Hedging is insurance of financial risks. Risk hedging. What is this in simple words? For what purposes is hedging used?

Hedging(in English hedging, from English hedge ( hedge) - barrier, insurance, guarantee) - this is a reduction in risk, insurance against losses caused by changes in market prices for goods in comparison with the prices that were taken into account when concluding the contract.

The purpose of hedging (risk insurance): protection against unfavorable changes in market prices, commodity assets, interest rates, etc. For example, an investor has Gazprom shares in his portfolio, but is wary of a decline in prices for this instrument, so he opens a share in Gazprom or buys, and thus insures himself against a fall in prices for this asset.

The meaning of hedging: the buyer/seller of a commodity enters into a contract for the purchase and sale of it and at the same time carries out a transaction of the opposite nature on futures, that is, the buyer enters into a transaction to sell, and the seller to purchase the commodity.

Hedging mechanism: balancing obligations in the cash market (commodities, currencies) and opposite in direction in the futures market.

The result of hedging: reduced risks and reduced possible profits.

One of the most common is hedging with futures contracts. The emergence of futures was caused by the need to hedge against changes in commodity prices. The first transactions with futures contracts were made precisely to protect against sudden market changes. Until the 1950s, hedging was used only for withdrawals. Currently, the purpose of hedging is not to eliminate, but to optimize risks.

In addition to operations with futures, operations with other derivatives instruments: forward contracts and options can also be considered hedging operations. However, according to IFRS standards, the sale of an option cannot be recognized as a hedging transaction.

The hedging process is a method of using an instrument (currency, metals, raw materials) that reduces the risk and adverse impact of market events on the price of the instrument. Not every tool is suitable for this method of work, so it is important to study the data about them and what relationships they have, if at all.

Hedging example

As an example, let's take the following situation - there is a certain enterprise in Russia, and it needs to take out a loan for several million US dollars.

The profit of this enterprise is in rubles, which means that it will be unprofitable for it if the dollar exchange rate rises. Respectively further rise of the dollar against the ruble will have an extremely negative impact on the company's profits.

To insure against such situations, the company will have to purchase a futures contract on the US dollar or a call option on it. Consequently, as a result of the growth of the dollar exchange rate, the cost of the loan that must be repaid will also increase.

Enterprise will make a profit from production tools and will be able to receive compensation for losses from the rise of the dollar.

Let's look at the meaning of futures and options to understand the essence of the method.

Hedging Strategies

There are many strategies using hedging, which are based on the possibility of reimbursing losses incurred in the commodity market during unidirectional movements of the spot price (the price at which a currency or commodity with quick delivery is sold) and the futures price in the futures market.

Let's look at some strategies using this technique:

1. Hedging by selling futures. It consists of selling futures on the futures contracts market in a quantity that is comparable to the volume of the hedged consignment of goods.

2. Hedging by purchasing a put option. If you purchase an option of this type, you have the opportunity to sell the future at a certain price at any time. When purchasing this type of option, the seller of the commodity fixes the minimum selling price, while having the opportunity to take advantage of a profitable price increase in the future.

3. Hedging by selling a call option. If you purchase an option of this type, you have the opportunity to buy futures at a specified price at any time. When selling an option, the seller agrees to sell the future at the strike price if the option buyer requests it. The seller receives a premium for selling the option.

4. Various hedging instruments. There are many different hedging techniques based on options transactions. To select certain hedging instruments, it is necessary to conduct a thorough analysis of the needs of the person who is engaged in hedging, the current situation in the economy, and the prospects of the industry.

Although there are difficulties in developing and applying hedging strategies, they play a very important role in the ability to ensure stability in development.

It is necessary to understand how and where to apply these methods, because hedging is, first of all, risk reduction, and profits should come primarily from production activities.

Video about hedging currency risks

In the system of enterprise risk management methods, the main role belongs to internal mechanisms.

Internal mechanisms for neutralizing financial risks are methods for minimizing their negative consequences, selected and implemented within the enterprise itself.

These include:

risk avoidance;

limiting risk concentration;

hedging;

diversification;

creation of special reserve funds (self-insurance funds or risk fund);

insurance.

Hedging is a system of concluding futures contracts and transactions that takes into account probable future changes in exchange rates and aims to avoid the adverse consequences of these changes.

In a broad interpretation, “hedging” characterizes the process of using any mechanisms to reduce the risk of possible financial losses - both internal (carried out by the enterprise itself) and external (transferring risks to other business entities - insurers). In a narrow sense, the term “hedging” characterizes an internal mechanism for neutralizing financial risks, based on insuring risks against unfavorable changes in prices for any inventory items under contracts and commercial transactions involving the supply (sale) of goods in the future (usually derivative securities - derivatives).

A contract that serves to insure against the risks of changes in exchange rates (prices) is called a “hedge,” and the business entity carrying out the hedging is called a “hedger.” This method makes it possible to fix the price and make income or expenses more predictable. However, the risk associated with hedging does not disappear. It is taken over by speculators, i.e. entrepreneurs taking a certain, pre-calculated risk.

There are two hedging transactions: upside hedging and downside hedging.

Upward hedging (purchase hedging) is an operation to purchase futures contracts or options. An upward hedge is used in cases where it is necessary to insure against a possible increase in prices (rates) in the future. It allows you to set the purchase price much earlier than the actual product was purchased. A hedger that hedges to an upside insures itself against possible price increases in the future.

Downward hedging (sale hedging) is an exchange operation involving the sale of a futures contract. A hedger who hedges down expects to sell a commodity in the future, and therefore, by selling a futures contract or option on the exchange, he insures himself against a possible price decline in the future. A downward hedge is used in cases where the product needs to be sold at a later date.

Depending on the types of derivative securities used, the following mechanisms for hedging financial risks are distinguished.

1. Hedging using futures contracts is a mechanism for neutralizing risks from operations on commodity or stock exchanges by conducting opposite transactions with various types of exchange contracts.

The principle of the hedging mechanism using futures contracts is based on the fact that if an enterprise suffers a financial loss due to changes in prices at the time of delivery as a seller of an actual asset or securities, then it gains in the same amount as a buyer of futures contracts for the same amount of assets or securities. securities and vice versa.

2. Hedging using options - characterizes the mechanism for neutralizing risks in transactions with securities, currencies, real assets or other types of derivatives. This form of hedging is based on a transaction with a premium (option) paid for the right (but not the obligation) to sell or buy, during the period specified in the option contract, a security, currency, real asset or derivative in a specified quantity and at a predetermined price.

3. Hedging using a SWAP operation - characterizes the mechanism for neutralizing risks in transactions with currency, securities, and debt financial obligations of an enterprise. The swap operation is based on the exchange (purchase and sale) of relevant financial assets or financial liabilities in order to improve their structure and reduce possible losses.

Swap (English Swap i.e. exchange) is a trade and financial exchange operation in the form of an exchange of various assets, in which the conclusion of a transaction for the purchase (sale) of securities, currency is accompanied by the conclusion of a counter-transaction, a transaction for the reverse sale (purchase) of the same product through a certain period under the same or different conditions.

Hedging example: Let's say you are a shareholder of GazProm, and you expect the stock to grow in the long term. But fearing a short-term price decline, you insure yourself, i.e. hedge against the fall. To do this, you buy an option with the right to sell (English put option) shares of GazProm at a certain price. If suddenly your fears become reality and the market price of the stock falls below the strike price specified in the option, then you will simply sell the share at this price specified in the option.

For business success, it is not enough to earn high profits; you also need to minimize costs and especially losses. Any entrepreneurial activity carries an element of unpredictability: often everything can change due to circumstances beyond the control of the parties to the transaction. Naturally, it is impossible to predict all market fluctuations and possible force majeure, but you can try to insure your business against large financial losses. This activity is called hedging.

What kind of set of measures this is, what tools can be used for hedging, how effective it will be for business, we will explain and show with specific examples.

What is hedging

This is an English term (English Hedging), comes from “hedge” - guarantee, insurance. In modern financial activity hedging– a set of actions aimed at managing monetary risks by influencing the possible dynamics of the value of future assets. The seller or buyer who insures himself in this way is called hedger.

The point of hedging is to insure against possible market fluctuations by simultaneously taking two opposite positions in assets. Thus, no matter what happens to the market situation, the investor, trader, seller or buyer will end up with exactly what he planned.

IMPORTANT! Hedging makes it possible to guarantee the avoidance of financial losses, but thereby eliminates the opportunity to gain additional profit by taking advantage of a favorable turn in the market situation. Hedging means protecting yourself from potential risk at the cost of reducing potential profit.

FOR EXAMPLE. The company mines iron ore. According to forecasts, in a quarter the price of this resource will drop significantly. The company's management, in order not to lose future profits, can take one of two paths:

• sell part of the supply contracts, thereby reducing production costs and slightly reducing the volume of production (“the profit not collected” on the ore price is compensated by funds received from the contracts);
• fix the price of your products for a certain period by concluding an appropriate agreement.

If the forecast turns out to be incorrect (iron ore does not become cheaper, but increases in price), the company will not be able to take advantage of this favorable environment, receiving only the planned profit and nothing beyond it.

The buyer can also insure his transactions by making such transactions.

Where is hedging most often used?

The use of hedging is popular when trading goods in global demand, both on and off exchanges. Assets can be:

• securities;
• metals;
• energy resources;
• corn;
• currency, etc.

Hedging mechanism

To ensure risk management, an agreement is concluded not regarding the transaction itself, but regarding the obligations for this asset - derivative. The derivative has a number of features:

• the purpose of a derivative is not to sell an asset, but to hedge a risk;
• Unlike a regular contract, a derivative is a formality;
• this is a type of security, it can be sold on its own without regard to the asset (by one party or both);
• the price of a derivative does not have to be tied to the price of the underlying asset, although it usually changes with it;
• buyers and sellers of derivatives may not necessarily be the owners of the asset itself;
• you can enter into a derivative not only on the underlying asset, but also on another derivative (for example, an option on a forward transaction);
• Derivatives are settled in the future tense.

REFERENCE! Hedging occurs when a transaction participant enters into a contract in the asset market and at the same time (or earlier) in the derivative market.

In the Russian Federation, actions related to derivatives are regulated by Federal Law No. 39-FZ “On the Securities Market” of April 22, 1996.

Hedging instruments

Possible financial risks can be insured using various economic instruments. They are called derivatives because they are based not on the sale of the asset itself, but on the application of one or another derivative.

ATTENTION! Derivative instruments, like the assets themselves (commodities, liabilities, securities), are sold according to the laws of the market, and the participants in transactions with them are the same.

Let's look at the most common hedging instruments:

1. Futures(from the English “future” - “future”) - an instrument that stipulates the obligation of the parties to pay for a specified asset or derivative in a specified quantity the price agreed upon by the parties in this contract. This is a strict agreement that is binding on both parties. Futures are regulated by the exchange, which takes a guarantee for this - a small percentage of the contract. The most liquid derivative of all, but also the one with the highest degree of risk.
2. Forward(from the English “forvard” - “forward”) is an instrument similar to futures, operating outside the exchange. Most often used when trading currencies.
3. Option(from English « option" – “parameter, option”) is a financial instrument that allows the user to choose whether or not to exercise the right to buy/sell an asset at a fixed price at the time specified in the agreement, in contrast to a futures contract, where there is no such choice. Exchange-traded (standardized) and over-the-counter options can be used. There are different types of options:
   • put options– allowing you to sell or not sell at a fixed price;
   • call-options – giving the right to buy or not to buy at an agreed price;
   • double options– bilateral contracts.

Examples of derivatives

Futures example

Company A entered into a futures contract with a supplier on the stock exchange to purchase 1,000 tons of grain at a price of 12,000 rubles. per ton, and the wheat has just been planted. Experts suggested that due to the drought, the harvest would not be large and prices would rise. When the futures expiration date approaches, if this contract was not previously sold to another company, the following options are possible:

1. The price of grain on the market has not changed - at the same time, both the seller and the buyer will not change their balance.
2. The harvest turned out to be higher than expected, and the price of grain dropped to 10,000 rubles. per ton. Firm A will incur losses in the amount of 2,000 rubles. on each ton, which will need to be additionally charged to the supplier in addition to the contract amount.
3. The price has risen, as the buyer expected, grain on the futures execution date is quoted at 13,000 rubles. per ton. In this case, company A receives the planned profit, and the supplier experiences a loss of 1000 rubles. for every ton, that is, the balance will decrease by this amount.

In addition to these financial flows, company A, when concluding a futures contract, paid the obligatory exchange interest - the guarantee of the transaction (from 2 to 10%, depending on the rules of the exchange).

PLEASE NOTE! No real grain is transferred in a futures transaction.

Forward example

The Verum company entered into a forward contract with the Dilogy company to purchase 100 of its shares in six months at a price of 200 rubles. per share. At the appointed time, representatives of “Verum” will transfer 20,000 rubles to the account of “Dilogy”, and representatives of “Dilogy” will provide “Verum” with 100 shares. There are no options. If the transaction was carried out through an intermediary, he is entitled to a commission, and there may be some overhead costs for processing.

Option example

1. In 2016, the company purchased an option that allowed it to purchase 10,000 US dollars in a year at a price of 50 rubles. for a dollar. Since a year later the rate increased to 57 rubles. per dollar, this option turns out to be profitable, and the company will use it, making a profit of 7 rubles. for every dollar, that is, 70,000 rubles.
2. The individual entrepreneur acquired an option for the right to sell his real estate in a year at a price of 250,000 rubles. per sq.m., counting on a fall in prices for new buildings. If this had happened, he would have exercised the option, sold the property and kept the difference, or, even more profitably, would have purchased a similar area at the market price, leaving a profit. However, in the Russian Federation there is a fall in prices on the primary real estate market, and at the time the option is exercised the price per sq.m. does not exceed 197,000 rubles. Such an option turns out to be unprofitable, and the owner, naturally, will not use it - he has such a right.

Hedging Strategies

To improve hedging efficiency and reduce financial risks, derivatives can be used in different ways:

• use one derivative or combine them in a convenient “proportion”;
• hedge the entire transaction or only part of it;
• make a transaction on derivatives earlier than on fixed assets;
• enter into contracts for assets and derivatives of varying duration and volume;
• use derivatives on hedging items other than the underlying asset (for example, when planning to buy oil, minimize the risk with an option to buy gold).

Hedging is an effective way to insure against financial risks.

When buying shares and other financial assets, they worry about their future value and fear unfavorable movements in the market value. The simplest way to protect yourself in this case is to place a stop order to close the transaction (stop loss). But a stop loss is not always effective, since sometimes the price can “pierce” it a little, and then reverse, but without a trader. A much more effective way is hedging. In essence, hedging is a risk management tool that allows, through the acquisition of one asset, to compensate for the possible unfavorable movement of another.

Fig.1. An example of a sharp downward price movement followed by a reversal.

Hedging is a lot like insurance. It’s not for nothing that this term comes from English. hedge - insurance. For a fraction of the cost of the car, owners purchase insurance policies that entitle them to payout if something goes wrong with the vehicle. The same is possible with the help of instruments for hedging financial risks when trading on the stock exchange. By purchasing an asset on the stock exchange, you can acquire the right to sell it in a certain volume before a certain date in the future for a cost that is several times less than the value of the asset (like an insurance policy - cheaper than a car).

Risk hedging instruments

The most common instruments for hedging risks are derivatives market assets - futures and options, which are contracts to carry out a transaction in the future at predetermined prices. The buyer's risk is the unknown sale price, while the seller's risk is the unknown price of the subsequent purchase. And derivatives market instruments make it possible to determine this price in advance, making it possible to hedge both the investor’s long and short positions. Futures contracts are contracts that give a mutual obligation to buy/sell an asset at a certain date in the future at a pre-agreed price.

Futures are presented for various groups of assets: indices, stocks, bonds, currencies, commodities. Therefore, they allow you to hedge them.

The second group of derivatives market assets are options, and in the domestic market options are presented specifically for futures contracts.

An option is the right to buy/sell a certain amount of an underlying asset (the corresponding futures) before a certain date in the future. Since options are futures contracts, their asset groups are therefore the same.

It is worth noting that not only derivatives market instruments are hedging assets. If there is a certain situation, other exchange-traded assets can serve the purpose of hedging.

How to learn to hedge using futures and options? Read our special, which contains many practical examples.

Basic hedging methods

1. Classic hedging appeared on the Chicago commodity exchanges. When, due to the risks of non-execution of transactions postponed for various reasons (for example, the delivery of wheat that has not yet grown on a certain date), together with the transaction contract, an option was concluded for the supply of this product at the price of the primary contract.
2. Direct hedging is the simplest method of hedging. Having a certain asset and fearing for its future exchange rate fate, the investor enters into a forward contract for its sale, thereby fixing the sale price for the period of the forward contract.
3. Anticipatory hedging can serve as a tool for hedging currency risks when planning a transaction. Planning the further implementation of the transaction and observing the appropriate value of the asset at the moment, the investor buys a futures contract for the specified asset, as a result of which its current value is fixed for a transaction in the future.
4. Cross hedging is often used to hedge a portfolio of securities. The essence of the method is to conclude a futures contract not for an existing asset, but for another, with a certain degree of similarity in trading behavior. For example, to hedge a portfolio consisting of many securities, if there are certain concerns about a possible decrease in its value, you can sell a futures or options contract on the RTS index, which is a barometer of the Russian market. Thus, the investor assumes that if the portfolio as a whole declines, the market will most likely also have a downward trend, so a short position on a futures contract on the index will make a profit, mitigating the portfolio drawdown.
5. Hedging by direction. If an investor has a certain number of long positions in his portfolio and is afraid of their exchange rate decline, the portfolio must be “diluted” by a certain amount with shorts on weaker securities. Then, during a period of general decline, shorts, which decline faster than long positions, will make a profit, compensating for the loss of longs.
6. Cross-industry hedging. If there are securities of a certain industry in the portfolio, they can be “insured” by including in the portfolio longs for securities of another industry, which is more prone to growth when the first declines. For example, a decrease in domestic demand securities when the US dollar rises can be hedged by including longs on exporters' securities, which traditionally grow when the value of the currency increases.

Now that you are familiar with the basic risk hedging tools, it's time to start learning strategies. And then try to apply them in practice.