Hedging Strategies & Risk Management: Futures, Options, Swaps, and Short Selling

Key Concepts

Hedging is the practice of reducing exposure to price fluctuations or other risks. Derivatives like futures, options, swaps, and short selling are tools to achieve this. This unit covers:

• Purpose of hedging: Protecting against adverse price movements.
• Hedging with futures: Locking in prices for commodities or assets.
• Hedging with options: Using calls/puts to limit downside risk.
• Hedging with swaps: Managing interest rate or currency risks.
• Short selling: Betting against an asset’s rise to profit from declines.
• Margin requirements: Collateral needed for short positions and derivatives.

1. Why Hedging Matters

Hedging is essential for:

• Producers: Locking in selling prices (e.g., farmers selling wheat futures).
• Investors: Protecting portfolios from market crashes.
• Businesses: Avoiding currency or interest rate shocks (e.g., NEPSE-listed companies hedging against rupee depreciation).

Example: A Kathmandu-based exporter of garments to Europe hedges against USD/NPR volatility using currency swaps.

2. Hedging with Futures Contracts

Futures are agreements to buy/sell an asset at a future date at a predetermined price. They are ideal for commodities (gold, silver) or financial assets (stock indices).

How Futures Hedge Risk

• For Buyers (Long Hedge): Locks in a purchase price (e.g., a silver refinery buying futures to avoid spot price spikes).
• For Sellers (Short Hedge): Locks in a selling price (e.g., a farmer selling wheat futures to avoid price drops).

Worked Example: Silver Refinery

• Spot price: Rs 1,500 per tola.
• Storage cost: Rs 50 per tola (paid semiannually).
• Interest rate: 10% per annum (continuous compounding).
• Futures price = Spot price + (Storage cost + Interest cost) × Time. $$\text{Futures Price}=1500+\left(\frac{50}{2}+\frac{1500\times 0.10}{2}\right)=1500+75+75=\text{Rs 1,650 per tola}$$ The refinery buys futures at Rs 1,650 to hedge against spot price rises.

Advantages of Futures Hedging

3. Hedging with Options

Options give the right (but not obligation) to buy/sell an asset. They are flexible but costly.

Key Strategies

• Buy a Put: Protect against price drops (e.g., an investor buying a put on NMB Bank stock).
• Sell a Call: Collect premiums if the stock won’t rise (e.g., a bank hedging against loan defaults).
• Straddle: Buy both a call and put for volatility (e.g., a trader expecting a NEPSE index crash or rally).

Worked Example: NMB Bank Stock

• Stock price: Rs 500
• Put option: Exercise price Rs 400, premium Rs 20 If the stock falls to Rs 350, the put is worth Rs 50 (400–350), netting Rs 30 profit (50–20 premium).

Option Pricing and Hedging

The Black-Scholes model (covered in Unit 4) helps price options, but hedging often uses delta hedging (adjusting positions dynamically).

4. Hedging with Swaps

Swaps exchange cash flows based on interest rates, currencies, or commodities. Common types:

• Interest Rate Swap (IRS): Exchange floating for fixed rates (e.g., a bank hedging loan risks).
• Currency Swap: Exchange principal/cash flows in different currencies (e.g., a Nepali exporter hedging USD revenue).

Worked Example: Bank Loan Hedging

A bank lends Rs 100M at floating rate (10% + LIBOR) but wants fixed rate. It enters an IRS:

• Pays fixed 8% to receive floating 10% + LIBOR.
• Net effect: Fixed cost of 8% (10%–2%).

5. Short Selling and Margin

Short selling profits from price declines. Margin is collateral required (e.g., 50% of stock value).

How Short Selling Works

1. Borrow shares (e.g., 100 shares of NMB at Rs 500).
2. Sell short at Rs 50,000 (minus broker fees).
3. Buy back at lower price (e.g., Rs 450) to return shares.
4. Profit = Rs 5,000 (500–450) × 100 shares.

Risks

• Unlimited loss if price rises (e.g., NMB stock surges to Rs 600).
• Margin calls if price drops further.

6. Margin Requirements in Derivatives

• Futures: Initial margin (e.g., 5–10% of contract value).
• Options: Premium paid upfront (no margin for calls; puts may require margin).
• Short Selling: Margin = Short sale proceeds + maintenance margin (e.g., 30%).

Example: Margin for Short Sale

• Short 100 shares of NMB at Rs 500.
• Margin = Rs 50,000 (sale proceeds) + 30% maintenance = Rs 65,000.

In the Real World

1. NEPSE Hedging: Stock traders use index futures (e.g., NEPSE-50) to hedge against market downturns.
2. Daraz Logistics: Uses futures on fuel prices to lock in delivery costs.
3. Ncell/NTC: Currency swaps hedge against USD/NPR exchange rate fluctuations for imported equipment.

Visuals

Futures Hedging Flowchart

flowchart TD
  A["Spot Price Risk (Uncertainty)"] --> B["Enter Long Futures Contract"]
  B --> C["Lock in Future Purchase Price at K"]
  D["Actual Spot Price Rises (P > K)"] --> E["Profit = (P - K) - Futures Premium"]
  F["Actual Spot Price Falls (P < K)"] --> G["Loss = (K - P) - Futures Premium"]

Option Hedging Payoff Diagram

graph TD
    subgraph Stock Price
        A["<180"] -->|"Call Worthless"| B["Profit = -Premium"]
        C["180-230"] -->|"In-the-Money"| D["Profit = (Stock - 200) - Premium"]
        E[>230] -->|"Deep ITM"| F["Profit = (Stock - 200) - Premium"]
    end

Swap Cash Flow Table

Exam Tips

1. Futures Pricing: Always include storage costs + interest (use continuous compounding formula).
2. Options: Know whether a call/put is in-the-money (ITM/OTM) based on spot vs. strike price.
3. Swaps: Focus on net cash flows (e.g., fixed vs. floating rate differences).
4. Short Selling: Calculate margin requirements and unlimited loss potential.
5. Black-Scholes: If asked, recall the formula for call/put prices (though Unit 7 focuses on applications).
6. Real-World Links: Tie examples to Nepal (NEPSE, Daraz, banks) or global firms (Google hedging currency risks).

Practice Question: A farmer expects wheat prices to drop from Rs 2,000 to Rs 1,800 in 6 months. How can they hedge using futures? Calculate the futures price if storage costs are Rs 50/ton and interest is 8% (continuous).