Hedging – What is it and uses risk management

The second part of the two-part article

Before discussing the use of the hedge against off-set risk, we need to understand the hedging role and purpose. The history of modern futures trading began in Chicago in the early 1800's. Chicago is located near the Great Lakes close to the agricultural land and cattle in the Midwestern United States, making it a natural center for the supply, distribution and trade of agricultural products. The ingots and deficiencies of these products caused chaotic fluctuations in the price. This has led to the emergence of a market that allows traders, processors and agricultural companies to negotiate contracts to protect them from the risk of adverse price changes and to allow them to hedge.

The first exchange of goods in 1848 was the formation of the Chicago Board of Trade (CBOT). Since then, modern derivatives have grown more and more than the agricultural sector. The products include stock prices, interest rates, currency, precious metals, oil and gas, steel and a variety of other. The origins of commodity exchange and futures stock exchange were created to support hedging. The role of speculators is beneficial, as they increase trading volume and significant volatility in the otherwise small and illiquid markets.

A bona fide hedge is bought or sold by someone with a real product. The hedge item establishes a forward or commodity position, thus introducing the price of the product. Someone who buys a hedge is known as "Long" or "Taking Delivery". The hedge-selling person is called "Short" or "Making Delivery". These positions known as "contracts" are legally binding and executed by the stock exchange.

Entering trade for speculation or hedging is done via broker or commodity trading advisor. Stock and futures markets are different from the stock market, although they operate with the same customers. These are regulated by various agencies such as the Commodity Futures Trading Commission, which are responsible for regulating retail intermediaries in the United States, and Commodity Trading Advisors, who are truly portfolio managers for derivative transactions.

Let's look at some real-world examples of risk hedging or risk mitigation using interchangeable derivative transactions.

first Example: The fund manager has a $ 10 million portfolio that is very similar to the S & P 500 index. The Portfolio Manager believes that the economy is deteriorating with declining corporate returns. The next two to three weeks report quarterly corporate earnings. While the report shows companies are weak in revenue, they are concerned about short-term general market correction. Without the prerogative of foresight, you will be sure of the size of your income data. At present it is exposed to market risk.

The manager thinks of his options. The biggest risk is that it does nothing if the market falls as expected, with the risk of giving up recent profits. If you are selling your portfolio early, you also risk being misplaced and missing a rally. Sales also result in significant brokerage fees with additional fees that will later be repurchased.

Then he realizes that the hedge is the best option to reduce short-term risk. He commands the CTA (Commodity Trading Advisor) call, then orders the $ 10 million S & P 500 equivalent on the Chicago Mercantile Exchange "CME" after consulting locations. The result is now that, when the market decreases as expected, the losses from the portfolio are earned from the Index hedging index. If your earnings report is better than expected and your portfolio continues, you will continue to generate profits.

Two weeks later, the fund manager recalls the CTA and closes the hedge by returning the number of equivalent contracts in CME. Irrespective of the emerging market events, the investment fund manager was protected during the short-term volatility. The portfolio was not at risk.

2nd Example: The ABC electronics company has recently signed a mandate to deliver $ 5 million to electronic components in the coming years for a European overseas retailer. These ingredients are built up within 6 months after two months of delivery. ABC immediately realizes that it is exposed to two risks:

1. the increasing and fluctuating price of copper can cause losses for 6 months in the company. 2. Currency fluctuation could easily contribute to losses. ABC as a young company can not absorb these losses in view of the competitive market from others. The resulting losses would result in redundancy and possibly shutdowns.

ABC calls the CTA and assigns two hedges after the consultation, up to the 8-month maturity until the delivery date. Cover No. 1 is to buy a long $ 5 million of copper, effectively closing today's price against further price increases. ABC has now eliminated all price risks. The risk of plant closures is greater than attracting increased profits if copper prices are expected to fall. After all, ABC does not deal with speculation about copper prices.

Hedge 2 represents equivalent sales between the Euro Currency and the US Dollar. As ABC effectively accepts the EC as insolvent, rising US dollar and weak EK damage would further weaken profits. The hedging result is neither a risk nor a surprise to ABC at the level of copper or currency. A risk-free transaction and full transparency are the result. In the 8 months following the order and after the customer has been accepted, ABC will notify CTA of closing the hedge with the sale of copper and the repurchase of euro currency deals.

There are many examples of mitigating the risk of an institution or a financial portfolio. New products have been continuously created and made available in both the OTC and Exchange markets. It is wise to consult a qualified stock market advisor or agent to discuss the analysis of a continuous risk management solution or a one-time hedge.

Source by sbobet

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