The financial market has numerous investment instruments and all of them come with their potential of profits and exposure to risk. One of the instruments are classified as derivatives. Derivatives are those instruments that derive their values from an underlying asset. Based upon the underlying, they could be called as equity derivatives, index derivatives, currency derivatives, commodities derivatives, etc. Derivatives not only helps in price discovery but also helps in transferring the risk. The risks could be Diversifiable or systematic and Non – Diversifiable or unsystematic and to minimize this risk fund managers, investors, businesses, banks, etc. uses hedging as a tool.

Hedging is a strategy that immunizes the risk of any potential losses against any negative price movement by transferring it to someone who is willing to accept it. People who take this risk are known as speculators. Speculators create a naked position and expect the market to move in their direction, hence, benefiting them. Their profits and losses are extreme, as they do not protect their position against diversity movement of the prices.

Hedging techniques generally involve the use of a bit of complex strategies using derivatives, commonly futures and options and in some cases hybrid instruments as well. Basically, it is done by creating either a counter position in derivatives or in equity with negative correlation. In this way, the profit of one instrument is offset by the loss of the other, limiting the profits and hence, minimizing the losses.

Hedging primarily uses Futures for security against any diversity in prices. Generally, future is a pre-defined contract whose price is determined by adjusting freight, handling, storage and quality costs, along with the impact of supply and demand factors to the spot price. There is regular change in the prices of spot and futures which is known as the basis, however, the risk arising out of the difference is defined as basis risk and the difference between spot and futures prices is defined as narrowing of the basis.

When the market is characterized by contango, narrowing of basis benefits the short hedger and a widening of the basis benefits the long hedger, whereas, in a market characterized by backwardation, a narrowing of the basis benefits the long hedger and a widening of the basis benefits the short hedger. However, if the difference between spot and futures prices increases (either on negative or positive side) it is defined as widening of the basis. The impact of this movement is opposite to that as in the case of narrowing.

We can understand Hedging by an example: An investor buys 1500 shares of XYZ company at Rs. 309 for a total of Rs. 4,63,575, with a view of rise in share prices over the next few months. But there is a fear of fall in share prices due to various circumstances. As his fears, the market falls and he would incur loss so to avoid this diversity against the price movement, he can hedge this position by selling Nifty Future.

First, he needs to consider the risk associated with the shares in respect to the Index, this is known as Beta. Beta is calculated by dividing the difference in rate of return of the share minus the risk free trade by the Index rate of return minus the risk free trade. Now supposingly, the Future of Nifty is trading at Rs. 5778 and the beta of the share is calculated to 0.81, to hedge the position he needs to sell Rs. 3,73,645 worth of Nifty Future i.e. approximately 64 units. Since, Nifty Index contains 50 units in 1 lot, he can either sell 1 lot of Nifty Future or 2 .If he over-hedges and sells 2 lots and the market falls 10%, then notionally, he is at a profit of Rs. 577.8 per lot and loss of Rs. 24.90 per share but an overall profit of Rs. 20,420. In this way the investor not only saved himself from a total loss of Rs. 37,364 instead earned Rs. 20,420 as his expectations.

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Global Scenario

Some of the busiest corners of the multitrillion-dollar-a-day foreign-exchange market are quieter these days.

The currency market is experiencing its first slowdown since the 2008 financial crisis. Banks, fearing a global credit crunch brought on by Europe’s sovereign-debt struggles, are lending less, reducing the flow of currency across borders. As currency funds suffered a miserable year, investors decamped to other markets or for the safety of cash.

After surging 55% from April 2009 to April 2011, foreign-exchange volumes flattened out. The main driver behind plateauing volumes was an 8% drop in foreign-exchange swaps, in which banks and other companies lend one currency to borrow another. Trading volume averaged $3.47 trillion a day in October 2011, roughly the same as April 2011,

Trading across many assets, such as stocks and commodities in addition to currencies; evaporated amid concerns that Greece’s debt woes would spread to other countries in Europe.

Some Positive Cues

Though it hasn’t been all downhill, there’s plenty to catch some breath. Some emerging-market currencies, like the Mexican peso and Russian ruble, saw higher trading volumes. The Dow Jones Industrial Average managed to briefly edge above 13,000 for the first time in nearly four years. Greece has secured a series of bailout packages that will sidestep a chaotic default, while the European Central Bank has bolstered Europe’s financial system by providing banks with cheap, unlimited loans. The U.S. economy is picking up steam and fears of a “hard landing” in China have disappeared.

Investors may not believe the world economy is in a better place, but they’ve stopped worrying about it. Currency options-trading suggests money managers have turned unusually calm about future swings in global currency rates despite the economic problems afflicting the U.S., Europe and China–not to mention the threat of an oil-price shock. Analysts say volatility fears are low mostly because central banks in the U.S., Europe, Japan and China are again taking big steps to shore up the global markets.

In Indian context, something happened as we turned the calendar from 2011 to 2012. The fears of imminent collapse two months before Christmas have certainly waned. In Europe the LTRO (long term refinancing operations) performed better even than the ECB (European Central Bank) hoped. Then there is the fiscal compact. There is still concerns about short term funding and still concern about whether the banks will be able to raise the capital. There’s less of a concern about an event shock, but still concern about process shocks as we go along and Greece and other countries have to roll over their debt. That’s certainly had a positive impact on investor sentiment here in India, although Indian exposure to Europe is not dominant. To the extent that Europe seems to be less unstable today, it does help domestic investor sentiment here too and we’ve seen that on all the market indices.

All emerging economy currencies have depreciated in the pre-Christmas months, but Indian rupee depreciated more than other currencies and it was the worst performing currency in the world or whatever. What explains that is that India is a current account deficit economy. Those emerging economies that had a surplus or a small deficit were less hit than countries that have a sizeable deficit like India, and that deficit was growing. So the rupee depreciation was a result of external flows practically thinning out and driven by the dynamics of the current account deficit.

The Ideal Way Out

Eventually India needs to make the balance of payments more robust to inspire confidence. There is need to diversify the export destinations and product mix. As far as imports are concerned, dependence on oil imports should be reduced and one way to do that is to deregulate petroleum product prices in true sense.

Oil prices are a big factor and largely beyond one’s control and are very complex economic and geopolitical factors that drive oil prices. Just looking at the world economic situation, the U.S. growth situation is quite modest and Europe is probably in a recession and Japan is growing but… And then there are the political factors, which is Iran. If Iran is outside the world pool there could be price pressures. If Saudi Arabia because of fiscal concerns, its commitment to extend fiscal supports to other Arab countries, to meet that commitment they might want to keep oil prices at a certain level. There are economic factors, there are political factors and there are market factors, all of them that determine oil prices which are largely out of control. India imports as much as 80% of oil it needs and more than a third of total imports, so oil prices are a big factor for inflation management, for the fiscal deficit and for macroeconomic stability for the country.

Gold imports of course have added to the misery arising from BoP crisis. We need to provide other safe havens and need to attract more stable flows, FDI for example. And finally we must encourage, if not pressurize our corporates to hedge their foreign exchange exposures. They don’t do that adequately. They do cost benefit calculations, if the rupee is not moving rapidly, they calculate the cost of hedging is higher than the risk they take by not taking. But as happened in the pre-Christmas months, it can certainly overshoot, so corporates should hedge more.