Features of Hedging, Forward, Future, Options and Swaps

Hedging

Hedging is a standard practice followed in the stock market by investors to safeguard themselves from the losses that might arise from market fluctuation. In a way, hedging is the insurance that helps the investor to lessen their losses, but it does not prevent the negative things happening in the course of life or business. Hedging is followed in all walks of life like opting for car insurance, life insurance, term insurance and so on.

The technique of hedging is also followed at an institutional level by portfolio and fund management companies to minimize their exposure to different types of risk and to decrease its negative impact.

In the stock market, the hedging technique is used in the following areas:

• Commodities
• Securities
• Currencies
• The interest rate
• Weather

Hedging is also a technique that will help the investor to gain profits by trading different commodities, currencies or securities. Hedging is of three types namely:

• Forward contract: The forward contract is a non-standardized agreement to buy specified assets at a determined price on a date agreed by two independent parties. The forward contract is drawn for various types of assets like commodities, currencies, etc.
• Futures contract: The futures contract is a standardized agreement to buy specified assets at a specified price on a date agreed by two independent parties. The futures contract is drawn for various types of assets like commodities, currencies, etc.
• Money Markets: Money markets cover many types of financial activities of currencies, money market operations for interest, calls on equities where short-term loans, borrowing, selling and lending happen with a maturity of one year or more.

Hedging strategies

When looking for investment options, hedging helps the investor to spread their risks and reduce them to a certain extent. As the market is unpredictable so are the hedging techniques. The hedging technique will have a constant modification as per the market situation and the investment type.

Some of the common strategies followed in hedging are as follows.

• Asset allocation: While investing, the investor can hedge their risks by diversifying their portfolio into asset allocations that carry risk and assets that provide stable returns and balance their portfolio.
• Structuring the portfolio: Another type of hedging is the technique of structuring. Here the investor will invest a portion of their portfolio in debt and some in derivatives. Debt gives stability and derivatives to protect the investor portfolio from risk.
• Hedging by options: This technique involves call and puts options of assets. This helps the investor to safeguard their portfolio directly.

Benefits of hedging

• The basic advantage of hedging is that it limits the losses of the investor.
• Hedging protects the profits of the investor.
• It increases the liquidity of the financial markets as hedging prompts the investor to trade across different markets of commodity, currencies and derivative markets.
• The hedging offers flexible price mechanism as it requires very less margin outlay.

Hedging offers a scalable advantage to investors and traders to effectively trade in the market. As risk is an essential part of the trading cycle and its main motive is to gain profit. However, as the market remains unpredictable, hedging offers a safety net for investors and helps them to protect themselves from market uncertainty.

Forwards

Forwards and futures are very similar as they are contracts which give access to a commodity at a determined price and time somewhere in the future. A forward distinguish itself from a future that it is traded between two parties directly without using an exchange. The absence of the exchange results in negotiable terms on delivery, size and price of the contract. In contrary to futures, forwards are usually executed on maturity because they are mostly use as insurance against adverse price movement and actual delivery of the commodity takes place. Whereas futures are widely employed by speculators who hope to gain profit by selling the contracts at a higher price and futures are therefore closed prior to maturity.

Futures

Futures are exchange organized contracts which determine the size, delivery time and price of a commodity. Futures can easily be traded because they are standardized by an exchange. Per commodity traded there are different aspects specified in a futures contract. First of all is the quality of a commodity. For a commodity to be traded on the exchange, it must meet the set requirements. Second is the size of a single contract. The size determines the units of a commodity that is traded per contract. Thirdly is the delivery date, which determines on which date or in which month the commodity must be delivered. Thanks to the standardization of futures commodities can easily be traded and give manufacturers access to large amounts of raw materials. They can buy their materials on the exchange and don’t need to worry about the producer or take on contracts with multiple suppliers.

Options

Options are a form of derivatives, which gives holders the right, but not the obligation to buy or sell an underlying asset at a pre-determined price, somewhere in the future. When you take an option to buy an asset it is called a ‘call’ and when you obtain the right to sell an asset it is called a ‘put’. To determine whether it is profitable to exercise an option, the current market price (spot price) and the price in the option (strike price) need to be compared. By comparing both prices, a choice can be made to either exercise the option or let it expire. When exercising an option there are three positions on which the holder can find themselves. The first is in the money (ITM), where the strike price is more favorable than the spot price and thus it will be advantageous to exercise the option. The second is at the money (ATM) in which the strike and spot price are equal and so no advantage can be gained. The third is out the money (OTM), where the strike price is higher than the spot price. In this case it is better to let the option expire and buy the commodity at the current market price. There are two ways of settling an option between two parties. The first way is to physically deliver the underlying commodity. The other way is to cash settle the option. In this way the difference between the spot and strike price is paid to the holder of the option upon exercising of the option. An option has a few advantages over other derivatives. The most important advantage is that an option is not binding, in the way is does not obligate one to buy a commodity. It gives you the right to buy it and so when the price of the option is higher than the current market price you can just let the option expire and buy at the spot price. The only loss made, will be the premium which is the cost for maintaining the option. Another advantage is the usefulness of options as a hedging tool. Options offer the tools to successfully hedge price movements with a small investment risk.

Swaps

A swap is an agreement between two parties to exchange cash flows on a determined date or in many cases multiple dates. Typically, one party agrees to pay a fixed rate while the other party pays a floating rate. For example, when trading commodities the first party, an airline company relying of kerosene, agrees to pay a fixed price for a pre-determined quantity of this commodity. The other party, a bank, agrees to pay the sport price for the commodity. Hereby the airline company is insured of a price it will pay for its commodity. A rise in the price of the commodity is in this case paid by the bank. Should the price fall the difference will be paid to the bank.