Wall Street, New York City. Image source: Marco Rubino © 123RF.com
This is our second article in a row to cover the interesting topic of hedging in trading. While our initial take on the matter was focused on homogenous hedging, this time we shift our attention to heterogeneous hedging.
Heterogeneous hedges are constructed using financial instruments from different asset classes that have a discernible price correlation, such as some equities and bonds; commodities and FX pairs, and other such possible combinations. While homogeneous hedges are used to negate asset class risks, such as falling copper prices in the copper mining industry, heterogeneous hedges are used to counter more intricate types of risks.
A heterogeneous hedge can be used to ward off potential fallout from, say, inconsistent politics on the economic cycle. For instance, assume a European company that produces vintage furniture that is exported to the United States. The company executives monitor the current political climate and begin to fear that the U.S. President might decide to start a currency war with the EU.
Their specific fears are that the FED might be pressured into lowering the Federal Funds Rate, which would naturally cause the dollar to depreciate, thereby benefiting US exporters. Accordingly, this would be a problem for the European company receiving its payments in dollars, due to a less favourable exchange rate between the greenback and the stronger Euro (it's base currency).
Assume also that the company has just received a massive order from the U.S. for delivery of X amount of different types of furniture in 4-months' time. The payment will be transacted upon delivery with the current exchange rate at that time. The invoice is for 300 000 USD, and the current exchange rate of the EURUSD is 1.11600. The company’s execs fear a less favourable exchange rate in 4-months’ time because of a possible rate cut by the FED, which might reduce the company's profit margin upon delivery.
The executives hope to receive at least 268 817 EUR from the order, which would happen if the exchange rate remains unchanged. However, if the underlying rate were to rise to, say, 1.30000 at the end of the 4-months, the company would make only 230 769 EUR on the same invoice for 300 000 USD. Instead, if the exchange rate were to fall to, say, 1.08000, then the final profits will be equal to 277 777 EUR. Essentially, the company executives estimate that the overall risk is equal to 38 048 EUR – the invoice amount with the current exchange rate minus the invoice amount with the higher exchange rate (26 8817-230 769).
To hedge that risk, they can purchase a long call option on the EURUSD with expiry in exactly 4-months' time, which would grant them the right (but not an obligation) to purchase the underlying futures contract on the EURUSD at a predetermined price. Suppose that the executives decide to set the strike price at the current spot rate, which is 1.11600; and that the premium due for that option is, say, 1.30 per one cent of the dollar amount. Hence, the total payable premium will be 0.013 x 300 000 = 3900 USD.
If the exchange rate has fallen to, say, 1.08000 upon delivery, the option will become worthless and will not be exercised. The furniture company would have made 277 777 EUR from the delivery, which exceeds the initial invoice value of 268 817 EUR by 8960 EUR, which is a windfall profit due to the more favourable exchange. However, these windfall profits would be offset by 3494 EUR, which was paid as premium for the option (the cost of the hedge).
Thus, the net profits would be equal to 274 283 EUR, which still exceeds the invoice value of 268 817 EUR. If the exchange rate has instead increased to 1.30000 at the end of the 4th month, then the call option would be exercised at the 1.11600 strike price. The difference between the two exchange rates is equal to 0.184 USD. Consequently, the generated profit from the long option's execution would be equal to – 0.184 x 300 000 USD = 55 200 USD or 42 461 EUR with the then exchange rate of 1.30000.
Under the 1.30000 exchange rate, the company's invoice would amount to only 230 769 EUR in revenue, which is less than the desired 268 817 EUR under the 1.11600 exchange rate. Thus, because of the less favourable EURUSD exchange rate, the company would lose an amount of capital equal to 38 048 EUR. These incurred losses, however, would be offset by the generated profits from the hedge.
Consequently, in this second scenario, the company would generate a net profit of 919 EUR from the hedge. The generated profits from the option (42 461 EUR) minus the option’s premium payable (3494 EUR) minus 38 048 EUR = 919 EUR. The company would receive these profits in addition to the revenue receivable (230 769 EUR) from the invoice.
Even though retail traders do not dabble in the furniture business, the above example underpins the intricacy of using options to hedge against potential market risks. Namely, the uncertainty of trading with futures contracts. Traders can apply the same logic in order to negate any potential losses to their primary positions in the future. However, they should keep in mind that hedging is costly, and it could reduce the potential profits they would have otherwise generated from their primary trades.
Gold is undergoing a correction, as investors take profits to offset losses from falling stock prices, impacting their margins. However, we anticipate a renewed wave of [...]
The Swiss stock market index is mirroring its global counterparts, such as Germany 40 and US100, experiencing a sharp decline following the announcement of new [...]
We’re analyzing the weekly chart to grasp the broader market trend. Over the past three years, the US30 index has surged by 17,000 points, often resembling a nearly straight [...]
Over the past week, the DAX has experienced a sharp decline, plunging by an astonishing 3,400 points. This downward movement is not isolated, as its international counterparts, such as the UK100 and US100, are also facing significant [...]
EURUSD recently formed a double top at 1.0930, signaling a potential trend reversal, and has since begun a correction. After a 600-pip rally since early March, a pullback at this stage is both expected and healthy. Given these conditions, we are placing a [...]
Since early March, EURJPY has surged nearly 1,000 pips, providing us with several excellent trading opportunities. However, as the rally matures, many early buyers are beginning to take profits, leading to a noticeable slowdown in the uptrend. On Friday, the pair formed a [...]
The AUDJPY currency pair continues to be dominated by bullish momentum, as multiple golden cross patterns reaffirm the strength of the ongoing uptrend. Despite this, we are witnessing a much-needed [...]
The EURAUD currency pair appears to be undergoing a trend reversal, signaling a potential shift in market direction. A notable technical development is the formation of a Death Cross on the chart, a widely recognized bearish indicator that typically suggests a [...]
After securing an impressive 200-pip profit last week, the EURJPY currency pair is now undergoing a southward correction, retracing some of its recent gains. Despite this temporary pullback, the Golden Cross remains intact, reinforcing our view that the overall trend continues to be [...]
The appearance of a Golden Cross in Silver strengthens our analysis that the metal is currently in a strong uptrend, indicating further bullish momentum in the market. This technical pattern, where the short-term moving average crosses above the [...]
This trade presents a considerable level of risk and can be classified as an opportunistic move based on recent price action. The GBPUSD currency pair has experienced a substantial bullish rally, surging by nearly 500 pips in a strong upward movement. However, after this extended period of appreciation, the pair is showing signs of a potential [...]
The anticipated Death Cross on the SMI20 appears to be failing as price finds strong support at the 23% Fibonacci retracement level. After testing this area, the index has shown bullish strength, printing several large green candles, signaling an increase in [...]
A Golden Cross has just appeared on the USDJPY chart, signaling a potential bullish move. This technical pattern occurs when the 20 period moving average crosses above the 60 period moving average, a widely recognized indication of increasing [...]
After 2 months of a down trend, we finally see some indications of price recovery for Oil. The golden cross, a historic buy signal, supports this [...]
For the past month, the German DAX40 has experienced a remarkable 10% surge, reflecting strong bullish momentum. Despite ongoing market volatility and frequent pullbacks, every dip continues to attract fresh buyers, reinforcing the [...]
Oil continues its downward trajectory, despite occasional pullbacks. The overall trend remains bearish, reinforced by multiple Death Cross patterns, a classic sell signal indicating further weakness. Adding to this bearish outlook, the critical [...]
Over the past few days, gold has experienced a sharp decline of more than $100. This downturn can be attributed in part to traders securing profits to manage their margins, which are under strain due to the significant drop in major indices. Currently, gold has fallen below the [...]
The NASDAQ 100 index is showing strong bullish momentum, as evidenced by the formation of a Golden Cross on the chart. This classic buy signal occurs when the short moving average crosses above the long term moving average, suggesting that upward momentum is [...]
The EURAUD currency pair has encountered a significant resistance level, failing to break above the critical 61% Fibonacci retracement level. This suggests that bullish momentum is weakening, reinforcing the case for a potential downward move. Given this technical setup, we favor entering a [...]
The UK100 is experiencing a remarkable rally! Over the past few weeks, the British stock market index has surged nearly 800 points. Each minor dip has attracted more buyers, fueling the bullish momentum. However, since last week, we’ve observed a slight [...]
