What is hedging?

Hedging is the process of making an investment to reduce the risk of adverse price movements. It can be thought of as insurance against a negative event. Hedging locks in future prices meaning even if spot prices reduce significantly you are protected to a floor (the hedged price) – the insurance.

Where is hedging used?

Hedging is used to lock in future rates or prices when the project sponsor, investors, or banks want to reduce their exposure to given price or rate changes. It is not a bet on changes being positive or negative but rather setting a future price. Hedging is most commonly used in the financial markets to reduce exposure to various risks.

• Portfolio managers may want to hedge against exposure to a specific sector
• Multinational corporations hedge against foreign currencies to remove foreign exchange risk
• Sponsors hedge interest rate volatility on their long term borrowings (essentially fixing future rates)
• Gold mines hedge a portion of their annual gold production to ensure steady income against fluctuations in gold price
• Manufacturers hedge commodity prices to prevent losses from the rising cost of raw materials

Tools/instruments used for hedging

The two most common financial instruments used for hedging are

• Options – the right, but not the obligation, to buy or sell a specific quantity of the underlying asset at a fixed price on or before the expiration date
• Forward/Futures – a contractual agreement to buy or sell a particular commodity, financial instrument at a pre-determined price in the future

Forwards allow you to lock in a future rate whereas options give you the choice at a point in the future to lock in a rate. This choice is obviously beneficial to the purchaser and as such the seller of the option will demand a premium, or up front payment.

Below show the simple payoff charts for the forwards and options

Gold price hedging strategies

Two common gold price hedging strategies include

• Forward contracts
• Collar option

The forward contract consists of agreeing a quantity and price of gold in the future.

The collar option consists of buying a put option and selling a call option. The premium received on the call option is intended to partially offset the premium paid for the put option while retaining insurance on the gold price (see diagram below).
The collar option will effectively lock in the price of gold without paying too much for the insurance. Note that the upside gain is reduced by using a collar however the point of hedging is to provide certainty (and to net the cost of buying a put with selling a call) – not to make profits from financial instruments.

Case Study

We can use an example to demonstrate these two methods given different gold prices. Assume

• You currently own one ounce of gold
• Current spot price is USD 1300 / oz
• You sell a call with a strike price of USD 1500 / oz
• You buy a put with a strike price of USD 1100 / oz (together a collar option)
• As an alternative to the options you sell a forward at USD 1300 / Oz

In addition, keeping things simple for demonstration purposes we assume no commissions or fees and that the premiums received and paid for the options offset each other.

Now, let us investigate what happens as the spot price changes at the time of forward and option expiry.

Case 1: Gold Price drops to USD 1000 / Oz

• The call option (held by other party) will not be exercised since the price of gold is less than the strike price of USD 1100/oz
• The put option (held by you) will be exercised, allowing you to sell the gold at $1100/oz, USD 100 / Oz more than the current spot price
• The sold forward contract will be met for the same reasons as the put option

The collared hedge option has provided insurance to falling gold prices allowing you to lock in a gold price at USD 1100/oz. The forward gives the same outcome with the exception of not having to pay a premium upfront that is needed for the options.

Case 2: Gold Price stays at USD 1300 / Oz

• The call option will not be exercised as the option is out of the money
• The put option will not be exercised as the option is out of the money
• Since neither option is exercised, you sell the gold at current price
• The forward price matches the spot price so you will sell the ounce of gold at USD 1300/ Oz.

Case 3: Gold Price rises to USD 1600 / Oz

• The call option (held by other party) will be exercised and you will have to sell the gold at the strike price of USD 1500/ Oz, at a discount to of USD 100 / Oz to spot
• The put option (held by you) will not be exercised since the current price of gold is higher than the strike price
• You will need to sell your forward gold at USD 1300 / Oz, at a discount of USD 300 to spot.

It may be possible to reverse positions on the market for options and forwards, depending on the specific arrangements for your project.

By using the collar option hedge, the price of gold is locked in effectively at USD $1100/oz preventing any downside loss. There is also the potential limited upside gain of up to USD $200 due to the strike price of the call option.

Below are snippets from a disaster model which show the effects of using forwards and options as a hedge for locking in price.

The model shows that the strike price of the long put option is the same as the price negotiated in the forward contract.

If a disaster event happened in the last quarter of 2010 meaning you don’t have the physical gold to sell, the financial statements below show the difference between using a collar option hedge and a forward for locking in price. The forward contract is obligated to sell at the locked price, during the disaster period, there is no volume to sell and a loss is incurred at the forward price.

Using a collar hedge option, however, shows us that during the disaster period, there is no obligation to meet a seller the at the strike price, hence preventing the loss. This highlights a basic benefit of using the collar option hedge as a means of locking in price in the future as opposed to that of using a forward contract.

For more information on how to model hedging, see our tutorial on Financial Modelling of Interest Rate Hedging.