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Hedging

(An Exchange Risk Off-Setting Tool)


Hedging
A Hedge is an investment to reduce the risk of adverse price
movements in an asset.
Characteristics:
a) Risk offsetting tool
b) Similar to insurance.
c) Not to make money but to reduce losses.
History of Hedging
 Alfred Jones is called the Father of Hedge Fund. He was the First
Money Manager.
 In the year 1968, 140 Hedge funds were available.
 During 1969-70, heavy looses occurred and it was unsuccessful
 In the year 1999-2000, Hedge fund rejuvenated and till now it exist
successful to reduce the loss to certain limit.
Hedging Instruments
Forward Contracts
Future Contracts
Options
Call option
Put Option
Forward Contract
• It is an agreement to buy or sell an asset at a certain future time for
certain price.
• Mr.X –Importer has to make a payment in $ for consignment in 6
month time- not sure what the Rs./$ then – contract with a bank to
buy $ in 6 months from now at a decided rate.
Future Contract
• A Future contract is an agreement between two parties to buy or sell
an asset at a certain time in the future at a certain price.

• Example: An Automobile manufacture – huge quantities of steel as


raw material – export contract – risk of increasing steel prices – buy
steel future contracts, the automobile manufacturer is protected.
Futures & Forwards
Distinguished

Future Contract Forward Contract


• They trade on exchange. • Trade in OTC Markets.
• Are Standardised. • Are Customised.
• Regulated. • Not regulated.
• Easy to terminate. • Difficult to terminate.
• Less costly • More Costly
Call Option
• An option is a contract between two parties giving the taker (buyer)
the right, but not the obligation, to buy or sell a parcel of shares at a
predetermined price. To acquire this the buyer pays a premium to the
writer (seller) of the contract.
• Example: Mr.X purchases a August Call option at Rs.40 for a premium
of Rs.15. That is he has purchased the right to buy the share at Rs.40
in August. If the stock rises above Rs.55(40+15) he will break even
and he will start making profit.
Put Option
• A Put Option gives the holder of the right to sell a specific number of
shares of an agreed security at a fixed price for a period of time.
• Mr.X purchases Y Ltd. AUG 3500 put premium 200. This contract
allows Mr.X to sell 100 shares of Y Ltd at Rs.3500/share at any time
between the current date and the end of August. To have the
privilege, X pays a premium of Rs.20000 (Rs.200/share for 100
Shares).