Hedging

A hedge starts with two decisions: direction and size. A party that owns the asset, or will receive it, faces losses when prices fall and therefore sells the derivative, a short hedge. A party that must buy the asset later faces losses when prices rise and buys the derivative, a long hedge. Interest rate and currency exposures follow the same logic once the exposure is expressed as a long or short position in a rate or a currency.

Size is governed by the hedge ratio. The variance-minimising ratio equals the correlation between changes in the spot price and changes in the futures price, multiplied by the ratio of the standard deviation of spot changes to the standard deviation of futures changes. The number of contracts is that ratio times the exposure value, divided by the value of one contract, then rounded to a whole number. A ratio of one is only optimal when the hedge instrument tracks the exposure one-for-one.

Forwards, futures and swaps lock in a level. They cost nothing upfront but are symmetric: the hedger surrenders favourable moves along with unfavourable ones. Options are asymmetric. A purchased put protects a holder below the strike while leaving upside intact, and a purchased call caps a buyer's cost, but the premium is paid whether or not the protection is used. Collars finance the premium by selling the opposite option, giving protection within a band at the cost of the far tail of the favourable side.

Structure also matters for cash flow. Futures are marked to market daily and require variation margin, so a hedge that is economically sound can still create liquidity strain before the offsetting exposure settles. Forwards and swaps defer settlement but carry counterparty credit exposure, which is why cleared and collateralised structures dominate much of the market.

The basis is the spot price of the exposure minus the price of the hedging instrument. It converges toward zero as a futures contract approaches delivery on the same underlying, but it fluctuates in the interim, and the hedged outcome equals the locked-in price adjusted by the basis change. Any mismatch in the underlying asset, the maturity or the quantity introduces basis risk.

Cross-hedging is the deliberate acceptance of asset mismatch when no contract exists on the exact exposure, as when refined product risk is managed with crude contracts or an obscure currency is hedged through a correlated liquid one. Long-dated exposures hedged with short-dated contracts require rolling, which exposes the hedger to the shape of the futures curve: rolling in contango steadily erodes value, and rolling in backwardation adds to it.

Corporate treasuries hedge transaction exposure on foreign-currency receivables and payables with forwards, convert floating-rate debt to fixed with interest rate swaps, and fix input costs with commodity contracts. Dealers who write options hedge the resulting exposure dynamically, rebalancing an offsetting position in the underlying as delta changes. On financial statements, hedge accounting can route effective gains and losses through other comprehensive income, aligning their recognition with the hedged item rather than letting derivative marks distort earnings.

At Level I, be able to identify whether an exposure calls for a long or short hedge, compute the contract count from a hedge ratio, describe how the payoff profile differs between a forward and a purchased option, and evaluate a hedge on the combined position rather than on the derivative in isolation. Distinguishing hedging from speculation and arbitrage on the basis of pre-existing exposure is a recurring test point.