The document discusses hedging and arbitrage as financial strategies to mitigate risks and capitalize on price discrepancies. It outlines how hedging can protect producers, like farmers, from price fluctuations and explains the concept of arbitrage where investors exploit price differences across markets for profit. Additionally, it emphasizes the importance of understanding various risks and transaction costs involved in these strategies.

1. HEDGING & ARBITRAGE

2. HEDGING
 A PRODUCER WHO IS PLANNING TO PRODUCE AND SELL HIS PRODUCT
SOME TIME IN FUTURE BUT WANTS TO LOCK IN TODAY’S PRICES,CAN CHOOSE
TO GO FOR FUTURE HEDGE.
 A hedge is an investment position intended to offset potential losses/gains
that may be incurred by a companion investment. In simple language, a
hedge is used to reduce any substantial losses/gains suffered by an
individual or an organization.
 A hedge can be constructed from many types of financial instruments,
including stocks, exchange-traded funds, insurance, forward contracts,
swaps, options, many types of over-the-counter and derivative products,
and futures contracts.

3. EXAMPLE
Example: Assume in June a farmer expects to harvest at least 10,000 bushels of soybeans during
September. By hedging, he can lock in a price for his soybeans in June and protect himself
against the possibility of falling prices.
At the time, the cash price for new-crop soybeans is $6 and the price of November
bean futures is $6.25. The delivery month of November marks the harvest of new-crop
soybeans.
The farmer short hedges his crop by selling two November 5,000 bushel soybean
futures contracts at $6.25. (Typically, farmers do not hedge 100 percent of their
expected production, as the exact number of bushels produced is unknown until
harvest. In this scenario, the producer expects to produce more than 10,000 bushels
of soybeans.)
By the beginning of September, cash and futures prices have fallen. When the farmer
sells his cash beans to the local elevator for $5.72 a bushel, he lifts his hedge by
purchasing November soybean futures at $5.95. The 30-cent gain in the futures
market offsets the lower price he receives for his soybeans to the cash market.

5. Why it matters
 Hedging is like buying insurance. It is protection against unforeseen events,
but investors usually hope they never have to use it. Consider why almost
everyone buys homeowner's insurance. Because the odds of having one’s
house destroyed are relatively small, this may seem like a foolish investment.
But our homes are very valuable to us and we would be devastated by
their loss. Using options to hedge your portfolio essentially does the same
thing. Should a stock or portfolio take an unforeseen turn, holding an
option opposite of your position will help to limit your losses.
 Portfolio hedging is an important technique to learn. Although the
calculations can be complex, most investors find that even a reasonable
approximation will deliver a satisfactory hedge. Hedging is especially
helpful when an investor has experienced an extended period of gains and
feels this increase might not be sustainable in the future. Like all investment
strategies, hedging requires a little planning before executing a trade.
However, the security that this strategy provides could make it well worth
the time and effort.

6. Categories of hedgeable risk
 Commodity risk: the risk that arises from potential movements in the value of commodity
contracts, which include agricultural products, metals, and energy products.
 Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural
business of banks, but an unwanted risk for commercial traders, an early market developed
between banks and traders that involved selling obligations at a discounted rate.
 Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to
deflect the risks they encounter when investing abroad and by non-financial actors in the global
economy for whom multicurrency activities are a necessary evil rather than a desired state of
exposure.
 Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a
bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-
income instruments or interest rate swaps.
 Equity risk: the risk that one's investments will depreciate because of stock market dynamics
causing one to lose money.
 Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a
foreign currency.

7. Arbitrage
 No risks and no returns, is the basic investment theory. However, there are fleeting moments when
risks could be lowered and returns maximised. Welcome to the world of arbitrage.
 In arbitrage, combinations of matching deals are struck that capitalise upon the imbalance, the
profit being the difference between the market prices. An arbitrageur would typically buy a
particular commodity at a lower price on one exchange and sell it on another where it fetches them
a higher price. This creates a natural hedge and therefore the risk is low.
 Arbitrage happens in most of the markets like equities, currencies and commodities. And in the case
of the fledgling commodity markets in India, this opportunity has been providing avenues that not
many have explored. "One can expect on an average 25-30% returns from the arbitrage in
commodities. However, at off-price aberrations, returns can be as high as 50% and 70%, " said Anand
James, commodities manager, Geojit Commodities, a brokerage house.

8. Commodity arbitrage
 Arbitrageurs in the commodity markets look for three places to make a killing. They look at the
trapping price differences between the spot and futures market, they then look at differences
between two different national exchanges and then between two international exchanges.
 Condition for arbitrage
 The same asset does not trade at the same price on all markets ("the law of one price").
 Two assets with identical cash flows do not trade at the same price.
 An asset with a known price in the future does not today trade at its future price discounted at the
risk-free interest rate (or, the asset has significant costs of storage; as such, for example, this
condition holds for grain but not for securities).

9. Example
 Step1: An investor buys a gold futures contract listed on Multi- Commodity Exchange (MCX), a
national commodity exchange that offers investors access to various commodities. This contract is
supposed to mature in December 2006 and is available at Rs 8924 per 10 grams.
 Step2: At the same the investor enters into a contract to sell gold in November on the National
Commodity and Derivatives Exchange, another national commodity exchange in India. The price in
this case for a similar quantity of gold is Rs 8960, which is higher that the amount on the MCX.
 Step 3: On October 14, it is seen that the rates for the gold contracts on both the exchanges have
moved . On the MCX the Gold December contract became Rs 8,902, losing Rs 22 per 10 gms. And
on the NCDEX, the price for the Gold November contract has gained by Rs 97 to become Rs 8,863.
 Step 4: Now the arbitrageur will sell the contract on MCX and lose Rs 22. At the same time he will
liquidate the Gold November contract and gain Rs 97. Totally, the investor will stand to gain Rs 75
from this transaction.

10. Speed and costs
 In markets where the window of opportunity, that is the difference in prices between
exchanges, is slim, arbitrages gain by pumping in more money. Smart arbitrageurs track
different exchanges simultaneously and then cash in by making a fast move. A little delay
and the imbalance could get corrected and the riskless opportunity could turn the other
way.
 Many a times, transaction costs dampen the arbitrage opportunity. Typically, brokers charge
0.05% of the total trading value. This charge can be reduced as arbitrages increase the
volume of trade. In many cases brokers charge as low as Rs 50 for a lot. Then there are the
taxes as well. Other costs involved are exchange charges at 0.006%, service tax and
educational cess at 12.24% and stamp duty at 0.01%
 International experience suggests that as a result of arbitrage, prices of commodities in
different markets tend to converge to the same price, in all the markets, in each category. In
fact, the speed at which prices converge is a measure of market efficiency.
 Investors would do well by using the advisory services that are available nowadays. While
doing so, demand total transparency from the advisors and remember that such
opportunities are only temporary.