Hedging Meaning – Concept, Strategies, How-to

Hedging – How to and concept

Hedging currency or stocks is a very worthwhile proposition if done correctly, in times of high volatility it is essential.

Hedging – Meaning

Heding is cutting your risk when adverse conditions are expected or as a general practice. It is primarily utilizedto keep value constant. There can be a profit, but that is not the aim of a hedge. Think of it as insurance on a house or stock/currency.

A hedge is an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security.

Source: Investopedia

1. Hedging – When and Why

Hedging to pay!

Let us assume we want to buy a product, playstation 5, from the USA.

It will be available after 2 months

You have to pay in US Dollars.

Price is 2000 US Dollars.

Today to buy dollars(convert INR to USD) costs: 50 Rs. per dollar.

You have 2000 x 50 = 100000 + 10000 in your bank account.

Great! we have the money and will be able to send the money as per todays price + 10%.

The pay date is: 2 months away. The price of US Dollars can change and become Rs. 60 per dollar. Then we are out of luck and can’t buy the PS5! We only have 110000 in our account but the cost is now: 120000.

This is where hedging saves us, we can buy a call and sell a put to lock in a price for the dollars we have to purchase at the end of 2 months.

2. Hedging to Receive!

Let us assume we want to SELL a product, playstation 4

We are located in India and the buyer is in USA.

The buyer and we have agreed to a date 2 months away for the sale i.e. he will transfer money to after 2 months.

We will receive US Dollars in 2 months.

Price we have agreed is 1000 US Dollars.

US Dollar price today is: Rs. 50 per dollar

If we receive the money today, we would get: 50 x 1000 = 50000.

If the dollar price goes down to 40 in the 2 months we would only get 1000 x 40 = 40000.

We don’t want to take the risk of dollar going down i.e. we want to protect the value of our incoming money, this is where hedging comes into play.

Note: The price of US Dollars in our example can move in a favorable direction as well, but that is speculation and has led to notable failures of big and small companies alike.

How to hedge

There are two major ways to hedge the risk of currency going against us:

1- Futures

2- Options

Let us take a look at how both of these instruments can be used to hedge the currency risk we face in our example above.

1. Futures

This one is a simple transaction.

When you need to buy dollars at a later date, you simply buy a future.

When you need to sell dollars at a later date, you sinply sell a future.

There will be a margin requirement for buying/selling the future. There will be mark-to-market everyday i.e. if you boughtat 50 and the price went to 49 the exchange will request you to give 1 to the broker at the end of the day. You will receive 1 if the price goes to 51.

This is not a preferred method.

2. Options

The choice of most risk-managers.

Continuing from our example:

We have to send 2000 US Dollars 2 months from now.

We want to make sure that the price stays within our risk parameter.

Here is what could be done:
(This is theoretical, there will be some discrepancies)

We are considering options which expire the same month as the payment to be sent.

Time required: 5 minutes.

Buy Call Option near 51 strike price. Premium to be paid to buy: 0.75 per dollar.

Sell Put Option near 49 strike price. Premium to be received to sell: 0.75 per dollar.

Our upfront cost of trade = 0.75 – 0.75 + brokerage + taxes + other charges if any.

Then comes the end of the month:

Case 1

US Dollar Price: 40

Our call option is now worthless = -0.75

Our put option is making a loss = -9 – 0.75

We can purchase dollars for: 40

While in the beginning we could buy for 50.

What is our price now(including all the above = 40 + 9 + 0.75 + 0.75 = 50.50

We wanted to purchase at 50 and by doing this we ended up paying an extra 1%.

Case 2

US Dollar price: 60

Our call option is now worth: 9 – premium we paid (0.75)

We keep the premium from writing/selling the put: +0.75

What is the price of US Dollars we wanted to purchase: 60 – 9 + 0.75 – 0.75 = 51

We wanted to purchase at 50 and by doing this we ended up paying an extra 2%.

In case 1 it would be profitable to not hedge our US Dollar requirement, that would be a risk.

What if we have to recive US dollars?

Read more about Futures and Options: Click here

Did I miss something? Do you want more information, comment below and I will get back to you.

All information here is for educational/research purposes only.

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