives are appropriate for hedging because they allow an investor (or company) to take a position that is negatively correlated with their existing exposure. Specifically, a decline in the price of the underlying asset will lead to an increase in the value of the derivative contract and help stabilize net value.
Examples of Hedging with Derivatives:
Hedging Stock Price Risk (using Options):
An investor has a long position of 500 shares of a company and is concerned about a price decrease over the next couple of months.
The investor can buy a Put Option on the stock, which gives them the right, not the obligation, to sell the shares at a set price (the strike price).
If there is a decrease in the stock price, the loss in value of the shares will be offset by some gain in the value of the put option that is now worth more due to the drop in the stock price. This is typically referred to as a Protective Put.
Hedging Commodity Price Risk (using Futures):
A U.S.-based airline knows that it will need to buy a commodity - jet fuel- in six months. The airline is concerned that oil prices may increase during that time.
The airline can take a Long Futures contract to buy crude oil at a price established today.
When the price of oil increases, the higher acquisition cost of physical fuel is covered by gains on the futures contract, thereby fixing the fuel cost.
Hedging Against Exchange Rate Risk (using Forwards):
For example, suppose an Indian exporter expects to receive $100,000 in 90 days. The exporter may be worried that the INR strengthens against the USD, meaning they will get fewer Rupees for the same amount of Dollars.
The exporter can enter into a Forward Agreement to sell $100,000 in 90 days at a fixed rate of exchange, fixing their revenue in INR.
For additional considerations about specific market risks, you may want to familiarize yourself with Understanding Open Interest in Derivatives, or you may also want to enroll in courses like the Risk Management in Stock Broking House Certification Course.
Popular Hedging Strategies with Derivatives
Sophisticated investors and corporations use many strategies to manage risk using Hedging in Derivatives.
For a complete overview of practical applications, see the Advanced Level Options Trading Course. Finally, follow along with some research studies regarding market momentum to strategically manage the market, such as the Advanced Technical Analysis Course.
Key Considerations, Benefits, and Risks
While hedging with derivatives is an important strategy, it comes with important implications, benefits, and drawbacks.
Benefits of Hedging
Risk Reduction: The most important benefit of hedging is limiting downside exposure and the accompanying financial certainty and stability.
Cost Control: Organizations are able to lock in future costs (i.e., raw materials, interest rates), which leads to more accurate budgets and improved financial planning.
Flexibility: Derivatives target risk with precision without the need to liquidate the underlying asset.
Capital Preservation: Hedging preserves capital from abusive and large unexpected swings in the market.
Key Risks and Considerations
Costs: Hedging isn't free. Hedging entails a premium (in options) plus transaction costs, as well as a margin requirement (in futures). This cost reduces your potential profit.
Basis Risk: This occurs when the price of the derivative product does not perfectly correspond with the price of the underlying asset, leading to an imperfect hedge.
Opportunity Cost: Although hedging limits downside risk, it often prevents upside profit. In the situation that the market moves positively, a hedged position will earn less than an unhedged position.
Complexity: While derivatives can be complicated, some strategies (i.e., spreads, collars) are also complicated. The knowledge required to execute these strategies is significant. Misunderstanding the instruments you use can generate large losses for your organization (this is generally tied to a speculative use instead of hedging).
Counterparty Risk: When trading through over-the-counter (OTC) derivatives such as Forwards or Swaps, there is a risk that the counterparty will default on the contract terms. This risk remains uneliminated but reduces to the lowest levels possible when trading exchange-traded derivatives (i.e., Futures and Options).
When considering hedging costs, investors must properly contextualize and manage their risk exposure from pricing risk. This cost conflict must be balanced against the probability and severity of the risk investors are aiming to hedge. Again, proper analysis and vigilance, as taught in the Technical Analysis Course, are very important as well.
Conclusion
Hedging in derivatives is an elaborate, powerful, and necessary technique for modern financial risk management. Whether it be a corporation managing profit margins against commodity pricing fluctuations, or an individual investor managing risk on a long-term portfolio, derivatives such as futures and options can provide an effective and flexible financial insurance policy for everyday investors. Hedging can add further cost and complication in an already complex market landscape, but the right hedging strategy can control risk, provide stability in capital, and allow businesses and investors to focus on their keyword motives, rather than wishfully thinking, hoping, worrying about a distribution of market pricing.
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