Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 9. Hedging with Options

INTRODUCTION

Institutional investors such as pension funds and insurance companies are exposed to changes in the values of shares, bonds and other financial assets. Company profits can be eroded by movements in borrowing rates, currency exchange rates and the market prices of physical commodities such as oil. Food producers find it very difficult to manage their businesses if crop prices are highly volatile.

All of these risks, and more, can be hedged by the use of forwards, futures or swaps. An investor concerned about potential losses on a portfolio of US shares can short S&P 500 index futures. If the shares fall in value the investor will earn compensation in the form of variation margin receipts on the futures contracts. A business due to receive foreign currency can enter into an outright forward FX deal with a bank to sell the currency at a fixed rate of exchange. A company concerned about rising interest rates can use an interest rate swap to fix its borrowing costs. A farmer can hedge against volatility in the market price of a crop by shorting exchange-traded futures contracts.

Hedging exposures of this kind with forwards, futures and swaps has many advantages. But all the strategies discussed above share one common characteristic. The exposure to the market variable is hedged out, but at the expense of being unable to benefit fully from favourable movements in that variable.

An equity investor who sells index futures is protected against losses ...