Meaning of the term hedging
Hedging is mitigation against risk exposure by taking a position in one market to offset risk exposure expected in another market. Hedging protects the hedger from future fluctuations in prices or exchange rate consequently an investor is guaranteed expected future profits. The hedger can be able to forecast the profit levels or revenues expected from a transaction without the fear of risk exposures. Hedging protects against various types of risks such as commodity risk, currency risk, equity risk among others. Some of the hedging strategies against these risks include futures contracts, forward exchange contracts, money market operations for currencies operations, etc.
Short and long hedge
Hedging can be effectively done by taking two positions, a short position and a long position (Mishkin,17).
A short hedge is a mitigation strategy that aims at preventing the occurrence of a loss from a risk that has already been undertaken. This type of hedge protects against a decline in the value of an asset that has already been undertaken. For example, a shareholder may acquire a forward contract to mitigate against future declines in the prices of shares. A short hedge is also referred to as a selling hedge since it protects an investor from price fluctuations of an asset that is to be sold in the future.
On the other hand, the long hedge is acquired by investors who want to secure an asset that they want to purchase in the future from prices increases. This can be effectively done by acquiring a long futures contract, which shall offset any price increases on the assets. This type of hedge is also referred to as an input hedge since it protects against risks of assets that have not yet been acquired by the firm.
Computation of expected gain in futures contract
- To cover the expected delivery of 5000000 litres, 5 future contracts shall be undertaken:
- 5000000/10000000 = 5 contracts
- Cost of the future contract at Current rate:
- 14.5 *1000000/1000 = 14500 * 5 = 72500
- Cost of future contract in January:
- 14.75*1000000/1000 = 14750 *5 =73250
- Gain in the futures market:
- 73250-72500 = 1250 pounds
To find out the gain or loss in the hedging strategy, the gain in the futures markets is compared against that in the cash market. The current price of the oil per 1000 liters is not provided but the gain of 1250 pounds in the future contract shall be able to offset any losses in the cash market assuming the current cash price is the same as the current spot price of the futures contract.
The company might still be able to make a profit if the current cash price is less than the current prices of the futures contract. The hedging strategy is therefore effective.
Costs of hedging
Hedging protects an investor from risks arising due to future uncertainties. Every hedge has a cost, which includes the cost incurred in acquiring the hedging strategy e.g. the cost of a call or a put option. Sometimes the hedging strategies may yield losses rather than gains to the investor. For example, a futures contract may yield a loss rather than a gain when increases in the futures market are less than the gains in the cash market. The transaction cost of a hedging strategy is compared with the implicit costs that the company might incur if interest rates or exchange rates change adversely thereby causing losses to a firm. The potential loss is compared to the cost of hedging to determine whether the hedging strategy is effective (Levi,23).
Fabozi, Frank. The Handbook of Financial Instruments. New York: Wiley Fiinance, 2002.
Hull, John. Options, Futures and Other Derivatives. London: Prentice Hall, 2008.
Levi, Maurice. International Finance. 5th. New York: Routledge, 2009.
Mishkin, Fredrick. The Economics of Money Banking and The Financial Markets. London: Pearson Education, 2006.