Hedger
Also written Hedgers
A participant who already carries interest rate risk from a real business exposure and uses derivatives to remove it, rather than to take a view on the market.
In plain language
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.
How it works
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:
| Exposure | Hedge |
|---|---|
| Hurt if rates rise (holding bonds, planning to borrow) | Sell GOI bond futures · buy a put · sell T-bill futures · buy MIBOR futures |
| Hurt if rates fall (cash to invest later, bonds maturing) | Buy GOI bond futures · buy a call · buy T-bill futures · sell MIBOR futures |
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.
The formula
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
A worked example
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.
Why NISM asks about it
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.
Common exam traps
- 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.
Check yourself
1.A wheat farmer and a miller contract to exchange Rs 10,000 for 100 kg of wheat after 2 months. Which risk does the FARMER acquire by signing this contract?
- a)The risk that the price of wheat will rise above the price specified in the contract, losing him additional income
- b)The risk that the price of wheat will fall below the price specified in the contract
- c)The risk that he will have to pay more for wheat in future than he otherwise would have
- d)He acquires no risk at all, since the forward price is fixed in advance
Show the answer
Answer: (a) The risk that the price of wheat will rise above the price specified in the contract, losing him additional income
The workbook makes the point that both parties reduce a risk AND acquire a risk when they sign. The farmer reduces the risk that the price of wheat will fall below the contracted price and acquires the risk that the price will rise above it (thereby losing additional income he could have earned). Options (b) and (c) describe what the miller acquires and reduces. Option (d) misses the whole lesson: this is precisely why hedging is described as eliminating risk and locking in a known level, not as guaranteeing a profit — a hedger gives up the good outcome along with the bad one.
2.A short hedge is used to protect against which risk, and how is it executed?
- a)A decline in the cash price of a fixed income security, executed by selling futures contracts
- b)A rise in the cash price of a fixed income security, executed by selling futures contracts
- c)A decline in the cash price of a fixed income security, executed by buying futures contracts
- d)A rise in the cost of future borrowing, executed by buying call options
Show the answer
Answer: (a) A decline in the cash price of a fixed income security, executed by selling futures contracts
"A short hedge is used to protect against a DECLINE in the cash price of a fixed income security. To execute a short hedge, futures contracts are SOLD." By establishing it, the hedger has fixed the future cash price and transferred the price risk of ownership to the buyer of the futures contract.
The reasoning in the workbook's example: an investor holding a bond is long on debt securities and short on interest rate, so he is exposed to rising rates. To hedge, he must go long on interest rate by taking a short position in bond futures.
Option (c) describes a long hedge, used by someone who intends to buy an asset later and fears prices rising.
3.According to the workbook, what essential role do speculators play in the interest rate derivatives market?
- a)They assume the price risk hedgers lay off, act as counterparty and add depth and liquidity to the market
- b)They guarantee settlement of trades so that hedgers face no counterparty risk
- c)They set the theoretical price of futures contracts against which the exchange computes margins
- d)They eliminate mispricing between the cash and derivatives markets
Show the answer
Answer: (a) They assume the price risk hedgers lay off, act as counterparty and add depth and liquidity to the market
"Speculators play a vital role in the ETIRD markets. Derivatives are designed primarily to assist hedgers in managing their exposure to price risk; however, this would not be possible without the participation of speculators. Speculators, or traders, assume the price risk that hedgers attempt to lay off in the markets... hedgers often depend on speculators to take the other side of their trades (i.e., act as counter party) and to add depth and liquidity to the markets."
Option (b) describes the clearing corporation, which provides the settlement guarantee through novation. Option (d) describes arbitragers, who eliminate mispricing across markets. Note that although a speculator acts as the economic counterparty, on an exchange the legal counterparty to both sides remains the clearing corporation.
Where this is taught
- Series IV · Chapter 2: Interest Rate Derivativesintroduced here
- Series V-D · Chapter 13: Basics of Derivativesintroduced here
- Series VIII · Chapter 1: Basics of Derivativesintroduced here
- Series IV · Chapter 5: Strategies using Interest Rate Derivatives
- Series V-D · Chapter 22: Strategies using Interest Rate Derivatives
Related terms
- HedgingTaking a derivative position that moves opposite to an exposure you already have, so gains on one offset losses on the other and the future rate is locked in at a known level.
- Basis riskThe risk left over after hedging, because the exposure and the contract used to hedge it do not move identically — in size, in expiry date, or in what they are written on.
- ArbitragerA participant who locks a profit by entering opposite transactions in two markets at once — carrying no exposure and taking no view, and in the process pulling the two prices back together.
- Duration-based hedge ratioThe number of interest rate futures that drives a bond portfolio's duration to zero — portfolio modified duration times market value, divided by futures modified duration times futures price over par.
- Interest Rate FuturesA standardised exchange-traded contract to buy or sell a notional government security, or an interest rate itself, at a price agreed today for settlement on a future date.
- Long hedgeA hedge made by buying futures to protect against a price rise before a planned future purchase — the gain on futures offsets the higher cash price, locking in roughly the futures price.
- Put optionA contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
- Short hedgeA hedge made by selling futures to protect an existing holding or a planned sale against a price fall — the futures gain offsets the lower cash price, locking in roughly the futures price.
- SpeculationTaking on risk not commensurate with the return sought, in the hope of a large gain, with minimal research into what the asset is actually worth — the opposite of investing, and not merely the short-term version of it.
- Overnight MIBORThe benchmark overnight rupee interbank rate administered by FBIL, and the underlying of India's money market interest rate futures contract, which is quoted as a rate rather than a price.
- UnderhedgingHolding fewer futures than the exposure needs — the specific failure of a duration-based hedge in a large yield move, because duration draws a straight line through a curved relationship.
- Imperfect hedgeA hedge that cannot fully offset an exposure because the contract is standardised — fixed lot sizes, a fixed expiry date and cash settlement leave a remainder the hedger keeps.
- Market side ruleThe rule that ties a market participant's buy-or-sell decision in interest rate futures and options to their expectation of rate direction, since bond prices and interest rates move inversely.
- Speculator or traderA derivatives market participant with no real underlying exposure, taking a position purely on a price view, preferring derivatives to the underlying for their leverage, low cost and speed of execution.
- True hedgeAn instrument that genuinely matches the exposure it protects — single-bond GOI futures for GOI security risk, in the workbook's example, unlike the Overnight Index Swap, which is successful but does not qualify.
- FPI participation in commoditiesHow foreign money reached Indian commodity derivatives — hedging by eligible foreign entities from October 2018, the FPI route without underlying exposure from 2022, and direct market access from May 2023.
- Long speculatorA trader who buys first and expects the price to rise — a long futures or option position taken with no corresponding short position in the spot market and no intention of using the commodity.
- Naturally longThe position every business holds in its finished goods — it gains when their prices rise and loses when they fall, which is why finished goods are hedged by selling futures.
- Naturally shortThe position every business holds in its raw materials — it must buy them in future, so a price rise hurts it exactly as a short position would, and a long hedge cancels the exposure.
- Offsetting hedgeA hedge undertaken to offset price risk that has arisen from a physical market activity already carried out — one of the workbook’s two basic hedging strategies, the other being locking in a price.
- Naked positionA long or short position in a futures contract held without any position in the underlying asset or an offsetting contract — fully exposed to price moves in one direction.