Hedging Introduction Hedging is a multivariate process for managing risks and achieving objectives. Among many other functions, it can price marketing, offer acquisition alternatives, provide portfolio insurance, stretch or shorten financial maturities, and improve working capital management. Hedging is multidisciplinary. Accounting, production, marketing, financing, taxation, legal aspects, and other areas must be considered in order to arrive at a comprehensive hedging program. Hedging is a dynamic process that manages specified risks with a suitable offset mechanism over time. This mechanism must have the capacity to generate financial responses that occur inversely to those using the underlying hedge items, be they portfolios, commodities or indices. For example, if the underlying portfolio decreased by R100.00, then the hedge account should have generated an offsetting increase of R100.00. If an underlying futures position advanced by R500.00, then the options hedge should have declined by R500.00 Hedging is not the simple buying or selling of futures and options against physicals. It is the prudent selection process whereby regulatory, financial operational, supply and demand, and other factors must be continually evaluated in order to derive the maximum benefits form the program. Insight All successful hedging programs have a common trait – insight. Although they carefully apply quantitative analysis, they are not formula approaches. Insight is the ability to penetrate the hedging problem, recognize the essential variables, and effectively place the appropriate hedge in position. Conditional Aspects Any hedging program has many conditional aspects. Awareness of these allows the hedge director to choose a better strategy, which can make a substantial difference in performance. This is analogous to another method or risk management – insurance. How much coverage is needed? For whom? For what? How large are the deductibles? These are important questions to answer in the final resolution of an insurance coverage program. Similar principles apply here. One can effectively secure coverage, but to do so to the extreme may reduce hedging performance. The introduction of too many moving parts and adjustment processes can be operationally and financially onerous. Methods The four basic methods by which hedges can be established are: Contractual arrangement Forward contracts Futures contracts Options contracts Contractual Arrangements: These occur when two parties agree to a legally enforceable set of terms. For most organisations, they are common occurrences during the ordinary course of business. Examples are an agreement to sell refined gold at a certain price, the sale of heating oil against a specified benchmark, or the receipt of computers for Dollars or Yen. These are non-standardised arrangements, in which terms are likely to vary for each situation. Performance risks are borne by both parties. In these cases, the amounts of the transactions and the conveyance of goods, securities, or services take place according to a specified schedule of delivery, payment for which precedes, coincides with, or follows the transfer of funds. There can be substantial penalties for any modifications or failure to comply. These transactions are not readily emendable to early offset or contractual adjustments. Forward Contracts: These call for the transfer of commodities, securities, or currencies at a specified time in the futures. Often the payment is to be made at that time. Although there is no explicit standardisation as in futures and options contracts, forward contracts tend to follow certain conventions. For example, the settlement (payment) procedures for conducting foreign exchange transactions at banking institutions are fairly well known, as are security payment practices. There are usually no requirements for good faith deposits – margining – for which futures and options positions are mandatory. Sometimes, letters of credit are necessary to conduct transactions, and significant penalties for premature or late offset bay be assessed. The marketplace for currency transactions is very broad, and performance depends on the trading partners. They may need to shop around because they are not conducting trades through a recognized exchange. Futures Contracts: These are standardised instruments. The standards include: specific size or quantity of contract; stipulated grades, acceptable securities, or underlying index; premium and discount structure (conversion factor process) when applicable, and invoicing, delivery and settlement procedures. The rules for trading hedging and margining positions are regulated by the particular exchange and the relevant regulatory bodies. Futures contract performance risks here are borne by the appropriate clearinghouses, not the trading partners. There is no stipulated penalty for premature or late offset. Unlike contractual arrangements, forward contracts allow greater flexibility for opening and closing positions. Options Contracts: These are unilateral contracts on an underlying futures contract, an underlying security or currency, or a physical commodity. The buyer of an option acquires the right, not the obligation, to exercise. The seller of the option incurs the obligation to satisfy the terms of the option should an exercise occur. There are two types of options: puts and calls. A call gives the purchaser of the option the right, but not the obligation, to exercise. In the case of an option on a futures contract, an exercise would give the owner a long position in the underlying futures contract, and the seller would be assigned the offsetting short position in the futures contract. The purchaser of a put, upon exercise, would receive a short position in the underlying futures, whereas the seller or grantor of the put would be assigned a long position in the underlying futures. No stipulated penalty is imposed for premature or late offset. Options allow flexibility for opening and closing positions. Concepts and Framework Three concepts capture a substantial portion of the hedging framework, i.e. time, interest, and volatility. They interact and modify one another, and they are fundamental building blocks for many financial models. Time Time can be the temporal distance to expiration for an options contract, to the first notice day or the last trading day, or time can represent an operational period or cycle. Depending on the circumstances, time can refer to the expected holding period, the required holding period, the expected growing period, the minimum processing period, the maximum marketing period, or whatever interval specification is appropriate for the hedge. In all these cases, time identifies the length of temporal distance between two decision or action points. Given appropriate substitutions for interest or volatility, these alternative lines represent time values for either futures or options. For futures, the primary factor would be interest rates multiplied by time, whereas for options their time value would be predicated upon the interaction of time and volatility. Regardless or a program’s sophistication, lines similar to these identify opportunities and costs, both of which are addressed by hedging. Specifications and actions affect hedging performance. In practice, these critical variables influence the time value of money, carrying charges, time value of option, expected price change or levels, selection of hedge instrument contract months, and other decision criteria. Interest Positions cost or earn interest. Hedging strategies evaluate costs (financial carrying charges) and opportunities (time values). Interest rates can be federal funds, short- term Treasury bills, Eurodollar rates, or whatever rates of interest are relevant to the situation. The rate of interest can also be an imputed opportunity cost. The multiplicative interaction between time and interest rates presents carrying charges and the time value of money. By substituting volatility for interest rates, one can see a similar multiplicative interaction between time and volatility. Volatility For the moment, we will view volatility as variability. In terms of volatility, changes or fluctuations constitute risks. Many factors influence volatility. For agricultural commodities these can include weather, transportation, pests, or blights, for financials, monetary or fiscal policies and actions. Volatility considers the potential of change. The greater the potential change, the greater the potential volatility and the greater the need for protection. Time compounds this risk factor. For example, a gold producer or jeweler may not be alarmed when gold is trading at $450 per ounce and its expected variation is $15 per ounce for one year. However, concern would be heightened if the outlook were for a potential variation of $150 per ounce for the same time period. Hedging recognizes the danger of change and attempts to neutralise it. Volatility is frequently considered as the variance or the statistical variation about a mean. A derivative is the standard deviation or square root of the variance. Risk measurement statistics are easy to compute; interpreting them properly is more difficult. These statistics look at both sides of the mean, the plusses and the minuses. In so doing, they place a symmetrical framework around the interpretation of risk. But this does not necessarily reflect reality. An unhedged portfolio manager is at risk when declining prices prevail, not in a time of higher prices. Likewise, a farmer is better off when prices are rising and he has not sold or hedged his crop. For these two examples, higher prices do not increase risk; it is lower prices that do so. Conversely, a user or consumer of commodities would be at risk if prices advanced when the cost of input had not been covered. For example, a metal fabricator sold finished goods, such as aluminium cans, assuming a comparatively favourable cost of input. Similarly, a financial institution extended credit (a mortgage), and subsequently prices of credit instruments fell (mortgage rates rose), placing the interim liquidation value of the mortgage portfolio at risk. Subsequently, higher interest rates would lower the market value of the mortgage portfolio. Also, the financial institution would have locked in a competitively lower and disadvantageous rate for its income stream. The symmetrical characteristic or risk can be approached with broader solutions sets. Interactions and Simulations Time, volatility, and interest interact with one another. Depending on their relative dominance different outcomes occur. By introducing other variables into financial modeling functions, one can obtain expressions for futures and options pricing models. Depending on the hedger’s input of needs, constraints, and modifications, these generalized models become dedicated ones. A hedger can simulate results by generating what-if scenarios and outcomes. This approach is very valuable because simulations isolate more desirable strategies against widely ranging conditions and highlight potential trouble spots.