Taming the Market Beast: The Art of Hedging with Derivatives

Editor || Munmun Bose

Amongst the unfolding erratic global situations, volatility is the new normal in the financial markets. So, what does one do to be equipped with the techniques to defend investments? What are the correct instruments for the risk management? Serving to these doubts, this article explores the concept of hedging strategies focusing on derivative.

What is Hedging?

Hedging is a financial strategy which protects your investments from the adverse market situations. You make an extra investment to protect yourself in case your main investment loses value.

For example, if you own a company that depends on oil prices, you might buy a contract that pays you if oil prices go up. This way, if prices rise and make your costs higher, you won’t lose as much money because your hedge will balance it out.

Hedging is commonly used in various markets, including commodities, equities, interest rates, and foreign exchange. The goal is to manage financial risk and provide stability, though it can also limit potential profits if the market moves favourably.

What are Derivatives?

Derivatives are financial instruments whose value is derived using an index, rate or from an underlying asset. Derivatives are like bets on how something’s price will change in the future. Instead of buying the actual asset, you’re making an agreement about what will happen to its price.

Why should we use Derivatives for Hedging?

Derivatives are used for hedging because they effectively reduce risk by protecting against unfavourable price movements in assets like stocks, commodities, or currencies. They offer a cost-effective and flexible way to limit potential losses without having to directly buy or sell the underlying asset, such as using futures or options to offset risks. This makes them an efficient tool for managing financial uncertainties.

Common Hedging Strategies using Derivatives

1.Futures Contracts

• What are Futures Contracts?
  Futures contracts are agreements to buy or sell an asset (like commodities or stocks) at a set price on a specific future date. They are traded on exchanges, making them reliable and easy to access.

• How to Use Futures for Hedging:

Hedging Commodity Prices: Imagine a farmer expects to harvest wheat in six months but worries that the price might drop. By selling wheat futures now, the farmer locks in a price. If the market price falls by harvest time, any losses on the wheat itself are offset by profits from the futures contract.

Hedging Stock Market Risk: If an investor holds a stock portfolio and is concerned about a market drop, they can sell stock index futures. If the market falls, the losses in the portfolio are balanced out by gains from the futures position.

2.Options Contracts

What are Options Contracts?
Options give the buyer the choice (but not the obligation) to buy (call option) or sell (put option) an asset at a set price before a certain date. The buyer pays a fee (premium) for this right.

• How to Use Options for Hedging:

Protective Put: If an investor owns a stock but is worried the price might drop, they can buy a put option. If the stock price falls, the put option increases in value, covering the loss. This strategy acts as insurance while allowing the investor to benefit if the stock price rises.

Covered Call: If an investor holds a stock but doesn’t expect its price to change much, they can sell a call option. The premium earned from selling the option provides income, and if the stock price stays relatively stable or falls slightly, the investor keeps the premium. However, if the stock rises significantly, the investor may have to sell it at the option’s strike price, potentially missing out on bigger gains.

What is the Black-Scholes Model in Options?

The Black-Scholes model, created by Fischer Black and Myron Scholes in 1973, is a formula used to figure out the fair price of European-style options. It helps traders and investors understand what an option should be worth by considering factors like the current price of the asset, the option’s strike price (the price at which the option can be exercised), how long until the option expires, the risk-free interest rate, and how much the asset’s price tends to fluctuate (volatility). This model has become a key tool in financial markets because it provides a consistent way to price options accurately.

3.Swap Contracts

• What are Swap Contracts?
  Swaps are agreements where two parties exchange cash flows or other financial instruments. The most common types are interest rate swaps and currency swaps.
• How to Use Swaps for Hedging:

Interest Rate Swaps: If a company has debt with a variable (floating) interest rate, they can swap it for a fixed-rate interest payment. This helps them manage their cash flow better by keeping their interest payments stable.

Currency Swaps: A company that earns money in one currency but has expenses in another can use a currency swap. By exchanging cash flows in different currencies, the company can match its income with its expenses and reduce the risk of exchange rate fluctuations.

4.Forward Contracts

• What are Forward Contracts?
  Forward contracts are agreements between two parties to buy or sell an asset at a future date for a price that is agreed upon today. Unlike futures, these are private, customized deals (not traded on exchanges), making them flexible but also carrying the risk that one party might not fulfil their end of the deal (counterparty risk).
• How to Use Forwards for Hedging:

Hedging Currency Risk: If a company expects to receive money in a foreign currency later, they can use a forward contract to sell that currency at a fixed exchange rate now. This protects them if the exchange rate changes unfavourably in the future.

Hedging Interest Rate Risk: If a company plans to take a loan in the future, it can use a forward rate agreement (FRA) to lock in the interest rate today. This ensures they won’t be affected if interest rates go up before the loan.

Benefits of Using Derivatives for Hedging

• Risk Reduction: Derivatives help manage and lower risks, such as price changes, interest rate fluctuations, or currency movements, protecting your investments or business operations.
• Flexibility: They offer tailored solutions to meet specific risk management needs without needing to buy or sell the underlying asset.
• Cost-Effective: Using derivatives to hedge can be cheaper than other strategies like selling assets or purchasing insurance.

Risks of Using Derivatives for Hedging

• Complexity: Derivatives can be complicated, requiring a strong understanding of how they work and their potential consequences.
• Counterparty Risk: For over-the-counter (OTC) derivatives, there’s a risk that the other party may not fulfil their obligations.
• Market Risk: Derivatives are also exposed to market risk, and a poorly executed hedging strategy could result in losses.

Conclusion

Hedging with derivatives is a smart way to manage financial risks. By using tools like futures, options, forwards, and swaps, both investors and companies can protect themselves from harmful market changes and keep their finances stable. However, it’s important to use these strategies carefully and fully understand both the risks and benefits involved.

By learning how to use these hedging techniques effectively, you can make informed decisions that protect your investments and help you succeed in the constantly changing world of finance.