What is Hedging in simple terms and Examples of risk insurance methods

Risk hedging refers to any measures aimed at reducing risks in investment or trading activities. However, risks do not disappear completely; it is impossible to reduce them to zero.

The purpose of hedging is to make risks controllable, this will allow you to build capital management strategies for different scenarios.

There are many techniques for reducing risks, including using options and futures contracts.

What is hedging

This is an English term (English Hedging), comes from “hedge” - guarantee, insurance. In modern financial activities, hedging is a set of actions aimed at managing monetary risks by influencing the possible dynamics of the value of future assets. The seller or buyer who insures himself in this way is called a hedger .

The point of hedging is to insure against possible market fluctuations by simultaneously taking two opposite positions in assets. Thus, no matter what happens to the market situation, the investor, trader, seller or buyer will end up with exactly what he planned.

IMPORTANT! Hedging makes it possible to guarantee the avoidance of financial losses, but thereby eliminates the opportunity to gain additional profit by taking advantage of a favorable turn in the market situation. Hedging means protecting yourself from potential risk at the cost of reducing potential profit.

FOR EXAMPLE. The company mines iron ore. According to forecasts, in a quarter the price of this resource will drop significantly. The company's management, in order not to lose future profits, can take one of two paths:

• sell part of the supply contracts, thereby reducing production costs and slightly reducing the volume of production (“the profit not collected” on the ore price is compensated by funds received from the contracts);
• fix the price of your products for a certain period by concluding an appropriate agreement.

How is currency risk hedging by participants in foreign economic transactions?

If the forecast turns out to be incorrect (iron ore does not become cheaper, but increases in price), the company will not be able to take advantage of this favorable environment, receiving only the planned profit and nothing beyond it.

The buyer can also insure his transactions by making such transactions.

How is hedge accounting ?

Do you need it

The hedging strategy is widely used in the financial sector and Forex as well. This risk reduction tool is used by many people:

• goods manufacturers and buyers strive to optimize currency and price risks;
• stock investors protect capital from falling stock market prices;
• Lenders and borrowers are interested in stable interest rates.

Experienced hedgers advise applying insurance against currency risks to the following categories of people:

• exporters who use foreign currency earnings to finance expenses in rubles;
• investors and companies whose majority of their credit funds are in foreign currency;
• importers, who often convert rubles to pay suppliers.

To answer the question of whether it is worth hedging risks, it is necessary to analyze financial activities:

1. Volume and percentage of high-risk transactions. If their number reaches 50% or more, insurance is a mandatory condition for the risk neutralization mechanism.
2. The ratio of probabilities and the occurrence of consequences of risks (investment or operational). If there are critical risks, each such transaction requires insurance.

Hedging mechanism

To ensure risk management, an agreement is concluded not regarding the transaction itself, but regarding the obligations for this asset - a derivative . The derivative has a number of features:

• the purpose of a derivative is not to sell an asset, but to hedge a risk;
• Unlike a regular contract, a derivative is a formality;
• this is a type of security, it can be sold on its own without regard to the asset (by one party or both);
• the price of a derivative does not have to be tied to the price of the underlying asset, although it usually changes with it;
• buyers and sellers of derivatives may not necessarily be the owners of the asset itself;
• you can enter into a derivative not only on the underlying asset, but also on another derivative (for example, an option on a forward transaction);
• Derivatives are settled in the future tense.

REFERENCE! Hedging occurs when a transaction participant enters into a contract in the asset market and at the same time (or earlier) in the derivative market.

In the Russian Federation, actions related to derivatives are regulated by Federal Law No. 39-FZ “On the Securities Market” of April 22, 1996.

Let's sum it up

Having understood the question of what risk hedging is, you should determine whether this financial instrument is worth using in practice or whether its effectiveness is insufficient.
The list of advantages includes the following features:

1. Financial risks are reduced.
2. Using a hedge, you can reduce operational risks, including transactions related to the timing of delivery of goods.
3. Financial stability is improving.
4. It is possible to achieve predictability of business development, and information transparency increases.
5. The amount of debt and capital financing can be reduced.
6. The presence of multiple counterparties, contract parameters and its instruments makes it possible to make the management decision-making system more flexible.

Despite the many advantages, hedging strategies have several disadvantages:

1. When using a hedge, there is a conscious refusal of the profit that may be on the spot market.
2. Additional costs are required to open and fulfill obligations on trades.
3. There is underlying hedge risk present. This definition should be understood as the possible occurrence of non-parallel price changes in the markets (spot and derivatives).
4. Established exchange restrictions. An example would be a large loss resulting from futures price limits being limited.
5. Possible changes in legislation. They may relate to tax or economic policy. These are excise taxes, fees, and protective duties. Given such features, insurance often brings more losses than income.
6. The structure of transactions when using insurance becomes more complicated.

Before you start using currency hedging, there are several factors to consider:

1. The quantitative relationship between probable and actual risks is studied.
2. Compare the volume of risks with the costs of insurance.
3. The possibility of using a hedge for an existing underlying asset is considered in detail.
4. We develop the most convenient and profitable scheme.
5. They decide on a site that best suits the conditions.
6. Choose a broker or clearing firm.

An important point is the correct choice of hedging strategies, since miscalculations in this can lead to financial losses.

Hedging instruments

Possible financial risks can be insured using various economic instruments. They are called derivatives because they are based not on the sale of the asset itself, but on the application of one or another derivative.

ATTENTION! Derivative instruments, like the assets themselves (commodities, liabilities, securities), are sold according to the laws of the market, and the participants in transactions with them are the same.

Let's look at the most common hedging instruments:

1. Futures (from the English “future” - “future”) is an instrument that stipulates the obligation of the parties to pay for a specified asset or derivative in a specified quantity the price agreed upon by the parties in this contract. This is a strict agreement that is binding on both parties. Futures are regulated by the exchange, which takes a guarantee for this - a small percentage of the contract. The most liquid derivative of all, but also the one with the highest degree of risk.
2. Forward (from the English “forward” - “forward”) is an instrument similar to futures, operating outside the exchange. Most often used when trading currencies.
3. Option (from English «option" – “parameter, option”) is a financial instrument that allows the user to choose whether or not to exercise the right to buy/sell an asset at a fixed price at the time specified in the agreement, in contrast to a futures contract, where there is no such choice. Exchange-traded (standardized) and over-the-counter options can be used. There are different types of options:
   put options – allowing you to sell or not sell at a fixed price;
4. call options – giving the right to buy or not to buy at an agreed price;
5. double options are bilateral contracts.

Nuances of a domestic forward

In foreign practice, forward transactions are much more common than in the Russian Federation. Many economists do not recognize the level of such contracts as higher than in betting or gambling. Nevertheless, the forward is increasingly occupying a place in Russian economic practice.

The legislative framework for forward contracts was laid down about 20 years ago in the following regulations:

• instructions of the Bank of the Russian Federation dated May 22, 1996 No. 41 “On establishing limits on open currency positions and monitoring their compliance by authorized banks of the Russian Federation” - for making forward transactions between banks or between a bank and a client;
• Regulation of the Bank of the Russian Federation dated March 21, 1997 No. 55 “On the procedure for maintaining accounting records of purchase and sale transactions of foreign currency, precious metals and securities in credit institutions” - defines a forward transaction as an agreement under which obligations are carried out with a delay of at least 3 days after the conclusion; Decree of the Government of the Russian Federation dated July 10, 2001 No. 910 “On the Program of Socio-Economic Development of the Russian Federation for the Medium Term (2002-2004)” - allowed transactions with deferred execution to be recognized as bets.

Examples of derivatives

Futures example

Company A entered into a futures contract with a supplier on the stock exchange to purchase 1,000 tons of grain at a price of 12,000 rubles. per ton, and the wheat has just been planted. Experts suggested that due to the drought, the harvest would not be large and prices would rise. When the futures expiration date approaches, if this contract was not previously sold to another company, the following options are possible:

1. The price of grain on the market has not changed - at the same time, both the seller and the buyer will not change their balance.
2. The harvest turned out to be higher than expected, and the price of grain dropped to 10,000 rubles. per ton. Firm A will incur losses in the amount of 2,000 rubles. on each ton, which will need to be additionally charged to the supplier in addition to the contract amount.
3. The price has risen, as the buyer expected, grain on the futures execution date is quoted at 13,000 rubles. per ton. In this case, company A receives the planned profit, and the supplier experiences a loss of 1000 rubles. for every ton, that is, the balance will decrease by this amount.

In addition to these financial flows, company A, when concluding a futures contract, paid the obligatory exchange interest - the guarantee of the transaction (from 2 to 10%, depending on the rules of the exchange).

NOTE! No real grain is transferred in a futures transaction.

Forward example

entered into a forward contract to purchase 100 of its shares in six months at a price of 200 rubles. per share. At the appointed time, representatives of “Verum” will transfer 20,000 rubles to the account of “Dilogy”, and representatives of “Dilogy” will provide “Verum” with 100 shares. There are no options. If the transaction was carried out through an intermediary, he is entitled to a commission, and there may be some overhead costs for processing.

Option example

1. In 2021, the company acquired an option that allows it to purchase 10,000 US dollars in a year at a price of 50 rubles. for a dollar. Since a year later the rate increased to 57 rubles. per dollar, this option turns out to be profitable, and the company will use it, making a profit of 7 rubles. for every dollar, that is, 70,000 rubles.
2. The individual entrepreneur acquired an option for the right to sell his real estate in a year at a price of 250,000 rubles. per sq.m., counting on a fall in prices for new buildings. If this had happened, he would have exercised the option, sold the property and kept the difference, or, even more profitably, would have purchased a similar area at the market price, leaving a profit. However, in the Russian Federation there is a fall in prices on the primary real estate market, and at the time the option is exercised the price per sq.m. does not exceed 197,000 rubles. Such an option turns out to be unprofitable, and the owner, naturally, will not use it - he has such a right.

Combining hedging contracts

Experienced players combine hedging instruments with each other, developing the least risky strategy.

Let's consider this using the example of a store purchasing apples. He plans to buy 30 tons of apples in September at a price of 30,000 rubles per ton, but worries that prices will rise if the harvest is bad. To protect itself from risks, but also not to lose benefits from a possible increase in value, the store enters into two transactions:

• Futures for the purchase of 30 tons of apples for 900,000 rubles. The deal is mandatory.

• Option to sell 30 tons of apples for 900,000 rubles. You can refuse this deal.

The option insures the store against losses on the futures. Here's how it works:

• The price increased to 40 rubles per ton. The store fulfills its futures obligations and buys apples below the current market price.

• The price dropped to 20 rubles per ton. The store fulfills its obligations under the futures (buys for 900,000), then exercises the option (sells for 900,000). Now you can purchase a batch at a favorable current price.

In both cases, the profit of the enterprise will be equal to the profit from the sale minus the costs of securing transactions.

Conclusion

Hedging is a delicate instrument that should not be approached without painstaking calculations. It protects against risk, but not against loss. Errors in planning lead to a situation in which the investor receives either a modest gain or a significant disadvantage. If you do not yet have extensive experience in managing cash, securities and other assets, it is better to take time to further study the area and give preference to traditional portfolio diversification.

Hedging Strategies

To improve hedging efficiency and reduce financial risks, derivatives can be used in different ways:

• use one derivative or combine them in a convenient “proportion”;
• hedge the entire transaction or only part of it;
• make a transaction on derivatives earlier than on fixed assets;
• enter into contracts for assets and derivatives of varying duration and volume;
• use derivatives on hedging items other than the underlying asset (for example, when planning to buy oil, minimize the risk with an option to buy gold).

Hedging is an effective way to insure against financial risks.

Rating of CFD brokers for hedging commodity, index and stock futures

The “reserve” for the rating of major league brokers is the TOP 20 brokers of the 2nd league: