Hedging example

Disclaimer: this article is for informational purposes only and does not constitute a solicitation to fund or to speculate in any form – remember that all investments involve risk.

Hedging is a set of strategies designed to minimize the losses. It manifests itself in the form of opening transactions within one market to compensate for the impact of risks of equal yet opposite position in another market. Read on and we will explain how it works with fixed and variable value items, provide a proper hedging example, and tell about some popular strategies.

Hedging method: explained

The basic idea of hedging is to create opposite positions that offset the risks and protect against currency, interest rate, and inflation fluctuations.

However, it is not necessary to resort to it in all cases. And in all investment styles.

For example, many people who follow long-term buy-and-hold strategies do not use them at all. The fact is that even with large drawdowns, the market recovers one way or another.

But if one adheres to an active strategy and intends to protect the portfolio from risks in the short term, hedging will help to reduce losses and even possibly gain profit. Both fixed- and variable-value items can be hedged. Both investors and companies – small and large – can use it.

Hedging fixed-value items

Fixed-value items are items that have a fixed cost.

The amount/rate is fixed in advance here (which is obvious) – it can not coincide with the current market situation at the time of payment. This is why companies use hedging even for fixed-value items.

Hedging variable-value items

And variable cost items have variable value. Anyways, they include:

• variable interest loans;
• the lion’s share of foreign exchange transactions;
• variable debt obligations.

Hedging example

The following are examples of hedging.

Example 1 – Conceptual

Hedging can essentially cover all businesses that deal with finances. Now we suggest a little dreaming. Imagine an international organization engaged in the production of high-tech household appliances and supply.

That is, it supplies products to the local market and also exports them. The organization’s economic department estimates that export sales account for 80 percent of total revenues. The main source of this income is currency.

And to limit losses, a company could, for example, build its own factory in another country (China, the US, or any other that uses the Euro as its currency) so that the goods produced there can be easily sold without fluctuations.

Example 2 – Fixed-value items

Suppose the same organization has issued a non-convertible bond with an interest rate of 10% per year. It pays it off annually. And suddenly the head has a suspicion (no matter how well-founded it is) that the interest rate at the time of the next coupon payment will be lower than 10%.

Therefore, he or she decides to enter into an agreement with a bank whereby one will receive from the latter 10% per annum on the underlying amount of the non-convertible bonds and in return pay a certain interest.

Example 3 – Variable-value items

Let’s assume that the organization (still the same one) has a loan of $500,000 on which it pays interest every six months at the current interest rate + 0.70% per year. The current interest rate is 6% per annum, but in the future it will rise to 8%.

It may rise, to be perfectly correct.

So the company rush to make an agreement with the bank whereby it will pay a fixed rate of 6% + some additional amount.

Example 4 – Forward hedging examples

Forward contract is the earliest and oldest form of risk limitation. It was born in grain trading.

Here’s the deal: The price of wheat, rye, and oats fluctuates depending on the crop. If farmers have a good one, the price can drop significantly, reducing the income from the sale. For example, at the time of harvest, wheat costs X dollars on the market.

To avoid such a situation, the farmer can immediately arrange to sell the grain some time in advance. Say, with a delivery date one month from now and at a price slightly above X.

Hedging examples: strategies

There are several types of hedging. Below are the main ones.

Cross – several assets are used at the same time and their diversification reduces risks. A little bit about how exactly it works and the formula for calculating.

Static & dynamic – the first implies a one-time creation of a protective position, the second – when it is modified in the process. For example, one expected the fall of an asset, but it continued to grow instead. The correction probability has increased, so now it is necessary to enlarge the rate of protection based on the new rules of the game and, consequently, on the new value.