Translated from Russian by Google Translate
2 Сентябрь 2009

Everything you wanted to know about hedge

One of the objectives pursued by all the traders - a reduction of currency risks. The fact is that sooner or later, you begin to understand that the divine point of entry and exit from the market is not enough. Looking for something extra, a strategy that would satisfy the rules of money management. One of these strategies, which received great publicity, began trading method of hedging assets. Hedging - a trade the two market-based instruments, which are mutually balance each other. In simple words, the meaning of hedging is that you, for example, buying one currency and selling another, associated with it. Due to this, as you would reimburse the loss. If the single currency on the derivatives market (this includes forex) you will lose out, then on another, related, in the bank you get a profit. This mutual balancing and is the basis of the concept of hedging.


Why use hedging

The main goal pursued by traders who resort to hedging strategies, the desire to reduce the level of risk during trading. Hedging exchange rate will allow you to either completely avoid or significantly reduce the uncertainty in the future and allow for more efficient financial management. It is worth noting that if you properly build its hedging strategy, it will not only reduce foreign exchange risks, but also will reduce costs. If we talk about big companies, the hedge allows for the protection of regular prices while there is no need to make a correction in the overall financial policy of the company or enter into forward contracts for the long term. By the way, if we talk again about the activities of companies and small businesses, then through the use of hedging assets simplified lending procedures, as many banks attach importance to hedge assets and account for them at a much higher rate.

Features hedging forex

All currency transactions connected with the forex market, carried on the principle of margin trading. It is this kind of trade is most prevalent and popular. This is no accident. I will bring several advantages, which are characteristic of margin trading:

• Even if you start trading with small capital, you have the ability to conduct transactions in amounts that are many times the size of your capital. This excess is called leverage (leverage)
• All foreign exchange transactions that you make, are carried out without the real money supply. This will significantly reduce overhead costs and enable transactions, for buying and selling currencies

And now look what the advantages of hedging currency risk:

• You can not cut your budget. That is, you will not need to cut some of their money from the general circulation
• You have an opportunity to sell the currency, which you get only after a certain time

In order to be able to perform transactions on the principle of hedging you just open a live trading account in one of the companies that provide mediation services on the Forex market.
Applies to the forex market, there are two types of hedging - hedging seller and buyer. Hedging the buyer means a complex of measures to protect the seller from risk, which may be associated with an increase in prices. Hedging the seller, in turn, is to reduce the risks associated with possible fall in the price.

Here is an example of hedging

Imports of goods

Suppose that some company is N, which imports of goods, within one month forward delivery of the consignment worth 70 000 euros. But as the company has set aside funds in U.S. dollars, then she will have to calculate to convert dollars to euros. Assume that the current euro exchange rate suits the company, but it may happen that the general manager of the company deems it necessary not to convert all available means, but only part. Therefore, the decision to hedge part of the funds by entering into the transaction. All this happens without the actual delivery of funds. Further, the manager takes, say, $ 7 000 on the trading account and buy euros for dollars on the currency pair EUR / USD. Now you need to calculate what the load can withstand our sum. This is done as follows: 70 000 * 0.0900 = 6 300.

Nuances in conducting the transaction can be seen in the table below:

hedge

As you can see, a transaction made on the trading account had brought a loss. But this loss was offset by profit, which was obtained as a result of conversion of euros in the bank. This conversion was carried out at a much better exchange rate than during the contract. From the above, I doubt you could understand that when such actions amount of any profit or loss will always be zero. In this way, and insure a variety of companies from the risk of a sharp jump in exchange rates.

In this article, I always mention that hedging is designed to reduce currency risk, but not its complete elimination. Therefore it is always worth to take into account that the FX market, with all his crazy dynamics, is unlikely to provide you with a stable and win-win trade, even with hedging assets. The main problem that can arise when hedging - it is an incomplete match the price movement of real assets and derivative instruments. The point here is that the prices on the real market and the urgent always be different, because they have different laws of supply and demand. But here, too, has its own nuances.

Although it is likely that the prices on the real and the derivatives market will be different, yet is aware that they can not vary too much, because the expense of having a good arbitrage opportunities. But these opportunities due to a high degree of liquidity of the currency market are reduced to zero, but it is not to say that in this case there will be no risk. The risk still remains, though not as significant. There are other types of risks, such as administrative restrictions, changes in legislation, etc. But these types of risks more characteristic of the markets, the terms and conditions which are controlled by the competent authorities. For example, a number of exchanges there may be restrictions on the maximum range of fluctuations in futures prices within a day.