Hedging: what is it and how is it applied on the stock exchange
In this article, we will discuss the concept of hedging. You will learn what hedging is, what hedging methods are used and how they allow you to minimize investment risks.
What is hedging
The word "hedge" is translated from English as "hedge", "fence" and is used colloquially as "protection", "reduction of risk". In finance, hedging is precisely protection against certain risks.
Any financial instrument has a number of obvious and non-obvious risks, ranging from currency, legal, and counterparty risks to the risk of tsunamis, wars, and the second coming. And situations often arise when an investor is ready to take on some risks, but wants to protect himself from other risks within the framework of one instrument. It is then that he uses a hedge — an instrument that, like a hedge, limits some risk from the investor.
Advantages of hedging
Well-thought-out and composed hedging allows to isolate the investor from a specific risk.
Cons of hedging
Hedging can be very expensive or, in some situations, ineffective. It depends on the development of the market. But in any case, the hedge will reduce the expected yield of the underlying asset by reducing the riskiness.
Depending on the development of the market and the specific risk that the investor wants to hedge, different tools are used to create this very hedge. And in each individual case, the best hedge in terms of price/level of protection can be either a simple bank deposit or a complex financial engineering product.
Strategies and methods of hedging
Let's consider what strategies and methods of hedging are used to protect the interests of the investor.
Familiar to every Ukrainian, the currency risk can be hedged within the investment portfolio. The simplest and cheapest hedge, in this case, will be holding a part of the portfolio in a more stable currency, be it on deposit in a bank (even such a simple method is, in fact, hedging) or buying OVHZs nominated in the currency of interest.
In short, the currency risk on the overall portfolio decreases (the purpose of the hedge), but the overall profitability of the portfolio also decreases (rates on foreign currency deposits in the bank and OVHZ in foreign currency are significantly lower). At the same time, we have the risk of the bank (if the original one lies either in OVGZ or in another bank) or the risk of currency payments of the state. The latter is similar to the usual risk of the state, in the case of hryvnia OVHZ, but with an additional risk in the form of the fact that payments must be in foreign currency and the state will have a harder time paying off obligations in a foreign currency than in the currency of which it is the issuer.
In more developed markets, forwards, futures and currency swaps are available to investors.
State risk is no less familiar to Ukrainians. Usually, this risk hedging occurs at the level of the instrument's issuance.
A classic example of such hedging at the instrument level is the guarantee of payments from one state to another. For example, there is a well-known case from the beginning of the full-scale war in Ukraine, when Canada guaranteed the issuance of Ukrainian bonds. This means that if Ukraine is unable to make payments under this instrument, Canada will pay them.
It is worth noting that this risk is very often hidden, for example, Ukrainian companies that listed their shares in Poland still carry the state risk of Ukraine. And if the risk is obvious in the above example, the investor should carefully monitor the sources of risk in his assets. The hedge in this case is complex, but within the framework of the developed market there is an instrument called credit default swap (swap), which will be discussed further.
Economic theory asserts that there are periods of economic growth and periods of economic decline. The reasons for this phenomenon are outside the topic of this article, but it should be noted that the risk of an economic downturn is present in the market.
This risk is a good example of a hedge strategy that is applicable in developed markets. For example, if an investor is interested in an asset that is highly cyclical (luxury brands, real estate, and similar areas that grow together, or even stronger, than the general economy), then as part of a cycle hedge, the investor may be interested in buying anti-cyclical assets (cheap product networks, manufacturers of consumer goods, credit unions, etc.).
This topic is closer to the topic of portfolio management, but within the framework of portfolio management, the use of such a strategy is cyclical risk hedging.
The risk of changes in the base price
One of the most understandable risks is the risk of changes in the price of the underlying asset. Actually, it was to protect against this risk that derivatives were created, which we will talk about in this article.
Initially, the request for such a hedge took place precisely in the production sphere, and the financial market, in turn, produced an instrument that still helps producers in jurisdictions with a developed financial market to hedge against strong fluctuations in the price of the underlying asset. Let's consider an example of hedging.
For example, you are a wheat producer. You are interested in fixing the price of the wheat you have just planted now in order to plan the sowing volume and your expenses. In this case, you fix the price with the help of a futures/forward derivative — in an hour, wheat will be bought from you at the price of this derivative.
Derivatives are a financial instrument that derives its value from the value of another commodity. There are basically 3 types of derivatives:
Let's analyze each type in more detail.
Futures/forward is an obligation to perform a transaction at a certain time in the future at a certain price. The difference between forward and futures is that the forward is not standardized. As part of hedging, this instrument is often used by producers and consumers because it assumes the delivery of the underlying asset (be it oil, wheat or shares) at the end of the futures period. Futures also have speculative potential, but futures speculation is risky and difficult to calculate.
An option is a right for one party and an obligation for the other party at a certain point in the future to execute a transaction at a predetermined price. In this case, the asset is valuable and the party that has the right to execute the transaction pays for its right to the party that undertakes the obligation to execute the transaction.
In the wheat producer example, you can buy an option to sell wheat at a certain price. If the price does not change much before the option's expiration date or if it falls down, you will earn less than when concluding a forward/futures contract. This is explained by the fact that unlike the forward/futures, the asset itself will have a different pricing. But in the event that the price of wheat rises sharply, you can not exercise your put option and make additional money by selling wheat at a better price.
A swap is an exchange, a fairly broad category of options that may differ in the technique of execution, but basically have an exchange between parties with certain risks. For example, the above-mentioned credit default swap is a derivative in which one party assumes the risk of the issuer's default in exchange for regular payments of a certain amount of the risk premium. In the event of the issuer's default, the party that received regular payments must reimburse the party that paid the premium the amount specified in the contract.
Often, a swap can be considered as insurance against a certain risk. That is why the swap is popular as a risk hedging instrument.
Other examples of swaps:
- currency swaps — allow you to fix currency exchange at a certain rate in a certain volume;
- interest rate swaps — allow you to exchange a fixed rate for a floating rate;
- asset swap — exchange of assets.
Read also: How to start investing in Ukraine in 2023
How hedging works in Ukraine
In Ukraine, only basic instruments are available to the investor in the form of a hedge through the second asset. There is a forward on the commodity exchanges, but it is an instrument for the hedge of the manufacturer and there are no speculative options.
Some banks offer currency swaps, but due to the high level of regulation of currency operations at this stage, the client needs to delve into the details. At the same time, as part of the vision of its development, the Settlement Center plans to launch the clearing of currency swaps and interest rate swaps, which, when implemented, can significantly increase the list of available instruments.
FC Daliz-Finance LLC has the ability to purchase military bonds on the secondary market, as well as the experience of purchasing military bonds through primary dealers. In the first months of the war, our clients bought military bonds worth more than 500 million hryvnias. Join their number by submitting an application on our website.
Frequently asked questions: what is hedging
How does hedging differ from diversification
Hedging is conscious protection against a specific risk, diversification is spreading the portfolio across different types of risks. In simple terms, diversification means placing one egg in 10 buckets, hedging means placing 10 eggs in 9 buckets, and leaving one empty.
What is a hedging transaction
A hedging transaction is a transaction whose purpose is to protect against risk. For example, with a currency hedge, the purchase of securities denominated in a more stable currency will be a hedging transaction. In this case, the value of the hedge will be the difference between the yield of the bond in the base currency and the yield of the bond in the stable currency multiplied by the size of the position in the stable currency.