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Information > Financial Terms > This page Hedging Reduced
to its simplest terms, a form of insurance used among traders or dealers
in grain, cotton, foreign exchange, or securities, to prevent loss through
price fluctuations. It is
not speculation, but the avoidance of speculation.
Hedging is the process of protecting one transaction by means of
another, and in the commodity markets takes the form of selling a
FUTURES contract in an amount equivalent to necessary cash purchases.
The process of hedging is based on the theory that the spread between
a cash commodity and its futures is constantly uniform - that is, futures
prices should be higher than cash prices by an amount representing the
cost of storage, insurance, etc., from the time of the transaction until
the arrival of the futures month. Hedging in grain is commonly practiced by elevator companies,
millers, and exporters. Foreign
exchange bankers, brokers, and dealers also practice hedging - the selling
by one who is "long" and the buying by one who is "short"
of an equal amount of the item dealt in.
Thus a person who hedges is in a neutral position:
he is committed to both "long" and "short"
contracts for an equal amount. A
typical illustration of hedging is that practiced by a flour mill.
Suppose a miller has contracts to deliver to customers 4,000 barrels
of flour a week for the next six months at a stipulated price.
This output will require approximately 470,000 bushels of wheat,
more than even the largest miller can carry in stock.
It represents a value, moreover, that if purchased at, say, $4.50
a bushel, earns an investment of $2,115,000.
Should the wheat decline only $0.01 a bushel, a loss of $47,000
is involved. This risk is
so great that millers as a class cannot afford to take it.
Millers are not speculators but are in the business of milling
and derive their profits from milling operations, not through price fluctuations.
To avoid assuming this risk, therefore, the miller sells in the
futures market an equal amount of wheat, distributing his futures sales
contracts to mature at times when he will need to buy cash wheat to fill
his flour contracts. In other
words, as fast as he buys cash wheat from samples that meet his milling
requirements, he sells an equal amount of futures contracts at a stipulated
price. Instead of actually
making delivery on the futures contracts, however, millers usually sell
their futures contracts to professional speculators or others who may
want wheat at the delivery time on the futures.
In case the price of wheat goes up, the miller has made a profit
on his holdings of cash wheat. This
profit, however, is offset by the necessity of having to pay a higher
price when he covers his contract on delivery date.
What he gains in the cash transaction is lost in the futures transaction.
On the other hand, if the price declines, the loss on his holdings
of cash wheat is offset by having to pay a lesser price when he covers
his contract on the delivery date.
Thus, whether the price rises of falls, the hedger gains (or loses)
as much on his cash contracts as he loses (or gains) on his futures contracts. A
person who is "long" in stocks may also hedge.
The hedging short sale, for example, may be used for this purpose.
Suppose one owns 100 share of U.S. Steel purchased at 25.
The price has declined to, say, 24, and the outlook indicates a
still greater decline. By
selling 100 shares short, with the intention of subsequently buying ("covering")
at lower price, one hedges. Thus if the stock declines to 20, the hedger covers at a 4-point
profit, thus offsetting most of the loss on his original purchase.
If the stock should instead rise, to, say, 30, the hedger can cover
his short sale by delivering his original purchase without loss of the
transaction. Or, similarly,
a hedge against a possible market decline, may be accomplished by the
purchase of a put, entitling the holder to sell 100 shares of U.S. Steel
at 25 to the maker of such put for a specified period of time.
Should the decline eventuate as expected, to, say, 20, the put
may be exercised within its duration at the put price of 25. Contrary
to popular impression, hedging, therefore, whether in commodities, foreign
exchange, or securities, is the very opposite of speculation, as it is
undertaken for the purpose of protecting against risk of price change. Banks
use interest rate futures to hedge a portfolio security.
If interest rates rise, the price of the security falls.
The loss will be offset by delivering the security at the price
specified in the futures contract or by purchasing back the future at
a lower price prior to the specified delivery date.
Fixed-rate liabilities can be hedged by buying futures.
A six-month CD can be turned into a three-month CD by buying a
three-month CD future. Financial
futures hedging strategies can protect against unfavorable interest rate
movements by locking in a certain position.
This strategy also prevents the bank from benefiting from favorable
movements in interest rates. Regulatory
approval is not required before a bank enters into futures transactions;
approval of the bank's board of directors is usually sufficient.
The board would normally be interested in having problems or opportunities
identified, financial risks quantified, alternative courses of actions
and their consequences identified, and operating, control, and record-keeping
procedures for financial futures explained for purposes of review. BIBLIOGRAPHY ANDERSEN,
T.J. Currency and
Interest-Rate Hedging.
New York Institute of Finance, New York, NY, 1978. BARKER,
B. "Hedging Techniques
for Interest Rate and Currency Risks."
Banking and Finance Law Review,
October 1988. KRAMER,
S.L., and others. Options Hedging Handbook.
Center for Futures Education, Spring Mill, PA, 1985. MCKENZIE,
J.L., and SCHAP, K. Hedging
Financial Instruments.
Probus Publishing Co., Chicago, IL, 1988. NODDINGS,
T. Superhedging.
Probus Publishing Co., Chicago, IL, 1986. Back to Information |