Bites Of Trading Knowledge #12

What is Hedging? -

Hedging is the action taken through the use of a financial instrument to minimize the loss or risk of the loss of value of an asset due to adverse asset price movements.

Who are Hedgers? -

Hedgers are market participants such as commodity producers who want to lock in selling prices of commodities they produce, or food manufacturers who want to lock in buying prices of raw materials purchased.

Market participants also include financial institutions handling financial assets and use derivative products such as futures to manage the risk of a portfolio of financial assets.

What is the difference between Physically Delivered vs Cash Settled Futures Contracts? -

Physical delivery is a term in a futures contract which requires the actual underlying asset to be “physically delivered” upon the specified delivery date, rather than being traded out with an offsetting contract.

Cash settled futures on the other hand allows for the net cash amount to be paid or received on the settlement date of the futures contract.

Futures exchanges may offer both types of contracts to market participants who have different purposes for trading futures contracts.

Common application of financial market instruments for managing risk and opportunities.

Diversification: Correlation in Futures

Investors could allocate a portion of their portfolio to establish a managed futures position to deliver non-correlated results under most market conditions, which may serve as a risk mediator within an overall portfolio. This may deliver lower relative returns during periods of price stability. However, during periods of market stress, managed futures could outperform the broad market.

For example, the Asia Tech 30 index which has no Thai companies as a component stock would not be expected to have any Thai Baht (USDTHB) currency exposure and which could be included in a managed futures portfolio at times where there is no or low correlation between the two markets and could be used as a hedge during times of negative correlation.

Source: ICE Connect

Diversification: Portfolio Focused on Asset Returns

Individual investors who have a portfolio of foreign stocks will have a return that is composed of the return of the foreign currency-denominated stock plus the change in currency exchange rates. Therefore, investing abroad means having exposure to two different sources of risk and return made up of the underlying asset and the exchange rate.

For a long-term investor, the focus on return-generating assets may be the priority rather than returns from currency exchange rates. This could imply removing currency risk through a clearly defined hedging strategy process initially and then adding back currency exposure at a later stage if it is determined that currency exposures could improve a portfolio’s return. Investors would need to analyze their expected returns with and without currency exposures and determine their net currency exposure that they would like to remove.  U.S. Dollar based portfolios could use futures contracts such as the Mini US Dollar Index ® Futures to hedge a basket of foreign stocks denominated in their respective domestic currencies.

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TRADDICTIV · Research Team

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