Hedging

HedgingHedging

Jayendra SalunkeJayendra SalunkeEMBA - ITM KhargharEMBA - ITM Kharghar

Batch XIII-B, Roll no – 70Batch XIII-B, Roll no – 70

This Session CoversThis Session CoversWhat is Hedging - ConceptWhat is Hedging - ConceptHedging Instruments – ExamplesHedging Instruments – ExamplesHedge fundsHedge funds– HistoryHistory– Hedge Funds todayHedge Funds today

Five famous Hedge FundsFive famous Hedge Funds

Hedging - ConceptHedging - ConceptUsed everywhere all time - StoryUsed everywhere all time - StoryNegative event can not be preventedNegative event can not be preventedRisk Offsetting toolRisk Offsetting toolSimilar to insuranceSimilar to insuranceTwo securities with Negative correlationTwo securities with Negative correlationNot to make money but to reduce lossesNot to make money but to reduce losses

How do investors Hedge ?How do investors Hedge ?Hedging instrumentsHedging instruments– DerivativesDerivatives

Forward ContractsForward ContractsFuture ContractsFuture ContractsOptions – Options –

– Put optionPut option– Call optionCall option

SwapsSwaps

Forward ContractForward ContractIt is an agreement to buy or sell an asset at a certain future time for certain price. It is an agreement to buy or sell an asset at a certain future time for certain price.

Shyam wants to buy a TV - Rs 10,000 - no cash - Can buy it 3 months later - Shyam wants to buy a TV - Rs 10,000 - no cash - Can buy it 3 months later - fears that prices will rise - contract with the dealer - contract is settled at maturity.fears that prices will rise - contract with the dealer - contract is settled at maturity.

Ram - importer - has to make a payment in dollars for consignment in six months Ram - importer - has to make a payment in dollars for consignment in six months time -not sure what the Re/$ rate then - contract with a bank to buy dollars six time -not sure what the Re/$ rate then - contract with a bank to buy dollars six months from now at a decided rate - underlying security is the foreign currency.months from now at a decided rate - underlying security is the foreign currency.

The difference between a share and derivative is that shares/securities is an asset The difference between a share and derivative is that shares/securities is an asset while derivative instrument is a contractwhile derivative instrument is a contract

Future ContractFuture ContractA future contract is an agreement between two parties to buy or sell an asset at a 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. Index futures are all futures contracts certain time in the future at a certain price. Index futures are all futures contracts where the underlying is the stock index and helps trader to take a view on the where the underlying is the stock index and helps trader to take a view on the market as a whole.market as a whole.Example - An automobile mfr - huge quantities of steel as raw material - export Example - An automobile mfr - huge quantities of steel as raw material - export contract - risk of increasing steel prices - buy steel futures contracts, - the contract - risk of increasing steel prices - buy steel futures contracts, - the automobile manufacturer is protected. automobile manufacturer is protected.

Increasing steel prices - Increasing steel prices - Increase in the value of the futures contracts - Increase in the value of the futures contracts - corresponding loss in the physical market - offset by his gains in the futures market. corresponding loss in the physical market - offset by his gains in the futures market. Decreasing steel prices - Decrease in the value of the futures contracts - losses in Decreasing steel prices - Decrease in the value of the futures contracts - losses in the futures transaction - corresponding gain in the physical market .the futures transaction - corresponding gain in the physical market .

Perfect hedge to lock the profits and protect from increase or decrease in raw Perfect hedge to lock the profits and protect from increase or decrease in raw material prices. material prices.

Call OptionCall OptionAn option is a contract between two parties giving the taker (buyer) the right, but 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 not the obligation, to buy or sell a parcel of shares at a predetermined price possibly on, or before a predetermined date. To acquire this right the taker pays a possibly on, or before a predetermined date. To acquire this right the taker pays a premium to the writer (seller) of the contract.premium to the writer (seller) of the contract.

Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he Sam purchases a December call option at Rs 40 for a premium of Rs 15. That is he has purchased the right to buy that share for Rs 40 in December. If the stock rises has purchased the right to buy that share for Rs 40 in December. If the stock rises above Rs 55 (40+15) he will break even and he will start making a profit. Suppose above Rs 55 (40+15) he will break even and he will start making a profit. Suppose the stock does not rise and instead falls he will choose not to exercise the option the stock does not rise and instead falls he will choose not to exercise the option and forego the premium of Rs 15 and thus limiting his loss to Rs 15.and forego the premium of Rs 15 and thus limiting his loss to Rs 15.

Call OptionCall Option

Put OptionPut OptionA Put Option gives the holder of the right to sell a specific number of shares of an 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.agreed security at a fixed price for a period of time.

Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200Sam purchases 1 INFTEC (Infosys Technologies) AUG 3500 Put --Premium 200This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any This contract allows Sam to sell 100 shares INFTEC at Rs 3500 per share at any time between the current date and the end of August. To have this privilege, Sam time between the current date and the end of August. To have this privilege, Sam pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).pays a premium of Rs 20,000 (Rs 200 a share for 100 shares).The buyer of a put has purchased a right to sell. The owner of a put option has the The buyer of a put has purchased a right to sell. The owner of a put option has the right to sell.right to sell.

Hedge FundsHedge FundsAlfred Jones – Alfred Jones – Father of Hedge fundFather of Hedge fund

First Money ManagerFirst Money ManagerRise of Industry Rise of Industry 1968 – 140 Hedge funds1968 – 140 Hedge funds

1969-70 Heavy Losses - 1973-74 No of hedge fund closures 1969-70 Heavy Losses - 1973-74 No of hedge fund closures 1986 tiger Fund - 1999- 2000 history repeats1986 tiger Fund - 1999- 2000 history repeats

The Down sideThe Down sideWhat Hedging means to youWhat Hedging means to you

Five famous Hedge FundsFive famous Hedge FundsGoldman Sachs Goldman Sachs Long Term Capital ManagementLong Term Capital ManagementMan GroupMan GroupSoros Fund ManagementSoros Fund Management

Thank YouThank You