Hedging - What Is It, And It's Uses In Risk Management
August 25, 2008 12:18pm
Hedging, understanding the benefits of risk management in an enterprise wide solution. Risk management and hedging is a useful tool to reduce market place liability. Here are some tips on its uses.
Second of a two part article Before I discuss the use of hedging to off-set risk, we need to understand the role and the purpose of hedging. The history of modern futures trading began in Chicago in the early 1800's. Chicago is located at the base of the Great Lakes, close to the farmlands and cattle country of the U.S. Midwest making it a natural center for transportation, distribution and trading of agricultural produce. Gluts and shortages of these products caused chaotic fluctuations in price. This led to the development of a market enabling grain merchants, processors, and agriculture companies to trade in contracts to insulate them from the risk of adverse price change and enable them to hedge.
The first commodity exchange was the creation of the Chicago Board of Trade, CBOT in 1848. Since then, modern derivative products have grown to include more than the agricultural industry. Products include Stock Indices, Interest Rates, Currency, Precious Metals, Oil and Gas, Steel and a host of others. The origins of the commodity and futures exchange was created to support hedging. The role of speculators is beneficial as they add trading volume and important volatility to what would otherwise be a small and illiquid market place.
A bona-fide hedger is someone with an actual product to buy or sell. The hedger establishes an off-setting position on the futures or commodity exchange, thereby instituting a set price for his product. Someone buying a hedge is known as being "Long" or "Taking Delivery". Someone selling a hedge is known as being "Short" or "Making Delivery". These positions known as "Contracts" are legally binding and enforced by the exchange. You can view a complete listing of the worlds different exchanges at: World Exchanges .
Entering your trades either for speculation or hedging is done through your broker or Commodity Trading Advisor. Commodity and Futures exchanges are distinct from Stock Exchanges, although they operate using the same principals. They are regulated by different agencies such as the Commodity Futures Trading Commission who are responsible for regulation of retail brokers in the USA as well as Commodity Trading Advisors who are really Portfolio Managers for derivatives.
Now let's view some real life examples of hedging or mitigation of risk by using exchange traded derivatives.
Example 1: A mutual fund manager has a portfolio valued at $10 million closely resembling the S&P 500 index. The Portfolio Manager believes the economy is worsening with deteriorating corporate returns. The next two to three weeks are reports of quarterly corporate earnings. Until the report exposes which companies have poor earnings, he is concerned of the results from a short term general market correction. Without the privilege of foresight, he is unsure of the magnitude the earnings figures will produce. He now has an exposure to Market Risk.
The manager thinks of his options. The greatest risk is to do nothing, if the market falls as expected, he risks giving up all recent gains. If he sells his portfolio early, he also risks being wrong and missing further rally's. Selling also incurs substantial brokerage fees with additional fees to buy back again later.
Then he realizes a hedge is the best option to mitigate his short term risk. He begins by calling his CTA (Commodity Trading Advisor) and after consultation places an order to sell short the equivalent of $10 million of the S&P 500 index on the Chicago Mercantile Exchange "CME". Now his result is when the market falls as expected, he will off-set any losses in the portfolio with gains from the Index hedge. Should the earnings report be better than expected, and his portfolio continues upward, he will continue making profits.
Two weeks later the fund manager again calls his CTA and closes the hedge by buying back the equivalent number of contracts on the CME. Regardless of the resulting market events, the mutual fund manager was protected during the period of short term volatility. There was no risk to the portfolio.
Example 2: An electronics firm ABC has recently signed an order to deliver $5 million in electronic components of next years model to an overseas retailer located in Europe. These components will be built in 6 months for delivery two months after that. ABC instantly realizes they are exposed to two risks. 1. the rising and volatile price of copper in 6 months may result in losses to the firm. 2. the fluctuation in the currency could easily add to those losses. ABC being a young firm cannot absorb these losses in view of the highly competitive market from others in the field. Losses from this order would result in lay-offs and possibly plant closures.
ABC telephones their CTA and after consultation places an order for two hedges, both for an expiry in 8 months, the date of delivery. Hedge #1 is to buy long $5 million of copper effectively locking in today's price against further price increases. ABC has now eliminated all price risk. The risk of plant closures is greater than the lure of increased profit should copper price fall. After all, ABC is not in the business of speculating on copper prices.
Hedge #2 is to sell short the equivalent of Euro Currency vs US Dollars. Since ABC is effectively accepting EC in payment, a rising US dollar and a weak EC would be detrimental and erode profits further. The result of the hedge is no risk and no surprises to ABC in either copper or currency levels. A risk free transaction and full transparency is the result. In 8 months with the order completed and the customer accepting delivery, ABC notifies the CTA to close the hedge by selling the copper and buying back the Euro Currency contacts.
Many examples exist to demonstrate the mitigation of risk to an institution or financial portfolio. New products are constantly created and available on both over-the counter and exchange traded markets. It would be wise to consult with a qualified Commodity Trading Advisor or broker to discuss the analysis for an on-going risk management solution or a one time only hedge.
Dwayne Strocen is a registered Commodity Trading Advisor specializing in analyzing and hedging Market and Operational Risk using exchange traded and OTC derivatives. Website: http://www.genuineCTA.com
View more detailed information on the role of Hedging and the benefits of Investing Off-Shore .
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Market Risk - Not To Be Ignored or Overlooked
July 28, 2008 10:19am
Understanding Market Risk and the solutions available to mitigate or eliminate financial loss in today's global market.
The first of a two part article
Fund managers, whether they be equity or bond traders, know all too well that returns are not simply a result of their asset selection
prowess. Many external factors come into play. But what are the issues facing the professional money manager. Management of risk is
one of the most important, and not all fund managers analyze their market risk. This is often explained as a lack of education and a failure
to understand the mitigating solutions for off-setting risk.
Market risk is defined as "the unexpected financial loss following a market decline due to events out
of your control." Stock or bond market volatility or market reversals can be the result of global events happening in
far flung corners of the globe. Top analysts and fund managers simply do not have the resources to crystal ball gaze
and predict those events.
Examples of several major unexpected events that sent shock waves throughout the financial community have been:
- 1982 Mexican Peso devaluation;
- 1987 stock market crash knows as "Black Monday";
- 1989 USA Savings and Loan Crisis;
- 1998 Russian Ruble devaluation;
- 1998 $125 billion collapse of Hedge Fund Long Term Capital Management;
- 2006 collapse of Hedge Fund Amaranth with losses of $5.85 billion.
In 1994 Bank J.P. Morgan developed a risk metrics model known as Value-At-Risk or VaR. While VaR is considered the industry standard of risk measurement, it has its drawbacks. VaR can measure total dollar value of a funds risk exposure within a certain level of confidence, usually 95 or 99 percent. What it cannot do, is predict when a triggering event will occur or the magnitude of the subsequent fallout. For some company's and funds, a steep decline or protracted recession can be devastating. Even forcing some un-hedged firms into bankruptcy. A triggering event can have a ripple effect forcing people out of work and economies into recession effectively putting more people out of work. No person and no economy is immune.
If you own a mutual fund, chances are your fund is un-hedged. Until recently, mutual fund legislation
prevented mutual funds from hedging. Many jurisdictions have repealed this rule however mutual fund managers have been slow
or decided to continue with "business as usual". The reason is that most investors of mutual funds are unsophisticated and do
not understand the hedging process and may re-deem their money from an investment strategy they do not understand.
Hedge funds on the other hand do not have these restraints. Investors are more sophisticated and are more open to the nature of hedge fund strategies. Some of which are not disclosed due to a fear of piracy by competing hedge fund managers.
Risk reduction solutions are not complicated but do require the services of a professional who understands the process. This is the role of a Commodity Trading Advisor, also known as a CTA. While most CTA's are hedge fund managers, few specialize in risk management analytics. The focus of a risk manager is on the analysis of solutions to reduce or eliminate market and / or operational risk. No matter the role, all Commodity Trading Advisors are specialists in the derivatives market.
The first step is the value at risk calculation to determine a funds risk liability. A risk mitigation strategy known as a hedge is then implemented. After all, identification of one's risk is only beneficial if a solution to off-set that risk is put into place. Hedging requires the use of derivatives, either exchange traded or over-the-counter. These can take many forms. The most commonly used hedging instruments are index futures, interest rate futures, foreign exchange, exchange traded commodities such as Crude Oil, options and SWAPS.
A more detailed explanation of derivatives and hedging will be discussed in our next article. Now that we've identified an easy solution for your market risk worries, the implementation of the right strategy can be as easy as a call to a qualified and registered Commodity Trading Advisor.
Dwayne Strocen is a registered Commodity Trading Advisor specializing in analyzing and hedging Market and Operational Risk using exchange traded and OTC derivatives. Website: http://www.genuineCTA.com
View more detailed information on the role of
Risk Management and Foreign Exchange Trading
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