Many events in the market can spoil the most seemingly promising trading positions. Changes in the level of profitability, the shape of the yield curve, financing rates, and the profitability of a certain issue compared to similar ones – all significantly affect the final financial result. A trader can offset potential damage by hedging his position. A trader hedges a risk-related position by adding one or more “legs” (legs – components) to it to reduce the probability of losses. Derivative products are especially popular among traders as hedging instruments, as they are highly liquid.
Traders engage in hedging for several reasons. The most typical reason for using hedging is to immunize a position from adverse changes in the variable that the trader is not going to bet on.
For example, a trader, hoping that the yield curve will become steeper, buys 10-year bonds and sells 30-year ones. He is betting that the yield of 30-year bonds will rise compared to the yield of 10-year bonds. He hedges his short position on 30-year securities with a long position on 10-year ones. Moreover, he does not care at all whether the yield curve becomes steeper in a market with rising or falling prices. He just wants to get rid of the impact of changes in the overall yield level to get a cleaner game on the yield spread of 10- and 30-year bonds.
Hedging can also provide a reduction in risk by switching to positions with less volatile variables. For example, hedging a long bond using bond futures transforms an ordinary (and risky) long position into a more rigorous game on cash-futures relationships.
Some types of hedging provide risk control by eliminating the possibility of maximum losses due to extremely large price changes. A statistician would say that hedging eliminates negative “tails” (price changes with a large amplitude, realized with a low probability) of the distribution of a trader’s financial result. For example, a trader wants to use a long position but is afraid of being trapped as a result of a significant drop in prices in the market. Then he can hedge his long position by buying several put options, the profit from which can limit his losses.
With the help of proper hedging, a trader can “refine” his game and reduce the risk. He eliminates the dependence of his financial result on the movement of variables that he has no idea about (and, therefore, his chances of making a profit are estimated as 50:50).
If a trader gets rid of the influence of “extraneous” parameters, his profit depends only on his ability to predict changes in those variables at the future level of which he is confident.
Proper hedging can also increase profit opportunities. Traders choose the size of their position according to the number of losses they are willing to take. If a trader reduces the size of his maximum possible losses by hedging, he can use a larger position. With the same risk that he would have in a non-hedged position of a smaller size, the trader can provide himself with a potentially greater reward.
Hedging can be free or paid. When a trader makes a short sale of bonds to immunize a position from changes in yield, he simply changes the nature of his game. If he pays cash for put options, which should limit his losses, he reduces his potential profit by the value of the options.
Hedging can be perfect or imperfect. An example of an almost perfect hedge is an urgent repo or an urgent reverse repo. Most cash market traders do not play on changes in financing rates. Therefore, they usually fix the position financing rate for a certain period (equal to the duration of the transaction financing).
Selling and buying bonds
But usually, traders have to resort to imperfect hedging. Even when a trader sells long bonds to hedge some long position on “old” long bonds (these are two issues that usually move in parallel), there is still a certain vulnerability of his position associated with a possible change in the yield spread of the two issues. The only ideal type of hedging is the liquidation of a position.
Traders use hedging mainly to avoid dependence on the direction of changes in profitability. They are often in a short or long position, not knowing in which direction the yields will move. Every day, “making the market”, traders sell and buy bonds at the moments determined by their clients. Even if a market maker buys bonds cheaper than the market or sells them more expensive, he does not want to take a long position just because his client is a seller, and a short position only because his client is a buyer.
If the bonds that a trader buys or sells are “prior”, then their liquidity may force him to maintain a position for several days. Therefore, if the market maker does not try to take a certain position purposefully, he will hedge a new deal usually either with the help of the current issue with a close maturity or with the help of some futures market instrument.
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