1.3 Hedging techniques

By hedging techniques include: structural balancing; gap control between sensitive assets and liabilities (GEO-management); management weighted average maturity (duration); entering into forward and futures contracts with the aim of creating offsetting positions; conducting security operations through the options; exchange of payments in accordance with the balance characteristics of participants of the transaction (swap contracts).

If the selection of assets and liabilities at amounts and terms is carried out in the framework of balance sheet positions, such an approach to managing price risk is called natural (or natural) hedging. To this type belong the first three methods of the just mentioned. The use of off-balance sheet activities is viewed as artificial or synthetic hedge. The content of this reception is to create off-balance sheet (artificial) position, which allows to obtain compensation for the financial losses the balance sheet position in the case of the price risk.

Off-balance sheet position is formed as a result of the conclusion of financial transactions, which the mechanism of action helps to minimize price risks. These contracts are derivatives, or derivatives, the value of which is derived from the value of the underlying asset (money, currency, securities).

Derivatives transactions carried out on the futures market. The vertical cut financial market represented by two segments: spot and forward. On the spot market transactions are concluded, the terms of which provides for the real deal (purchase, sale, lending, etc.) for a maximum of two working days from the date of the contract. Another name for this market - cash (cash). On the spot market transactions are concluded at the current market price.

If the period from the date of conclusion of the transaction to the date of execution of two working days, the agreement called urgent, and the market - urgent or forward. In practice, the indicated period may be several years, although usually it is 1 - 3 months. On the futures market transactions are concluded at the forward price, which reflects expectations about future changes in the price of the underlying asset. Futures contracts provide a preliminary definition of all terms of the agreement, including the contract price, which will happen on the real deal in the future. This allows both parties to become independent from the volatility of market prices during the period from the trade date until the date of its implementation.

Futures and Options Market is a complex and development of organisms. market infrastructure includes the leading exchanges of the world, the international OTC trading system based on electronic means of communication and a wide range of organizations engaged in brokerage and dealer functions. The most active and directly involved in the urgent financial market are commercial banks that conduct transactions with both own resources and from clients' funds on their behalf. Derivative financial instruments are forward contracts, financial futures, options and swap contracts, as well as hybrid instruments - swaptions, options forward transactions, options to buy (sell) futures, etc.

Transactions in derivatives are held to a hedging price risks, and obtain speculative profits (due to the favorable price changes). The operation of forward transactions classified as hedging in the case where the bank has a balance sheet position that there is a risk of financial loss due to changes in market prices, and is accounted for under this balance sheet position between the price of the underlying asset and the price of derivatives there is a relationship which gives the ability to significantly reduce the overall price risk. If the amount and timing of off-balance sheet positions coincide with the corresponding parameters of the balance sheet position, it allows you to compensate for the loss of one of these positions, the profit for the other. Sometimes the hedging operations only understand derivatives, which provide protection against price risks.

Depending on the purpose for which the operation of the futures market, all the participants can be divided into two groups, hedgers and traders (speculators). Hedger - a natural or legal person having a carrying position and carries out operations with derivatives to hedge the risk of this position. The essence of hedging transactions is to transfer price risk to the hedger to another market participant. The hedgers are interested in the final result as the sum of income and losses on balance sheet and off positions. Sellers, on the contrary, is calculated only on making a profit from the difference between the purchase and sale of derivatives. Hoping to get speculative profit, traders take the risk hedgers. For efficient operation of the market need and hedgers and traders, which provide him with high liquidity.

To protect against possible losses in the future held insurance operations along with hedging transactions in the urgent financial markets. security operation is to conclude an agreement with the player in the market, which for a fee agrees to compensate losses related to changes in asset prices. Consequently, the risk of changes in asset prices is transferred to the participant, who received an award - the insurance premium. insurance operation based on pre-payment of premiums for the possible compensation of future losses, regardless of whether the losses will occur or not. This does not exclude the possibility of taking advantage of the favorable changes in asset prices. There is a significant difference between hedging and insurance operations.

Effects of hedging are symmetrical. If one of the items a profit, then for the other place will have a loss. And the consequences of asymmetric security. This means that the insurance compensates for the negative consequences, allowing to benefit from favorable market conditions. The price for the opportunity to earn extra income is a premium. The cost of insurance operations far exceeds the value of the hedging operations, the costs of which are very small and, in comparison with the amount of operation, can not be taken into account. hedging transactions are carried out with the help of tools such as forward and futures contracts, swap transactions and financial risks of insurance operations are carried out with the help of options.

And hedging and insurance are intended to protect against risks, and so it is legitimate to consider these operations as a whole, make up the hedge process. That is why the options, which the mechanism of action reflects the essence of insurance, referred to as hedging instruments, along with forwards, futures and swaps. Choosing balance position on the timing and amount (i.e. exercising a natural hedge), the Bank does not require the participation of other market participants, who would take the risk.

In general, hedging process allows significantly reduce or completely eliminate the risk. hedging theory is immune to bank balance, protecting against unforeseen price changes in the market. Hedging is a way to stabilize the market value of the banking institution. But as between risk and return, there is a direct correlation, the low level of risk means limitation of opportunities to make a profit. Consequently, hedge drawback is that it does not allow hedger use the favorable development of the market situation.

Therefore, managers can not all hedge balance sheet positions, but only some of them. Creating a protection against price risks for the entire balance is called complete or makro hedging and transactions that hedge the individual active, passive or position - partial or mikro hedging.

Risks arising from changes in future prices of financial instruments, hedging is not required. Banks can take risks in the hope of favorable changes in prices, which would give an opportunity to get speculative profit. This approach to management strategy called non-hedging.

Given the inability to take advantage of favorable circumstances in risk hedging transactions, banks and their customers can use the strategy consciously does not hedge when some of the assets or liabilities is sensitive to changes in market parameters (interest rates, exchange rates). The strategy does not hedge aims at maximizing profits, and is accompanied by an increased level of risk. With this approach, the bank is not protected against adverse changes in the market and can incur large financial losses. hedging strategy to stabilize the profit for the minimum level of risk, and provides an opportunity to get the same results regardless of the volatility of financial markets. Choice of strategy depends on many factors, first and foremost - from the tendency of the bank to risk.

However, not always the choice of risk management strategy is an internal matter. Some banks may not allow their clients to speculate. In providing services to the client the bank has the right to insist on hedging, because the risks faced by the client, may result in losses of the bank. In some countries, supervisors forbid commercial banks to conduct speculative operations. And sometimes your own bank's management restricts the level of acceptable risk limits. Hence, the need of hedging confronts many market participants.

On international financial markets, there are many potential hedgers: Trade dealers of government securities and foreign currencies, which are protected by lower yields and exchange rates; investment banks, who use futures market for the sale of more current assets than it can be done on the spot market; exporters and importers to protect the future payments from changes in exchange rates; Corporation to fix the interest rate on attracted and placed funds; companies engaged in transactions with the property, the issuance of convertible shares are protected from possible interest rate increase until the completion of the issuance and placement; pension funds protect the income from investments in gilts and Treasury bills; banks that are protected from the reduction of credit interest rates and the increase in deposit rates in the future; mutual funds to protect the nominal value of financial assets, which they have, or fix prices for the financial instruments that will be purchased in the future.

This list of hedgers is far from complete, but it gives an idea of the diversity of the types of organizations that may use the term market transactions to reduce exchange-rate risk, interest rate risk, or in the stock market.