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Principles of Hedging
The principles of hedging in the Treasury market involve the following:
Identify the risk: The first principle of hedging is to identify the risk that needs to be hedged against. In the Treasury market, the primary risk is interest rate risk, which can be managed through various hedging strategies such as using futures contracts, options contracts, and interest rate swaps.
Determine the hedging instrument: Once the risk has been identified, the next step is to determine the appropriate hedging instrument to use. For example, an investor who is concerned about rising interest rates may choose to use a futures contract or an options contract to hedge against potential losses in their Treasury portfolio.
Set the hedge ratio: The hedge ratio is the proportion of the underlying asset that is hedged. The hedge ratio should be determined based on the level of risk that needs to be hedged against and the available hedging instruments. For example, if an investor owns $100,000 worth of Treasury bonds and wants to hedge against interest rate risk using Treasury futures contracts, they may choose to hedge 80% of their bond portfolio, or $80,000 worth of bonds.
Monitor the hedge: Once the hedge has been established, it is important to monitor it regularly to ensure that it is effective in managing the identified risk. This involves tracking the performance of the hedging instrument and the underlying asset to ensure that they are moving in opposite directions as expected.
Adjust the hedge: If market conditions change, it may be necessary to adjust the hedge to ensure that it remains effective in managing the identified risk. For example, if interest rates rise more than expected, an investor may need to adjust their hedge to ensure that it provides sufficient protection against potential losses in their Treasury portfolio.
Hedging is the process of offsetting the risk of price movements in the physical market by locking-in a price for the same commodity in the futures market. The reasons for performing hedging activities is for a converter, for example, it allows for better control and management of product pricing of their raw material costs and for a producer.
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