What is a Hedging Arrangement?
Hedging arrangement refers to a settlement between two parties whose aim is to reduce the level of future risks in the event of an adverse price movement of an asset. In a literal definition, hedging means a sort of insurance cover to protect a given asset from future risks. But in the financial market, it’s more of shielding a portfolio through using one financial instrument to offset the risk of the other investment.
What a Successful Hedging Arrangement Entails
Even though hedging will not eliminate future risks completely, it gives the company an opportunity to reduce damages over their investments. Usually, it means that the company risks will be minimal. However, this doesn’t necessarily translate to high profits. It means that the company loses will be relatively insignificant. If the hedge provides a winning outcome, the company’s revenues will not be adversely affected if it had not hedged. Otherwise, if it is a negative outcome, it may mean losses, which eventually affect the profitability of the company.
Derivatives Hedging Arrangement
Companies, portfolio managers, and other individual investors sometimes opt to use financial instruments known as derivatives to hedge over their assets. The instruments may be either contingent claims or forward claims.
Contingent claims include options contract and future contracts.
Options allow investors to buy financial instruments at the present price known as strike price and sell them at a future date at an agreed price. Options contracts include put options where a buyer speculates a drop in prices while a seller speculates a rise in prices and call options where a buyer speculates prices to rise while a seller speculates prices to go down.
A futures contract is an arrangement between a buyer and a seller to buy and sell a given asset at a future date on a predetermined price. It includes future speculation, which enables buyers to sell their assets at higher rates in future if price increases; and future hedging, which does not give the buyers an advantage over selling their security at higher prices. Instead, it reduces loses if the risk ever occurs.
Options Contract vs. Futures Contract
In the cases of option contracts and futures contracts, the differences are not often evident, because the benefits lie in optimizing returns and minimizing risks. However, options give rights to the holder to either sell or buy the asset during termination of the contract, whereas a future contract holder must fulfill the terms of the contract to fully benefit from the arrangement.
Overview of Forwarding Claims
Forward claims include swaps, forward contracts, and exchange-traded futures.
In swaps derivatives, there is an agreement between two parties to exchange sets of cash flows determined either randomly or by uncertain variables such as interest rates or commodity prices over a given pre-determined time frame. Though swaps are broad, there are common types worth mentioning: interest rate swaps, currency swaps, commodity swaps, credit defaults swaps (CDS), zero coupon swaps (ZCS), and total return swaps (TRS).
A forward contract is a customizable agreement to accommodate the parties involved in the buying and selling of a given asset. Usually, it’s based on a future date and price. Because it’s non-standardized, it’s often used for hedging, but it can also be used for speculation. When comparing it to other standardized future contracts, the main benefit lies in the ability to customize it to accommodate different commodities, delivery dates, and even amounts. Even better, the transaction can be either in cash or delivery basis – often referred as over-the-counter (OTC).
Exchange Traded Futures (ETFs)
Exchange-traded derivative refers to when traders base the value of a traded financial instrument over the value of another asset in a regulated exchange environment. Compared to forwarding contracts that are OTC, exchange-traded derivative contracts give traders security of standardization, future risks elimination, and simpler liquidity.
Example of a Hedging Arrangement
Let’s assume Joe owns some shares in Oil Exploration Corporation (OEC). Lately, the company has been experiencing constant growth and market stability. Therefore, management believes the price of oil will remain on an upward trend while still increasing the value of the company’s stocks. However, Joe is a little bit skeptical; he thinks the price will fall. As a result, he buys put option derivative. If in any case the above comes to be a reality, Joe gets the right to sell the OEC at the strike price – better known as married put. However, if the prices rise, Joe stands to lose while OEC stands to gain.
Diversification in Hedging Arrangements
When hedging, some investors sometimes just want to diversify their portfolios to reduce given types of risks without getting entangled in the ruthless calculations involved in the derivative hedging. Therefore, they may turn to diversification, also known as crude-hedging. The practice consists of buying recession-resistant-stocks like utilities to hedge against luxurious goods with higher margins. Even though diversification hedging may result in profits, it can lead to even higher risks since there are no guarantees as compared to derivative hedging practices.
Advantages and Challenges of Hedging Arrangements
More often, companies hedge against the rising prices of their assets. Therefore, if the foreseen occurrence happens, in this case, prices of these assets spike as speculated by the buyers, then they stand to gain. Similarly, the seller will benefit from the same hedging position in case the prices go below the lock price. This is because the seller will not make losses by selling their assets below the lock prices.
In cases when the speculators are wrong, and there had been an upfront commitment, companies involved tend to make huge loses. That is, the hedge works against them. The sellers receive lower prices below the existing market price, while the buyer pays for the same asset way above the current market prices.
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