Hedge Strategies

One of the existing developments in finance over the last 30 years has been the growth of derivatives markets. In many situations, both hedgers and speculators find it more attractive to trade a derivative on an asset than to trade the asset itself. Some derivatives are traded on exchanges; others are traded by financial institutions: fund managers and corporations in the over-the-counter market.

Many of the participants in futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. The risk might relate to fluctuations in the price oil, a foreign exchange rate, the level of the stock market, or some other variables. A perfect hedge is one that completely eliminates the risk. Perfect hedges are rare. For the most part, therefore, a study of hedging using futures contracts is a study of the ways in which hedges can be constructed so that they perform as close to perfect as possible.

In this essay, there is no attempt made to adjust the hedge once it has been put in place. The hedger simply takes a futures position at the beginning of the life of the hedge and closes out the position at the end of the life of the hedge. Futures contracts discussed in this essay are treated as forward contracts which ignore daily settlement. There are two key factors affect risk of future contracts: the asset underlying the future contract and the delivery month. The assumption of hedge strategies analyzed later is to rule out the factors of the delivery month by assuming that there is sufficient liquidity in all contracts to meet the hedgers' requirement. In other word, hedgers can choose a delivery month that is as close as possible to the expiration of the hedge.

Basic principles such as long hedge and short hedge.

There are two principles about hedge one is short hedges that involves a short position in future contracts. This is appropriate when the hedger already or will owns an asset and expect to sell it at some time in the future. For example, a short hedge could be used by a farmer who owns some hogs and knows that they will be ready for sale at the local market in two months. A short future position leads to a loss if the prices of hog increase in value and a gain if it decreases in value. It has the effect of offsetting the exporter's risk. The other one is long hedges that involves taking a long position in future contracts. It is used when a company knows it will have to purchase a certain asset in the future and wants to lock in a price now. The investor in long position will gain when the price of underlying asset increased and loss when the price decreased.

Different hedge strategies which are position matching, delta hedging and minimum variance hedging.