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Hedging Strategies in Derivative Markets
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Introduction
Hedging is one of the most popular strategies of the market risk management. The main purpose of hedging is to reduce the volatility (or variability) of the yield on the portfolio composed of spot assets and hedging tools. The hedging tools may consist of futures contracts, options and off-exchange tools such as forwards and swaps. Hedging strategies using futures contracts are the simplest ones and therefore very common in practice. The purpose of the study is to compare four hedging strategies where a share is a spot asset and a futures contract is a hedging asset (Fok, Carrol and Chiou,1997). The results of comparison showed the strategy based on the calculation of the internal rate of return to be the most effective. According to the other two criteria, the above strategy and the least squares method turned out to be the best. A correction for heteroscedasticity made with the use of the maximum likelihood method did not improve the hedging performance of shares. This work can be developed in several directions, namely: consideration of option hedging strategies; adding other spot assets, eg exchange commodities or currencies, to the portfolio; taking into account the degree of the investor’s risk aversion in calculating the hedge ratio; introduction of transaction costs into the model.
Taking into account the prolonged financial crises of recent years and the instability of the world economy, the paramount task is not to get the maximum possible profit, but to control risk and ensure predictability of financial results. Today, one of the most affordable ways to control and reduce risk is hedging, which is quite simple to use, allowing you to use derivative financial instruments to redistribute risk among participants in financial markets. There are a large number of hedging strategies with which you can reduce the risk of various financial assets depending on the wishes and preferences of the investor.
Along with diversification, insurance, arbitrage and immunization, hedging is one of the best-known market risk management strategies. Hedging is the insurance of the risk of adverse spot price changes by opening the opposite position in the derivatives market (Jeffrey 2000). The hedging mechanism works in such a way that with its help the total cash flow is stabilized by reducing the variance of flows for specific transactions.
The two main types of hedging are the seller’s hedge and the buyer’s hedge. A seller’s hedge (or short hedge) is used when a market participant plans to sell an asset in the future (goods, currency, securities, etc.) and seeks to limit the risks associated with a possible fall in the price of this asset. A buyer’s hedge (or long hedge) is used in the opposite situation when the hedger is interested in buying an asset and wants to reduce the risk of its price increase (Graham and Rogers, 2002).
As hedging instruments, exchange and over-the-counter instruments are distinguished. OTC instruments include forward contracts and swaps that are entered into directly between counterparties or through an intermediary. Such transactions are infrequent and mostly individual. Exchange hedging instruments include futures contracts and options. Futures are a highly liquid exchange instrument, which explains their active use by both hedgers and speculators.
In order to implement the seller’s hedge strategy and protect against falling prices, it is necessary to sell futures contracts on the underlying (spot) asset. And vice versa, a manager who plans to buy an asset in the future should buy futures contracts so as not to lose from the price increase. At the time of the purchase and sale of futures contracts, the hedger is also determined with the volumes (he will carry out full or partial hedging) and terms, depending on when he plans to close the spot deal.
As noted above, the standard and optimal situation is when the closure of a futures transaction coincides with the closure of a spot transaction. In this case, the optimal number of contracts required for hedging is calculated as the quotient of dividing the volume of the hedged position by the size of one futures contract.
However, in practice, investors usually carry out short-term hedges, so it is not always possible to find the right futures contract. If the deadlines for closing a spot position and a futures contract do not coincide, then you need to choose a contract that expires immediately after the spot transaction is completed. Otherwise, if the futures contract ends earlier, the spot position will not be insured for a certain period of time [5, p. 94]. Such a strategy is called spot hedging. In order to determine the optimal number of futures contracts for spot hedging, it is necessary to calculate the hedging coefficient, which shows how the price of a spot asset changes with respect to the price of a futures contract.
Two main approaches to calculating the hedging ratio can be distinguished – static and dynamic hedging. In the first case, the hedger calculates the number of futures contracts and the hedging ratio before opening a position, leaves them unchanged for the entire validity period, and then executes the contracts. In the second, the hedging coefficient depends on time and is calculated using multidimensional models of autoregressive conditional heteroskeletality, for more details, see [6, p. 39; 7, p. 160]. Of course, dynamic hedging seems to be a more flexible and therefore more accurate way to calculate the hedge ratio. In addition, the use of the MOLESY model allows one to take into account the autocorrelation of the remnants of the regression model, which is certainly present in the analysis of time series. The main disadvantage of this method is the dimension problem, which arises when a sufficiently large number of assets is included in the portfolio and does not allow us to estimate the conditional variational-covariance matrix of portfolio assets in a reasonable time.
Main Arbitrage and Hedging Strategies
In addition, as far as hedging is concerned, it is crucial to understand main arbitrage and hedging strategies using futures contracts, identifies the main problems that impede the development of the derivatives market, and suggests solutions.
Currently, the implementation of arbitrage and hedging transactions by bidders in most cases takes place using automated trading systems, through online networks. Given the growing interest in hedge and arbitrage strategies, the expansion of a number of derivative financial instruments is of great importance. The derivatives market provides ample opportunity to control risks, however, the inability of managers to use risk management tools competently and at a high level in building trading strategies can lead to significant losses. Consequently, constructively constructed strategies using preliminary market analysis are a direct guarantee of success.
So, arbitrage strategies are widespread investment tactics with minimal risk. They represent the purchase of the same financial instrument at a low price and the simultaneous sale of the same instrument at a significantly high price. An arbitrage operation is a form of spread operation, based not on the subjective forecast of a trader, but on fairly regular relationships between market prices (Hull, 2011).
Before considering arbitrage strategies, it is necessary to determine who such an arbitrator is and what is his purpose in the derivatives market. An arbitrageur is an individual or legal entity that performs arbitration transactions. The purpose of the arbiter is to trade financial instruments and profit from market imbalances. He takes two opposite positions on the “revalued” and “underestimated” contracts and is waiting for the elimination of the imbalance between the instruments.
Consider the main arbitrage transactions with derivative financial instruments. The spot futures strategy is a classic arbitrage strategy. Here, the prices of the underlying asset and the futures contract are coordinated among themselves. The difference between the spot price and the futures price has such a concept as a spread (basis).
By the time the contract ends, the spread will decrease and tend to zero. Note that if futures are more expensive than stocks, then you need to sell it, and buy a stock. Equally common is the futures futures strategy, or calendar spread. There is a sale of a distant futures series, since it is more expensive, that is, it is possible to sell the underlying asset at a higher price and buy a near futures series, since it is cheaper, and the arbiter agrees to buy the underlying asset at a lower cost. In accordance with the operations, there is a fixation of the positive difference between prices (Jin and Jorion, 2006).
Statistical arbitrage strategies are deals where futures are interconnected. If a securities have a high correlation, then futures should have the same high level of correlation. Futures prices may be different, and in connection with this a spread arises, but, as practice shows, in the future it may not be, and prices become equal. If you sell revalued futures and buy underestimated, then you can get risk-free profit.
Synthetic arbitrage between futures and options is based on the use of put and call options. The main purpose of making a call arbitrage is to buy a call at a discount to the price at which the shares are sold. Put arbitrage is similar to calling and is carried out by purchasing shares and exercising an option.
We can say that arbitrage strategies are the main attribute on the derivatives market, and before using them, you need to study the market, since many strategies involve risk situations. Next, consider hedging strategies and their types. Hedging strategies are a way of using hedging mechanisms to achieve the goals set by the hedger. The strategy is individual, therefore it is necessary to take into account a number of factors in order to choose the most suitable strategy.
Hedging is not a way to generate net income, but directly protection against losses. This is protection against market, that is, price risk, but not against other
types of risk in the market. Risk protection is carried out using derivatives instruments such as futures, forwards, options and swaps.
A hedge participant is a hedger who protects in his own interests. The following types of hedges are distinguished: producers of goods or owners of an asset, consumers of goods or buyers of an asset, wholesalers or intermediaries.
There are two types of hedging strategies – passive and active. The essence of the passive strategy is that the hedger minimizes his actions in the market in the interval between the beginning of the hedge and its end, that is, “hedged and forgot” . An active strategy involves the hedger constantly monitoring the market situation throughout the hedging period and opening or closing a position to obtain the desired final result.
Consider the basic mechanisms for hedging futures contracts. There is a distinction between hedging from a possible fall in the price of an asset in the future (short hedge, or hedging by the sale of a futures contract) and hedging from a possible increase in the price of an asset in the future (long hedge, or hedging by buying a futures contract).
At the same time, hedging by futures contracts is non-deliverable (settlement) and deliverable. With non-deliverable hedging, the problem is the very absence of a spot price at the time the hedge starts, since there is only the current futures price of the asset, which shows what the spot price will be at the time of the execution of this futures according to the collective opinion of the participants in the futures market from a position given moment in time. Therefore, no matter what the initial price of the concluded futures contract was, his personal spot price at the time of the conclusion of the spot transaction would be the price at which he had previously concluded the futures contract. The hedger seeks to ensure that the difference in futures prices for the desired period of time compensates for the difference in spot prices for the same period of time [6, p. 76]. Non-deliverable hedging is also convenient if there are no contracts with the necessary underlying assets on the futures market: then we will talk about cross-hedging. The essence of cross-hedging is that a position on the underlying asset is opened in the futures market, the price of which closely correlates with the price of the hedged asset.
If we talk about delivery hedging in the futures market, here we can draw an analogy with hedging forward contracts with the difference that in the futures market delivery guarantees are dictated by the exchange and do not depend on the delivery capabilities exclusively of the parties to the contract itself. It is worth noting that during delivery hedging, the hedging mechanism remains similar to non-delivery, that is, the variation margin formed on the account at the delivery date compensates for the result of the transaction at the spot price through the exchange mechanism. The mixed hedging mechanism is the “futures for goods” transaction (EPF transaction), which consists in buying and selling a real asset in accordance with a forward contract, but at the price of the futures market at the time the contract is executed. Since there is no spot price for the purchase and sale of an asset, the basic risk is also excluded. The result of such a transaction is that the seller and the buyer made a real transaction with their asset at the market price that they considered the most acceptable for themselves, that is, they were hedged.
Problems related to hedging
One of the most common problems in applying arbitrage and hedging strategies is the underdeveloped legislative and regulatory framework. The formation of market pricing conditions for the most important goods for the economy, in particular energy, grain, metals, construction materials, is impossible without an organized derivatives market for such goods. In order for commodity producers and consumers of these goods to make wider use of the derivatives market mechanisms, it will be necessary at the legislative level to recognize that the prices of exchange derivatives contracts for the supply of goods are market prices. This is important for tax calculation purposes, taking into account the real pricing policy in the financial market (Lin and Chang, 2009).
Another legislative problem is the lack of a single state body that is responsible for regulating the derivatives market. All important decisions taking place on the derivatives market are mainly taken by exchanges. Since each exchange determines the best solutions for its own benefit, the interest of market participants as a whole is lost. But for full-fledged activity in the derivatives market, an independent regulator of the financial derivatives market is needed, in the person of which a state body may well act. Therefore, the task of the state is that in the program of future projects for the development of the derivative financial instruments market, such a body should also take place in the derivatives market.
Another important problem of using arbitrage and hedging strategies is the lack of financial literacy of potential participants in the derivatives market. In order to bridge the gaps in functional literacy for implementing strategies with derivative financial instruments, it is necessary to carry out at the state level not only educational programs to improve the financial literacy of citizens, but also to focus on competent risk management in companies.
Another reason for the underdevelopment of the derivatives market is speculative interest. Such interest lies in the fact that in the market of derivative financial instruments there is a constant struggle of speculators in price forecasting, therefore one fixed-term contract can be bought or resold hundreds of times before it is executed. Speculation is important, but at the same time, it carries certain risks that may adversely affect the overall development of the country, since price fluctuations are associated, first of all, with an increase in the share of speculative capital in modern markets and it is speculators, not actual producers and consumers of traded goods often determine the dynamics of price movements in global markets.
One cannot say unequivocally that any of the above problems is important for an immediate solution, since each problem individually serves as a “crack” in the economic system as a whole. Therefore, the solution of existing problems will create the necessary conditions for the application of arbitrage and hedging strategies and will reliably strengthen the economic.
References
Fok, R. C., Carrol, C. and Chiou, M. C., (1997). “Determinants of Corporate Hedging and Derivatives: A Revisit”, Journal of Economics and Business, 49: 569-585.
Graham, J. R. and Rogers, D. A. (2002). “Do Firms Hedge in Response to Tax Incentives?”, Journal of Finance, 57: 815-839.
Hull, J. C. (2011). Options, Futures, and Other Derivatives, 8th ed. Upper Saddle River, NJ: Prentice Hall.
Jeffrey Wooldridge, (2000). “Introductory Econometrics: A Modern Approach”, Cincinnati, OH: South-Western College Publishing.
Jin, Y. and Jorion, P., (2006). “Firm Value and Hedging: Evidence from U.S. Oil and Gas Producers”, Journal of Finance, 61: 893-919
Lin, R. and Chang, Y., (2009). “Does Hedging Add Value? Evidence from the Global Airline Industry”, Working Paper: National Chengchi University.
Resources
Legal Environment of Business: Online Commerce, Business Ethics, and Global Issues: Ch. 14, 15, and 16
Week 2 resources from the University Library
Business Entities Assignment
> Bulleted Slides with detailed speaker notes to explain each slides bullets
> APA format
> Reference slide with in speaker notes citation where applicable.
Scenario: You are a sole proprietor presenting to a group of investors, seeking 20 million dollars to raise capital for your solar panel manufacturing and installation company, Solar Co.
Prepare a 7- to 10-slide Microsoft® PowerPoint®, Microsoft® Sway®, or Prezi® presentation with speaker notes for your potential investors, and address the following items:
Choose one type of business entity that you plan to use for Solar Co., and explain why you would choose this type of entity rather than the others. What risks and issues specific to this industry and Solar Co.’s business influenced your decision?
Assume that at least one investor will question whether Solar Co. should be organized as a corporation. Summarize, for the investors, what legal liabilities could arise for the directors or officers of that corporation. How could those liabilities for the directors and officers be minimized?
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margin: 4px 2px;
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