1.2 Types of hedging

Hedging sale. Hedging sales - is the use of a short position in the futures market for those who have a long position in the cash market. This type of hedging is undertaken for the protection of the selling price of the goods. It is used sellers of real goods for insurance against falling prices of this commodity. This method can also be used to protect the stock of goods or financial instruments not covered by forward contracts. Finally, a short hedge is used to protect future products or prices on the forward purchase agreements.

Short hedge begins selling a futures contract and terminated its purchase.

Here are a few situations that require the use of a short hedge. The trader bought a corn farmer in October, at a certain price. Grain placed in the warehouse and at risk of falling prices. Merchants can sell futures contracts, for example, in December, and to keep his position until it finds a buyer for the grain, after which he will eliminate his position. Alternatively, the dealer may have a supply of bonds, half of which was sold at a favorable price, and the other - is not yet sold. In order not to risk a fall in prices in relation to the other half, he can sell the corresponding number of futures contracts. If prices fall, a short position in the futures market will become a refuge for the remaining bonds. When a dealer sells more any portion of this reserve, it will reduce its futures position.

Consider the situation shown in which the locking mechanism via price hedging.

Hedger wants to hedge against a possible fall of stock prices (usually by means of futures contracts on the index shares, rather than shares themselves). He has the action, which now costs 100 tenge, and a month later it will need money for the purchase of real estate. However, the expectation that the price per share at the time of purchase will fall and it will not be able to pay for your purchase, it is pre-hedge:

a) it is, say, in January sells futures contract with delivery through three months at a price of 110 tenge per share and thus advance fixes his price. On the stock exchange jargon, this is called "to lock the price";

b) the sale of shares in the real market in February, it really sells it at a price lower than the desired - 90 tenge;

c) simultaneously eliminated (redeemed) futures contracts at the current price of the futures market - 100 tenge. The result is as follows (Table 1):

Table 1

Redemption of futures contracts

Months	Cash market	Futures market
January	Target price 100 tenge	Sale of a futures contract for 110 tenge
February	The sale of shares by 90 tenge	Buying a futures contract 100 tenge Profit 10 tenge

The final price: 90 + 10 = 100 tenge.

As a result of this loss of operations in the cash market were offset by gains from hedging, which made it possible to get the intended hedger prices.

Knowing the approximate amount of their shares, the hedger can insure all the sold quantity. So, if he knows that the number of its shares is 20 thousand. Pieces, it will acquire four futures contracts for 5 thousand. Pieces each. At the same time, if in the above example, in the cash market prices have risen, contrary to expectations, the additional profits obtained here would go to compensate for losses on futures transactions (Table 2).

Table 2

Futures transactions

Months	Cash market	Futures market
January	Target price 100 tenge	Sale of a futures contract for 110 tenge
February	The sale of shares by 105 tenge	Buying a futures contract 120 tenge Loss 5 tenge

The final price is: 105 - 5 = 100 tenge.

This example clearly shows that hedge not only reduces potential losses, but also deprives the additional profit. So, in the second case the shareholder may receive additional profit by selling shares at 105 tenge, if it does not hedge. Therefore, hedgers typically not insure the entire volume of production, and some part of it.

Hedging purchase. This operation is the purchase of a futures contract by anyone having a short position in the cash market. The result of a long hedge is to fix the price of the product purchase. It is used to protect and risks arising from the forward sales at fixed prices, and a rise in prices for raw materials used in the manufacture of a product with a stable price.

This type of hedging is often used brokerage firms have orders for the purchase of goods in the future, as well as companies - processors. In this case purchases are made on the futures market as a temporary replacement of the purchase of real goods. As a result, a long hedge protects against rising prices.

For example, the consumer knows that he needs to purchase 10 thousand. Barrels of oil in two months, but fears of price increases compared with the current level of $ 55 per barrel. Immediate purchase is impossible for him, since he has no storage. In this case, he buys 100 futures oil contracts on the stock exchange and sell them when the will to enter into a contract for the supply of the real. The overall result of the operation (Table 3):

Table 3

The contract for the supply of real

Months	Cash market	Futures market
January	No deals The target price is $ 55 per bbl	100 purchase of March contracts for $ 53 per bbl
March	Buys 10 thousand . for $ 83 per bbl	Sale 100 March contracts for $ 81 per bbl Profit of $ 28 per bbl

The final price of purchase: 83 - 28 = $ 55.

The costs of a futures contract itself will be insignificant, although the margin payments and loan will be higher than in the rapid elimination of the transaction, since the futures contracts held for two months.

Hedging with futures contracts has several important advantages.

1. There is a significant reduction in price risk of trade in goods or financial instruments. Although it is impossible to completely eliminate the risk, however well-executed hedge on the market with a relatively stable basis eliminates a large share of danger. It increases the stability of the financial side of the business, minimizes fluctuations in earnings caused by changes in commodity prices, interest rates or currency exchange rates.

2. Hedge does not interfere with normal operations and allows real-time protection without the need to change the price policies of stocks or engage in forward agreements inflexible system.

3. Hedging provides greater flexibility in scheduling. Since futures contracts are for the delivery of many months in the future, the company can plan ahead. Thus, the processor can buy soy beans only, if someone is willing and able to sell them to him. He must keep the beans and the finished product until someone does not buy it. With the futures contracts, it can control financial risk by replacing transactions with beans and their products on the transaction in the futures market. This makes more efficient management of excess inventory or shortages.

4. Hedge facilitates the financing of operations. In business, it decided to provide loans to secure supplies of commodities, and hedge plays an important role in determining the volume of the loan. For a non-hedging stock of goods bank provides credit, roughly equal to the company's own funds, which it can allocate for this purchase (i.e. the ratio of debt to equity will be 50/50 for the purchase of stocks). If these reserves are hedged, the share of bank credit can be up to 90%, and the rest is financed by the company itself (i.e. the ratio becomes 10:90). Suppose the company has 1 million USD. For the purchase of stocks of raw materials. It could be purchased at $ 2 million without hedging their reserves. ($ 1 million - a bank loan, and the rest - from the assets of the company). If the company has used futures contracts, it would buy $ 10 million of these reserves ($ 1 million - means the company, the rest - the bank credit). This gives obvious benefit companies, especially in a situation of business expansion. The good news is that the bank itself has more confidence in the credits that are issued against the liabilities covered by futures contracts.

5. If the hedge is started, it is not necessary to eliminate it only when the implementation of the real deal. It is possible to conduct operations "inside" of the hedge, the mercy of the contracts ahead of time and then again their selling if prices have gone up. In this case, the extra profits. However, these operations become speculative in nature, as futures position becomes equal in quantity and not on the opposite direction of the real market.

Analyzing the listed hedge examples, we can see that this operation is used as a temporary replacement surgery in the real market, which will be implemented in the form of transaction for immediate delivery. Consider other examples in which are alternative ways of behavior of the seller and the buyer to protect against price risk.

Suppose the farmer grown wheat, but he does not have the appropriate repository. This means that during harvest it should be sold whole wheat or resort to commercial storage.

December 1 of the Chicago Stock Exchange July wheat futures contracts available for $ 3. / bu. and forward the bid price for wheat for delivery in harvest time is 2.65 USD. / bu. These terms and conditions on the market meet the seller in relation to the price target and decides to hedge part of the expected yield by selling the July contract for three 5th. Bushels and fixing the futures price at $ 3 / bu. Seller believes that basis will increase compared to its current level of -35 cents, which is based on the bid price cash forward contract.

Suppose that the spot price has fallen to $ 2.3 / bu. at the time of harvest, and the July wheat futures were offered at $ 2.55 / bu. Because the seller took the hedge, he was protected from the reduction in the cash market. His initial futures position - sale of three of July futures for wheat at $ 3 / bu. and the reverse position - buy three contracts at $ 2.55 / bu. They allowed him to win in the futures market of 45 cents per bushel. This profit offsets the seller lower the yen in the cash market - $ 2.3 / bu. and thus, its selling price is $ 2.75 / bu. (2.3 + 0.45). The overall result is as follows (Table 4):

Table 4

Ways to conduct the seller and buyer to protect against price risk

Date	Cash market	Futures market	Basis
December 1st Harvesting	Buyer’s price $ 2.65 The selling price of $ 2.3.	For sale of futures at 3.0 USD  Buying futures for $ 2.55 Profit $ 0.45	-35 cents -25 cents

Each of the possible operations worked as follows:

1) If the seller did not use any of the pre-operations and would simply sell their goods during the harvest season, its selling price would be $ 2.3 / bu.;

2) if it is 1 December concluded a forward contract on the spot market, its selling price amounted to US $ 2.65 / bu.;

3) by resorting to hedging the sale, he got $ 2.75 / bu. (10 cents more than the bid price in cash forward contract), as a basis increased from -35 to -25 cents for the July quotation.

Now suppose that the period of harvest rates in the cash market rose to $ 3.4. /bu., and July futures were offered at 3.65 USD / bu. In this case, the seller would sell the crop at a higher price - $ 3.4 / bu. but also in the futures market would have suffered losses (65 cents per bushel), the mercy of futures contracts (Table 5).

Table 5

Ways to conduct the seller and buyer to protect against price risk

Date	Cash market	Futures market	Basis
December 1st Harvesting	Buyer’s price at 2,65 USD The selling price of $3,4	For sale of futures at $ 3.0  Buying futures for $ 3.65.  The loss of $ 0.65.	- 35 cents - 25 cents

In this situation, each of the possible operations would work as follows:

1) if the dealer waited until the harvest, and then sold the wheat, its price would be $ 3.4. / bu. (This operation is very risky);

2) if he has chosen a forward contract the cash market, the price of his wheat would be $ 2.65 / bu.;

3) due to hedge the sale price would be equal to $ 2.75. / bu., as a basis increased to the expected level of -25 cents.

This example shows that a short hedge made if not the best possible results, and not the worst.

Similarly, there is a situation for a long hedge.

Suppose a farmer calculated that in mid-November he will need as livestock feed 20 thousand. Bushels of corn. He expects that by the time prices will rise from the current level.

At the moment, the price of the December futures contract for corn is $ 2.2. / bu., His usual supplier of corn wants to sign a contract for the supply during the harvest at a price of $ 2.0. / bu. Since the buyer expects that the basis will be weaker and will be equal to approximately -30 cents, i.e. A. the purchase price will be $ 1.9 for it (2.2 - 0.3). He refuses to sign a forward contract and decides to hedge their spending on food, using the December futures contract. To insure the purchase price, he buys 4 December futures contract on the Chicago Mercantile Exchange corn 5 thousand. Bushels each priced at $ 2.2. / bu. In November, as expected, prices have increased, and December futures are offered at $ 2.6. / bu., and the price of corn in the cash market is $ 2.3. / bu. As a basis reached the expected level - 30 cents (2.3 - 2.6), the farmer decided to liquidate the hedge.

He buys corn in the cash market at $ 2.3. / bu. and eliminate their futures position by selling 4 December futures contract at $ 2.6. / bu. As you can see, a profit of 40 cents per bushel on the futures market is balanced by the higher purchase price in the cash market (Table 6).

Table 6

Ways to conduct the seller and buyer to protect against price risk

Date	Cash market	Futures market	Basis
July November	Seller price 2.0 USD The purchase price of $ 2.3	Buying futures at $ 2.2. Selling futures at $ 2.6. Earnings of $ 0.40.	- 20 cents - 30 cents

The final purchase price is 2.3 - 0.4 = $ 1.9.

If a farmer did nothing and waited for needed food, the purchase price would be equal to $ 2.3. / bu. If he took the cash forward contract market, the purchase price would be $ 2.0. / bu. And resorting to hedging to lock the feed costs, he made the purchase at the price of $ 1.9. / bu.

This hedge was more effective than the forward contract, as the basis has become weaker and reached the expected level. As with the previously discussed hedge examples, the risk is limited to changes in the base level.

Another benefit of the hedge (short) arises from the producers of seasonal products. For them, the futures market allows to insure the costs of storage and more accurately determine the time of sale spot.