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.