Hedging

t’s Uses In Risk Managementconcerned of the results from a short term general
Hedging, understanding the benefits for a riskmarket correction.   Without the privilege of
management solution.foresight, he is unsure of the magnitude the earnings
The second of a two part article….figures will produce.  He now has an exposure to
Before I discuss the use of hedging to off-set risk,Market Risk. The manager thinks of his options.  The
we need to understand the role and the purpose ofgreatest risk is to do nothing, if the market falls as
hedging.  The history of modern futures tradingexpected, he risks giving up all recent gains.  If he
begins in Chicago in the early 1800’s. Chicago issells his portfolio early, he also risks being wrong and
located at the base of the Great Lakes, close to themissing further rally’s.  Selling also incurs
farmlands and cattle country of the U.S. Midwestsubstantial brokerage fees with additional fees to buy
making it a natural center for transportation,back again later.
distribution and trading of agricultural produce. GlutsThen he realizes a hedge is the best option to
and shortages of these products caused chaoticmitigate his short term risk.  He begins by calling his
fluctuations in price. This led to the development of aCTA (Commodity Trading Advisor) and after
market enabling grain merchants, processors, andconsultation places an order to sell short the
agriculture companies to trade in contracts to insulateequivalent of $10 million of the S&P 500 index on the
them from the risk of adverse price change andChicago Mercantile Exchange “CME”.  Now his
enable them to hedge.result is when the market falls as expected, he will
The first commodity exchange was the creation ofoff-set any losses in the portfolio with gains from the
the Chicago Board of Trade, CBOT in 1848.  SinceIndex hedge.  Should the earnings report be better
then, modern derivative products have grown tothan expected, and his portfolio continues upward, he
include more than the agricultural industry.  Productswill continue making profits.
include Stock Indices, Interest Rates, Currency,Two weeks later the fund manager calls his CTA and
Precious Metals, Oil and Gas, Steel and a host ofcloses the hedge by buying back the equivalent
others.  The origins of the commodity and futuresnumber of contracts on the CME.  Regardless of the
exchange was created to support  hedging.  Theresulting market events, the mutual fund manager
role of speculators is beneficial as they add tradingwas protected during the period of short term
volume and important volatility to what wouldvolatility.  There was no risk to the portfolio.
otherwise be a small and illiquid market place.  YouExample 2: An electronics firm ABC has recently
can view a complete listing of the worlds differentsigned an order to deliver $5 million in electronic
exchanges at:components of next years model to an overseas
A bona-fide hedger is someone with an actualretailer located in Europe.  These components will be
product to buy or sell.  The hedger establishes anbuilt in 6 months for delivery two months after
off-setting position on the futures or commoditythat.  ABC instantly realizes they are exposed to
exchange, thereby instituting a set price for histwo risks.  1. the rising and volatile price of copper in
product.  Someone buying a hedge is known as6 months may result in losses to the firm.     2. 
being “Long” or “Taking Delivery”. the fluctuation in the currency could easily add to
Someone selling a hedge is known as beingthose losses.  ABC being a young firm cannot
“Short” or “Making Delivery”.  Theseabsorb these losses in view of the highly competitive
positions known as “Contracts” are legallymarket from others in the field.  Losses from this
binding and enforced by the exchange.order would result in lay-offs and possibly plant
Entering your trades either for speculation or hedgingclosures.
is done through your broker.  Commodity TradingABC telephones their CTA and after consultation
Advisor, Genuine Trading Solutions President Dwayneplaces an order for two hedges, both for an expiry in
Strocen, states that “Commodity and Futures8 months, the date of delivery.  Hedge #1 is to buy
exchanges are distinct from Stock Exchanges,long $5 million of copper effectively locking in
although they operate using the same principals. today’s price against further price increases. 
They are regulated by different agencies such as theABC has now eliminated all price risk.  The risk of
Commodity Futures Trading Commission who areplant closures is greater  than the lure of increased
responsible for regulation of retail brokers in the USAprofit should copper price fall.  After all, ABC is not in
as well as Commodity Trading Advisors such asthe business of speculating on copper prices. 
us.”Hedge #2 is to sell short the equivalent of Euro
Now let’s view some real life examples ofCurrency vs US Dollars.  Since ABC is effectively
hedging or mitigation of risk by using exchangeaccepting EC in payment, a rising US dollar and a
traded derivatives.weak EC would be detrimental and erode profits
Example 1:  A mutual fund manager has a portfoliofurther.  The result of the hedge is no risk and no
valued at $10 million closely resembling the S&P 500surprises to ABC in either copper or currency levels. 
index.  The Portfolio Manager believes the economyA risk free transaction and full transparency is the
is worsening with deteriorating corporate returns. result. In 8 months with the order completed and the
The next two to three weeks are reports ofcustomer accepting delivery, ABC notifies the CTA
quarterly corporate earnings.  Until the reportto close the hedge by selling the copper and buying
exposes which companies have poor earnings, he isback the Euro Currency contacts.