Hedger

The derivatives market has three kinds of participant, and the difference between them is not the trade, it is what the trade is attached to.

A hedger has a real exposure already. A bank's bond portfolio, an insurer's expected premium inflow, a company's planned borrowing — the interest rate risk exists whether or not he ever touches a derivative. He trades to make it go away.

A speculator has no such exposure. He takes interest rate risk on purpose, in exchange for the chance of a return, and in doing so supplies the other side of the hedger's trade. The workbook is blunt about the dependency: hedging "would not be possible without the participation of speculators."

An arbitrager has neither exposure nor view. He locks in a price difference between two markets simultaneously, and in the process pulls the two back into line.

The hedger's first task is to work out which way round his exposure runs, and bond arithmetic makes that easy to get wrong.

A bondholder is long the debt security and short the interest rate. If rates rise, his bond falls. So the hedge is to go long the interest rate — which means taking a short position in bond futures.

The workbook's selection table runs both ways:

The contract month is chosen to match when the rate change is expected to bite — not when it is convenient.

A hedger holding many bonds cannot hedge each one, because futures exist on only a handful of securities. He hedges the portfolio's modified duration instead, using the duration-based hedge ratio, and accepts the residual mismatch as basis risk.

Short hedge  : sell futures to protect a holding against a price fall
Long hedge   : buy futures to lock a purchase price ahead of an inflow

Lots for a single-bond hedge = Exposure (face value) ÷ 2,00,000

                                  Portfolio MD × Market value
Lots for a portfolio hedge  =  ────────────────────────────────────
                                  Futures MD × Futures price ÷ PAR

The workbook's long hedge, which is the case candidates see less often and are asked about just as much.

Insurance company X expects to receive Rs 200 crore of policy premiums in March. Its fund manager is not worried about prices falling — he is worried about rates falling before the money arrives, so that he is forced to buy bonds at a higher price and lock in a poorer yield.

12 February. The underlying 6.45% G-Sec 2029 trades at Rs 99.79 (yield 6.48%); the March futures trade at Rs 99.60 (futures yield 6.51%). He buys the March contract for the full Rs 200 crore:

Rs 200,00,00,000 ÷ Rs 2,00,000 = 10,000 lots, bought at Rs 99.60

26 March, expiry. The bond is at Rs 101.58, a yield of 6.23%. Rates fell exactly as feared.

Futures profit = (101.58 − 99.60) × 10,000 lots × 2,000 units
               = Rs 3,96,00,000  (Rs 3.96 crore)

The premiums now buy bonds at 101.58 instead of the 99.79 available in February — an extra cost of Rs 1.79 per 100, or Rs 3.58 crore on Rs 200 crore of face value. The futures gain of Rs 3.96 crore covers it, with the 19 paise of initial basis between spot and futures accounting for the difference.

The fund manager made money on the derivative and paid more for the bonds. That is a hedge working, not a trading profit — and the exam likes to test whether the reader can tell the two apart.

Chapter 5 (Strategies using Interest Rate Derivatives) opens at section 5.1 with the three participant types, then works through the short hedge (5.2.1), portfolio-based hedging (5.2.2), hedging future borrowing (5.2.3) and the long hedge (5.2.4). Section 5.7 closes the chapter on the limitations hedgers face. Chapter 10's risk disclosure material lists the same risks from the client's side.

The questions are classification questions — given a described participant, is this a hedger, a speculator or an arbitrager — and direction questions: which leg does a bondholder take, and in which contract month.

• A bondholder is short the interest rate, so he sells futures. The instinct to "buy protection" leads candidates to the wrong leg every time.
• The hedger is defined by the underlying exposure, not the position. The same short futures trade is a hedge for a bond portfolio and speculation for someone with no bonds.
• A hedge that loses money on the derivative has usually worked. The workbook lists "opportunity loss in case of increase in GOI price" as a limitation of hedging, not a failure of it.
• Hedgers need speculators. Without someone willing to take the risk off them, there is no counterparty — a point the workbook makes explicitly with the wheat farmer and the trader.
• Arbitragers lock in profits; speculators trade naked contracts. The arbitrager takes no risk and no view; the distinction is examinable.
• Exchange-traded hedges are never perfect. Standard lot sizes, a fixed last-Thursday expiry and cash settlement guarantee residual basis risk, which is exactly what section 5.7 is about.