Part two of two articles

Before discussing the use of coverage to offset the risk, we must understand the role and purpose of coverage.   The history of modern futures trading began in Chicago in early 1800. Chicago is located at the base of the Great Lakes, close to farmland and cattle country of the Midwest making it a natural center for the transport, distribution and marketing of agricultural products. Saturation and the scarcity of these products caused chaotic fluctuations in price. This led to development of a market to allow the grain merchants, processors, and agriculture companies to trade in contracts to protect against the risks of adverse exchange price and allow them to hedge.

The exchange of goods, first was the creation of the Chicago Board of Trade, CBOT, in 1848.   Since then, modern derivative products has grown to include more of the agriculture industry.   Products include stock indices, interest rates, currencies, precious metals, oil and gas, steel and a host of others.   The origins of the stock and commodity futures was created to support   coverage.   The role of speculators is beneficial, since trade volume and add significant volatility to what would be a small and illiquid market.

A bona-fide hedger is someone with a real product to buy or sell.   Coverage will be establishing a position outside the establishment in the future or commodity exchange, thereby establishing a fixed price for their product. Someone who buys coverage is known as "long" or "Taking delivery.   Someone selling coverage is known as "short" or "delivery Making". These positions are known as "contracts" are legally binding and enforced for change.  

Introduction operations either speculation or hedging is done through its agent or Commodity Trading Advisor.   Commodities and futures markets are distinct from stock exchanges, despite operating with the same principles.   They are regulated by different bodies such as the Commodity Futures Trading Commission, which are responsible for the regulation of brokers retail in the U.S., as well as Commodity Trading advisors are actually derivatives portfolio managers.

Now let's see some real life examples of hedging or mitigation of risk by using exchange traded derivatives.

Example 1:   A investment fund manager with a portfolio valued at $ 10 million very similar to the S & P 500.   The portfolio manager believes that the economy is worsening with deteriorating corporate returns.   The next two to three weeks are the quarterly reports of corporate profits.   Until the report exposes which companies have the incomes of the poor, is concerned the results of a general correction in the short term market.    Without the permission of foresight, he is not sure of the magnitude the earnings figures will occur.   He now has exposure to market risk.

The manager thinks his options.   The biggest risk is doing nothing, if the market falls as expected, he risks giving up all recent gains.   If you sell more of their portfolio demonstration of principles, also the risk of being wrong and missing.   Retail also incurs substantial brokerage fees apply to buy later.

Then he realizes a hedge is the best option to mitigate their risk in the short term.   Start by calling your CTA (Commodity Trading Advisor) and after consultation with an order to sell short the equivalent of $ 10 million that the S & P 500 on the Chicago Mercantile Exchange "CME."   Now, the result is, when the market falls as expected, you establishing the portfolio losses with gains in coverage rates.   If the earnings report better than expected, and his portfolio continues to rise, will profit.

Two weeks then the fund manager again calls his CTA and closes the hedge by buying back the equivalent number of contracts on the CME.   Regardless of the resulting market developments, the investment fund manager was protected during the short-term volatility. There was no risk to the portfolio.

Example 2: An electronics firm ABC has recently signed an order to deliver 5 million U.S. dollars in the components electronic model years to a store located abroad in Europe.   These components will be built in 6 months for delivery two months after that. ABC instantly realizes they are exposed to two risks.   1. the rising and volatile copper prices in the 6 months may result in losses for the company. 2.   the fluctuation of the currency could easily add to those losses. ABC is a young company that can not absorb these losses in view of the highly competitive market from others in the field.   Losses of this order would result in layoffs and possibly plant closures.

ABC and phone numbers of CTA in consultation with an order for two coverages, both for the expiry in 8 months the delivery date.   Hedge # 1 is to buy 5 million U.S. dollars while copper effectively in the price of Closing today against rising prices.   ABC has eliminated all price risk.   The risk of plant closures is greater   that the profit motive increasingly must fall in copper prices.   After all, ABC is not in the business of speculating on copper prices.

Hedge # 2 is to sell short the equivalent of euro against U.S. currency Dollars. Since ABC is indeed the acceptance of EC in payment, one U.S. dollar and a weak increase in EC would be detrimental and further erode profits.   The result of the coverage is no risk and no surprises to ABC in copper or currency levels.   A risk free transaction and full transparency is the result. In 8 months to complete and the customer accepts delivery, ABC reports the CTA to close the hedge by selling the copper and the repurchase of contacts for the euro.

There are many examples to demonstrate the mitigation of risk to a financial institution or holding company.   The new products are constantly created and available on both over-the counter and exchange of stock markets. It would be advisable to consult a qualified Commodity Trading Advisor or broker to discuss the analysis of a course on risk management solution or a single time coverage.

Dwayne Strocen is a registered Commodity Trading Advisor specializing in analyzing and hedging Market and Operational Risk using exchange traded and OTC derivatives. Website: http://www.genuineCTA.com.
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