Hedging: Fix the Price or Buy Protection
HedgingA hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.Read on Wikipedia → means using a trade to reduce a risk that already exists. A business may want a predictable currency payment, while an investor may want protection against falling share prices.
The result depends on the kind of protection chosen. A forwardIn finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.Read on Wikipedia → fixes a future price. A purchased optionIn finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.Read on Wikipedia → protects against an unfavourable move while allowing the buyer to benefit from a favourable one. The price of this right is called the premiumIn finance, an option is a contract which conveys to its owner, the holder, the right, but not the obligation, to buy or sell a specific quantity of an underlying asset or instrument at a specified strike price on or before a specified date, depending on the style of the option.Read on Wikipedia →.
Fixing the cost of an import payment
Consider ImportCo, a US company that must pay £10 million in three months. The amount in pounds is fixed, but the company does not yet know the dollar cost. A stronger pound would make its purchase more expensive.
In the chapter’s historical example, the bank offers to sell pounds forward at $1.2225 each. ImportCo agrees to buy the required amount at that rate:
£10,000,000 × $1.2225 per pound = $12,225,000Both parties must complete the forward. ImportCo has fixed its payment at $12,225,000, whatever happens to the exchange rate, assuming the contract is fulfilled.
| Market rate when payment is due | Cost without a hedge | Cost with the forward |
|---|---|---|
| $1.2000 per pound | $12,000,000 | $12,225,000 |
| $1.3000 per pound | $13,000,000 | $12,225,000 |
At the lower rate, ImportCo gives up a possible saving of $225,000. At the higher rate, it avoids an additional cost of $775,000. Neither outcome changes what the hedge was intended to do: make the payment predictable.
An exporter has the opposite currency need. The chapter’s ExportCo expects to receive £30 million, so it agrees to sell those pounds forward. At a bank buying rate of $1.2220, it fixes dollar revenue of $36,660,000. The importer needs protection against a rising pound; the exporter needs protection against a falling pound.
Protecting shares while keeping the benefit of a rise
An option provides a different kind of protection. Suppose an investor owns 1,000 shares worth $28 each and is worried about a fall over two months. The investor buys the right to sell those shares at $27.50 each.
That right is a put optionIn finance, a put or put option is a derivative instrument in financial markets that gives the holder the right to sell an asset, at a specified price, by a specified date to the writer of the put. The purchase of a put option is interpreted as a negative sentiment about the future value of the underlying stock. The term "put" comes from the fact that the owner has the right to "put up for sale" the stock or index.Read on Wikipedia →. In the chapter’s example, each contract covers 100 shares, so ten contracts protect the whole holding. The premium is $1 per share, giving a total protection cost of $1,000.
If the share price falls below $27.50, the investor can use the puts and receive $27,500 for the shares. After subtracting the premium, the result is $26,500. If the shares are worth more than $27.50, the investor can keep or sell them at the higher market price instead. The premium still reduces the result by $1,000.
This protects a minimum final value, but it does not prevent every loss. The shares were initially worth $28,000. A final value of $26,500 after the premium represents a $1,500 loss. Of that amount, $1,000 is the premium; the other $500 is the fall from $28 to the protected price of $27.50.
For readers who want to express this as a formula, let S_T be the share
price after two months. The function max chooses the larger value:
Final value after premium = 1,000 × max(S_T, 27.50) − 1,000The formula says to use either the market price or the protected sale price, whichever is higher, and then subtract the cost of protection. Interest and trading fees are excluded from these examples.
Choosing what to protect
A forward is useful when fixing the price is the priority. A purchased option is useful when the buyer wants a limit on an unfavourable outcome while keeping the benefit of a favourable move. That choice has a cost: the premium must be paid even if the protection is never needed.
FuturesIn finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.Read on Wikipedia → can also be used to hedge, but their standard sizes and dates may leave a mismatch. Their regular settlement payments can create cash needs before the protected business payment arrives.
The right question is how the hedge changes the combined result. A gain on a currency contract can offset a more expensive business payment, while a loss can come with a cheaper payment. Looking at either part alone can give the wrong impression of whether the protection worked.
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