Hedging

Presented By

Ekta Mittal

Avishek Bansal

Sanuj Kumar

Krishna Mishra

• Hedgers participate in derivatives market to lock in the prices at which they will be transacting in future.

• They try to avoid price risk by entering in future contract.

• Example. A wheat farmer

Hedge

• Hedgers can be govt. institutions, private institutions like financial institutIons, trading companies.

• They can also be participants like farmers, millers, extractors, processors who are influenced by commodity prices.

Who are Hedgers

• Hedger normally takes an opposite position in the derivatives market to what he has in the underlying market.

• Investor will always try to neutralize the risk.

Principles of Hedging

• Short hedge:-

short future position

sell an asset

• Long hedge:-

long future position

buy an asset

TYPES OF HEDGES

Short Hedge

• Short hedge is strategy used by producer/seller to reduce the risk of price movement of any commodity.

• Short hedge occurs when hedger already owns the asset, or is likely to own the asset and expect to sell it at some time in future.

• Short hedge takes place when producer fears that price of commodity will go down.

Example

• Suppose it is April 1 and a refined soy oil producer expects to produce soy oil in June. He has just negotiated contract to sell 10,000 kg of soy oil in June 1 market price.

• On April 1, the cash price for soy oil is Rs 450 per 10 kg.• June NCDEX soy oil futures price is Rs 465 per 10 kg. • The farmer is worried that cash price of soy oil(in June)

may decline significantly. • The farmer may hedge against the declining price risk by

short hedging. • To fully cover expected cash position, he needs to short

10 NCDEX soy oil futures (because the size of NCDEX soy oil futures is 1000 kg.)

Payoff Diagram

Long Hedge

•Hedges that involve taking long position in future contract are known as long hedge.

•It is appropriate when a one know it has to purchase certain asset in future and fear in rise in prise.

Long Hedge Cont…..

• Purpose oh hedging is not to make profit , but to lock on price to be paid in the future upfront.

• Hedger with long position usually avoid any possibility of having to take delivery by closing out their position before delivery period.

Long Hedge

• Suppose that

F1 : Initial Futures Price

F2 : Final Futures Price

S2 : Final Asset Price

• You hedge the future purchase of an asset by entering into a long futures contract

• Cost of Asset=S2 –(F2 – F1) = F1 + Basis

Example for buyer of long hedge.

Hedge Ratio

• Hedge ratio is the ratio of the size of position taken in the futures contracts to the size of the exposure in the underlying asset.

• A ratio comparing the value of a position protected via a hedge with the size of the entire position itself.

• Say you are holding $10,000 in foreign equity, which exposes you to currency risk. If you hedge $5,000 worth of the equity with a currency position, your hedge ratio is 0.5 (50 / 100). This means that 50% of your equity position is sheltered from exchange rate risk.

Optimal Hedge Ratio

• The hedge ratio is important for investors in futures contracts, as it will help to identify and minimize basis risk.

• This one that minimizes the variance of the hedger's position.

• For example, if the hedgers exposure in the underlying was to the extent of 11 bales of cotton, the futures contracts entered into were exactly for this amount of cotton. We were assuming here that the optimal hedge ratio is one.

Mathematical Formula

• h = ρ σS / σF

where:• σS: Standard deviation of ∆S• σF : Standard deviation of ∆F• ρ : Coefficient of correlation between .S and .F• h: Hedge ratio• ∆S: Change in spot price, S, during a period of time equal

to the life of the hedge• ∆F: Change in futures price, F, during a period of time

equal to the life of the hedge

Example

Let us consider an example. A company knows that it will require 11,000 bales of cotton in three months. Suppose the standard deviation of the change in the price per quintal of cotton over a three-month period is calculated as 0.032. The company chooses to hedge by buying futures contracts on cotton. The standard deviation of the change in the cotton futures price over a three-month period is 0.040 and the coefficient of correlation between the change in price of cotton and the change in the cotton futures price is 0.8. The unit of trading and the delivery unit for cotton on the NCDEX is 55 bales. What is the optimal hedge ratio? How many cotton futures contracts should it buy?

Cont..• If the hedge ratio were one, that is if the cotton spot and

futures were perfectly correlated, as shown in Equation 2, the hedger would have to buy 200 units (one unit of trading = 55 bales of cotton) to obtain a hedge for the 11,000 bales of cotton it requires in three months.

Number of contracts =11, 000/55 1 N p=1 = 200 2• However, in this case as shown in Equation 4, the hedge

ratio works out to be 0.64. The company will hence require to take a long position in 128 units of cotton futures to get an effective hedge (Equation 6).

Optimal hedge ratio = 0.8 x 0.032/0.040 3• h = 0.64 4• Number of contracts = 0.64 x 11,000/55 5• N p=0.8 = 128 6

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