Hedging instruments

Forwards - A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. Futures- A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market. Options- A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. Swaps - A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. Forward Rate Agreements (FRAs)- A contract agreement specifying an interest rate amount to be settled at a pre-determined interest rate on the date o the contract.

Hedging Strategies Using Futures and Options Basic Strategies Using Futures While the use of short and long hedges can reduce, or eliminate, both downside and upside risk. The reduction of upside risk is certainly a limitation of using futures to hedge.

Short Hedges
A short hedge is one where a short position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be sold in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will decrease. 1. For example, assume a cattle rancher plans to sell a pen of feeder cattle in March based on the spot prices at that time. The rancher can hedge in the following manner. Currently, A March futures contract is purchases for a price of $150 For simplicity, assume the rancher anticipates (and does sell) selling 50,000 pounds (1 contract)

 Spot prices are currently $155 If the spot price is March decreases to $140, the Rancher loses $10 per 100 pounds on the sale from the decreased price. But, the Rancher gains $10 by selling the futures contract for $150 and immediately buying (to close out) for $140 Hence, the eective price of the sale is $150 If the spot price in March increases to $160, The Rancher gains $10 per 100 pounds on the sale from the increased price And he loses $10 by buying the futures contract for $150 and immediately selling (to close out) for $160 Eective price of the sale is $150 The seller has eectively locked in on the price prior to the sale by osetting gains/losses

Long Hedges A long hedge is one where a long position is taken on a futures contract. It is typically appropriate for a hedger to use when an asset is expected to be bought in the future. Alternatively, it can be used by a speculator who anticipates that the price of a contract will increase. For example, assume an oil producer plans on purchasing 2,000 barrels of crude oil in August for a price equal to the spot price at the time. The producer can hedge in the following manner by using crude oil futures from the NYMEX. For example, currently, an August oil futures contract is purchases for a price of $59 per barrel. Spot prices are currently $60 What happens if the spot price in August decreases to $55? The producer gains $4 per barrel on the purchase from the decreased price Producer loses $4 by buying the futures contract for $59 and immediately selling (to close out) for $55 Eective price of the sale is $59 What happens if the spot price in August increases to $65? Producer loses $6 per barrel on the purchase from the increased price.

And the producer gains $6 by selling the futures contract for $59 and immediately buying (to close out) for $65 Eective price of the sale is $59 The producer has thus eectively locked in on the price prior to the sale by osetting gains/losses.

Hedging with Options: There is also a possibility to hedge price risks by using options, which grant the right but not the obligation to buy or sell a futures contract at a fixed price, which in this case will be called the strike price. Unlike using futures to hedge, hedging with options offers more possibilities for the holders of an option. They may lose their investment in the option when the price moves against them, but when the price moves in their favour they can let the option expire and take advantage of the favourable market price. Therefore the eventual result of option hedging can vary much more then when hedging with futures. There are costs involved in obtaining an option. The price for an option is called a premium and is based on intrinsic and time value. The intrinsic value is the difference between the strike price and the underlying assets market price. This will be the profit made by exercising the option or offsetting the option. The time value is determined by the possibility of the price increasing over time. When the maturity date of an option draws near, it becomes more unlikely the price will make significant changes and thus the time value decreases. The premium of an option can influence the decision to hedge a commodity using options and how and when the hedge will be placed. Similar to hedging with futures, hedging with option also offers two positions a hedger can occupy, which is either long or short. And just like futures, the basis can play an important part in the final price paid for a commodity. Long hedging using Options: A long position in option hedging gives the holder of the call the right but not the obligation to buy a futures contract. A holder of a long position expects the price of the futures contract to rise, hereby exercising the option and obtaining the futures contract at the lower strike price, or gaining the profit from offsetting his position. There are a number of different scenarios which can occur when hedging with options. In the first scenario the futures and cash price increase, while the basis remains unchanged. This will result in a profit, when the hedger offsets his position. The cash price will be decreased with the difference between the original premium and the premium upon the moment of settling the position. A hedger can also choose to exercise the option when the price has increased significantly, but the premium for options increases only slightly. In this cast the hedger would be able to

buy the futures contract for the strike price and sell it for the current futures prices, which would result in a substantial profit. The net buying price will be based on the cash price reduced with the profit made on exercising the option. The prices of both the market and futures price can however also decrease, which will result in an increased net buying price. The offsetting of the position will now cost the hedger money and thus the cash price will increase with the difference between the original premium and the premium upon the moment of settling the position. Another situation can occur where the price doesnt make a substantial change and the option will expire worthless. This will result in losing the entire premium paid for the option. Consequently, this would result in an increased net buying price, which is constructed of the cash price with the addition of the premium.

Short Hedge using Options: Short hedging with the use of option is mostly implemented by producers, who want to ensure themselves of a profitable price upon the delivery date. Therefore they will obtain a put with a favourable strike price. Similar to long hedging, short hedging can result in different results. The first and most favourable situation, in case of a short position with a put, is when the price decreases. The hedger is now able to sell his option for a higher price than the current futures price and thus additional profit is made. This profit along with the cash price will form the net selling price. In a different situation the price may decrease significantly while the premium only increases slightly. This may cause the hedger to exercise the option, which would result in selling a futures contract for a higher price than the current futures price. He can buy back this contract for the lower market price and sell his commodity on the cash market. The net selling price will be the cash price plus the profit made on offsetting the futures position. There is also the possibility the prices will increase. This will cause the offset of the option to cost the hedger money. The cash price will be decreased with the difference between the premiums upon obtaining the put and offsetting this position upon the maturity date, this forms the net selling price. The final situation is when the price makes no significant change. This will result in the option expiring worthless and the commodity being sold on the cash market. This will result in the net selling price being composed of the cash price reduced with the premium paid for the option. As the different situations above illustrate, the use of options never comes free and thus must be used in a sensible manner. Despite the costs, the use of options is a solid form of hedging due to the possibility to still gain additional profit from price increases. Whereas futures are a far more binding contract. The use of options as a hedging tool is not to make additional profits, but to limit potential losses.

Cross Hedging: The act of hedging ones position by taking an off-setting position in another good with similar price movements is called cross hedging. A cross hedge is performed when an investor who holds a long or short position in an asset takes an opposite (not necessarily equal) position in a separate security, in order to limit both up- and down-side exposure related to the initial holding. Although the two goods are not identical, they are correlated enough to create a hedged position as long as the prices move in the same direction. A good example is cross hedging a crude oil futures contract with a short position in natural gas. Even though these two products are not identical, their price movements are similar enough to use for hedging purposes.