What Are the Different Types of Hedging Tools?

Hedging is a financial term that refers to an investment that deliberately reduces the risk of another investment. It is a way to reduce business risks while still profiting from investments. Generally, hedging is to carry out two transactions related to the market at the same time, in opposite directions, with equal amounts, and the profit and loss. Market correlation refers to the identity of the market supply and demand relationship that affects the prices of two commodities. If the supply and demand relationship changes, it will affect the prices of two commodities at the same time, and the direction of price changes is generally the same. The opposite direction refers to the opposite direction of the two transactions, so no matter which direction the price changes, there is always a profit and a loss. Of course, in order to offset the profit and loss, the size of the two transactions must be determined according to the extent of their respective price changes, and the numbers should be roughly the same.

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1. Arbitrage strategy: the most traditional hedging strategy

Arbitrage strategies include convertible arbitrage, stock index futures arbitrage, intertemporal arbitrage, ETF arbitrage, etc., are the most traditional hedging strategies. Its essence is the application of the "one price principle" for pricing financial products, that is, when there are differences in pricing between different manifestations of the same product, buying a relatively undervalued product and selling a relatively overvalued product to obtain intermediate spread benefits . therefore,

Hedging is most common in the foreign exchange market, focusing on avoiding the risks of single-line trading. The so-called single-line trading is to buy short (or short position) when you are optimistic about a certain currency, and to sell short (short position) when you are pessimistic about a certain currency. If the judgment is correct, the profit will naturally be greater; but if the judgment is incorrect, the loss will also be greater than the hedging.

The so-called hedging is to buy a foreign currency at the same time and go short. In addition, another currency must be sold, that is, short selling. In theory, shorting a currency and shorting a currency requires the same silver code to be a true hedge, otherwise the hedging function cannot be achieved if the sizes of the two sides are different.

The reason for this is that the world's foreign exchange market uses US dollars as the unit of calculation. All foreign currency changes are relative to the US dollar

Deborah Lee, Head of Capital Services, Credit Suisse Asia Pacific, said that during 2005-07 before the financial tsunami, the main source of capital for Asian hedge funds came from European funds, private banks and wealthy funds, but currently, North American institutions (mostly (U.S.A., and Canada) into the Asian hedge fund market, becoming the main source of funds

However, U.S. institutional investors' investment in hedge funds is limited, and many can only invest in hedge funds with a market value of at least $ 100 million.

The capital limit of Asian hedge funds is about $ 1 billion. When the asset value of the fund rises near the limit, it needs to be suspended in order to conduct due diligence. This process takes several months. Just as FortressAsiaMacroFund recently raised $ 750 million, Need to suspend business

In the book "Quantitative Investment-Strategies and Technologies", hedging transaction models are summarized into four types, namely: stock index futures hedging, commodity futures hedging, statistics, and option arbitrage.

Hedging of stock index futures

Hedging of stock index futures refers to the use of unreasonable prices in the stock index futures market, participating in stock index futures and stock spot market transactions at the same time, or simultaneously trading in stock index contracts of different durations and different (but similar) categories to earn the difference. Stock index futures arbitrage is divided into current hedging, intertemporal hedging, cross-market hedging, and cross-product hedging

Commodity futures hedging

Similar to stock index futures hedging, commodity futures also have a hedging strategy. When buying or selling a certain futures contract, they sell or buy another related contract, and at the same time close the two contracts at the same time. . It is somewhat similar to hedging in the form of transactions, but hedging is buying (or selling) physical goods in the spot market and selling (or buying) futures contracts in the futures market; arbitrage only Buying and selling contracts on the futures market does not involve spot trading. Commodity futures arbitrage mainly has four types: spot hedging, intertemporal hedging, cross-market arbitrage and cross-species arbitrage.

Statistical hedging

Different from risk-free hedging, statistical hedging is based on the historical statistical law of securities prices for arbitrage. It is a type of risk arbitrage. The risk lies in whether this historical statistical law will continue to exist in the future. The main idea of statistical hedging is to find out the most relevant pairs of investment varieties (stocks or futures, etc.), and then find the long-term equilibrium relationship (co-integration relationship) of each pair of investment varieties. (Residual error of the co-integration equation) Start to open a position when it deviates to a certain degree-buy a relatively undervalued product, sell a short overvalued product, and wait until the profit returns when the spread returns to equilibrium. The main contents of statistical hedging include stock matching transactions, stock index hedging, securities lending and foreign exchange hedging transactions.

Options hedging

Option (Option), also known as option, is a derivative financial instrument based on futures. In essence, options essentially price and separate rights and obligations in the financial field, so that the assignee of the rights can exercise its rights on whether to conduct a transaction within a specified time, and the obligor must perform. When trading options, the party buying the option is called the buyer, and the party selling the option is called the seller; the buyer is the assignee of the rights, and the seller is the obligor who must fulfill the buyer's rights. The advantage of options is that the benefits are unlimited and the risks and losses are limited. Therefore, in many cases, using options to replace futures for short and hedging transactions will have less risk and higher yield than simply using futures arbitrage.

First, what is arbitrage? What is hedging?
Arbitrage generally refers to the purchase of a lower price and the higher price of a sale in the event that a certain physical asset or financial asset (in the same market or different markets) has two prices, thereby obtaining risk-free returns. Arbitrage refers to actions that profit from correcting abnormal conditions of market prices or yields. Abnormal conditions usually refer to the behavior of significant differences in prices of the same product in different markets, arbitrage, that is, buying low and selling high, causing the price to return to an equilibrium level. Arbitrage usually involves establishing a position in one market or financial instrument and then establishing a position in another market or financial instrument that offsets the previous position. After the price returns to the equilibrium level, all positions can be settled for profit.
Hedging is an investment that deliberately reduces the risk of another investment. It is a way to reduce business risks while still profiting from investments. Generally, hedging is to carry out two transactions related to the market at the same time, in opposite directions, with equal amounts, and the profit and loss. Market correlation refers to the identity of the market supply and demand relationship that affects the prices of two commodities. If the supply and demand relationship changes, it will affect the prices of two commodities at the same time, and the direction of price changes is generally the same. The opposite direction refers to the opposite direction of the two transactions, so no matter which direction the price changes, there is always a profit and a loss. Of course, in order to offset the profit and loss, the size of the two transactions must be determined according to the extent of their respective price changes, and the numbers should be roughly the same.
Second, what is the difference between arbitrage and hedging?
By definition, arbitrage and hedging are both "buy strong and sell weak". The scope of hedging is larger. In a sense, arbitrage is also a form of hedging.
Arbitrage is more about "correcting the inherent errors and irrationality of the market and making it return to a reasonable one." Many times it is similar to "contrarian" trading, and generally requires a high degree of correlation between arbitrage varieties. That is, the same rise and fall, the relative profit is earned. For example, the recent empty soybean oil is more palm oil, soy oil palm oil has risen and fallen, but palm oil has risen more, this arbitrage makes money.
And aside from the arbitrage part, the hedging in the general sense is a transaction of buying strong and selling weak, which is a "homeopathic" transaction. There is not necessarily a correlation between varieties, only the strength of volatility can be sufficient. For example, someone who is long copper short cotton is a hedge. Without a high degree of correlation, systemic risks can generally not be avoided. It is possible that both varieties will make money or both will lose money.
Third, what effect does arbitrage hedging have?
1, greatly reduce the risk, almost no risk to profit.
2. Conducive to promoting market perfection.
3. Suitable for investors with low risk tolerance and large amount of funds.

Silver arbitrage income is relatively low. Now most institutions expect only about 5-7% in the first half of the year. If the expected annual income is around 10%, it seems that the arbitrage income is significantly reduced. For arbitrage customers, pay attention to the rate of return.

Silver hedge returns are relatively high, with annualized returns above 35%, and arbitrage is about 10%. Clients are advised to conduct silver hedging transactions.

The silver arbitrage index before and after the listing of silver futures was around 300, which has been relatively low recently. During the day, silver futures and silver TD automatic trading arbitrage, and Tiantong silver, paper silver, Comex silver and silver TD arbitrage at night, which caused the profit of silver arbitrage. The rate has dropped significantly, and arbitrage can be 5% in the second half of the year.

There are many silver futures arbitrage orders, and they are automatically traded during the day. Tiantong silver is manually traded. Wooden sticks and mechanized army fight to see the gains. You know that the silver arbitrage era has passed, and the yield on hedge transactions is relatively high.

The average daily volume of silver futures is about 400,000 hands, silver TD is about 500,000-1.5 million hands, large institutions are doing arbitrage and hedging, small customers will have low returns, and customers below 5 million are advised not to operate. The silver arbitrage yield is relatively high. In 2010 and 2011, it was about two and a half years (about 30 months) before the silver futures were listed. The yield on silver hedging transactions will continue, unlike silver arbitrage futures, which directly reduce the yield a lot.

According to industry sources, recently, arbitrage customers under 3 million have gradually reduced operations, and about 30% have stopped operations. About 10% of customers have turned to hedging transactions. Hedging transactions are more difficult. Unlike silver arbitrage, looking at the silver arbitrage index can be operated. It is a very mechanical transaction. It is done before 280 or 300 and below 150 This method is relatively simple and very traditional, without much technical content.

Hedging trading For strategists, strategic operations require systematic operations, not simply one more and one empty. How to expand profits when there are profits and how to reduce losses when losses occur is the difficulty of hedging.

China is the second largest economy in the world.

In the book Dr. Wencai Liu's book "Wisdom of Hedging-Wealth Management from State, Enterprise to Individual", the author summarizes the seven pillars of wisdom of hedging:

1. Zero is the only best number. Be wary of huge gains or losses from hedging. When a company makes money from hedging, it forgets the company's main business. Hedging is to hedge risks and protect profits, not to make money from exchange rate changes. When you make money from exchange rate fluctuations, the analyst will ask why you are exposed to such a large risk; when you lose money from exchange rate fluctuations, the analyst will ask you why you are not fully hedged. So zero is the only best number.

2. Using the wrong person will destroy the risk aversion project. The company's chief financial officer should appoint the right person to perform risk management. For example, if you want to hedge commodity risk, you need a senior buyer who understands the supply and demand of the commodity. A clever approach is to determine the specific hedging strategy by the CFO under the guidance of the CEO's risk appetite for the company's management, and form a team of procurement, finance, and operations personnel to perform hedging.

3. Good hedging strategies come from real data. The CFO often questions the data from the operating unit and determines the credibility of the data. How confident is the finance director in the sales revenue, cost, and other data of the supply chain? How much is the data lagging? The answer determines the risk exposure of a company and how much hedging is needed. The CFO needs to update the data in a timely manner, gain insight into the data, and confirm the integrity of the data.

4. Exposure is not equal to risk. Many CFOs focus on the company's biggest exposure and assume it is the biggest risk. This is not all right. For example, a U.S.-based company exports all its products to China, but the RMB has not fluctuated much, but it has 10% of Euro revenue. The focus should be on 10% of euro revenue, as the euro is highly volatile. Risk is equal to exposure times volatility. A company may face a scenario: is it hedged by 200 basis points of interest rate risk on $ 500 million in debt or is it hedged by $ 350 million in energy price risk? For manufacturers, energy price risks are obviously greater.

5. Hedging is not all or two. How much a company hedges depends not only on how much risk is exposed, but also on its ability to take risks. Just as a car owner sets the amount of insurance coverage based on how much he can afford. If a company faces a $ 5 million fuel cost risk exposure, but it can withstand a $ 2 million fuel cost risk, it means it needs to hedge 60%. Especially with regard to fuel prices, the company did not fully hedge because it was concerned that fuel prices would fall. A company locked in the cost of diesel fuel at $ 3.08 per gallon to get the expected profit, but then the price fell to $ 2.50 per gallon, at which point the company would fall into the aftermath of Zhuge Liang's advice. But if the company does not hedge, its profits are fully exposed to the risk of price fluctuations.

6. A fixed-rate contract or forward may be the best hedge. Vendors of hedging instruments now prefer to offer fixed-rate contracts because customers need fixed-rate contracts. In this way, the buyer has no basis risk and no accounting problems. Forward contracts are based on spot prices and are very transparent, making them a good choice.

7. Options are not necessarily expensive. For many companies, the use of options as a hedging tool is an abomination, because premiums are paid in advance. In order to avoid possible losses in the future, it is necessary to pay money at the moment, which is difficult to accept and is commonplace. However, there are also some products with very low option fees in the market, such as some out-of-the-money options. Through the combination of call and put options, zero-cost option hedging tools can be generated.