The Researches on Hedging of Small and Medium-sized Enterprises

The Researches on Hedging of Small and Medium-sized Enterprises
ZHANG Yingjing, LIU Juanjuan
Institute of Science and Technology, Shanghai Maritime University
[email protected]
Abstract: With the rapid development of world economic integration, then the globalization of capital
markets system is gradually formed, China's commodity prices not only by fluctuations in the domestic
market, Also by the fluctuations of international market price, Small and Medium-sized Company in
order to avoid price negative fluctuations hurting their continuing operations, part of enterprises enter
into international or domestic future markets, due to the lack of professional knowledge of hedging and
the temptation of speculation, more and more small and medium-sized enterprise’s hedging are end in
failure, In this paper, first introduce the basic principle of hedging, and then proposed three models of
hedging, with hoping to give some advices to enterprise‘s hedging.
Keywords: Hedging, spot market, future market, buy long price fluctuations;
1 Introduction
The development of hedging theory has gone through several period, Represented of the traditional
hedging theory Keynesian who think reducing risk is the only motivation to engage in futures trading.
But Woking objected to Keynesian perspective, His theory of dynamic hedging regards hedging as a
tool to maximize the expected return, he first introduction the contents of profit into hedging theory
Later, Markowitz put forward the theory of portfolio hedging, which core content is that traders in the
futures market for hedging, in essence, is a portfolio assets investment in futures and spot market. Using
spot market and futures market to form an effective portfolio investment position is a key point of using
portfolio investment, by which can reach the goal of minimizing the risk and maximizing the profit. In
recent years ,domestic scholars of China begin to the empirical study and theory innovation research in
futures market, in empirical research field domestic scholars most using of abroad mainstream model to
test efficiency of Chinese futures market, Domestic scholar’s empirical results are very similar to the
foreign markets empirical results: such as Wu Cong-feng, Liang Cao-hui and Zhang Wei etc. have
carried out empirical studies of hedging on Soybean, copper, aluminum and wheat in Chinese future
market. In the theory research field Ling Xiao-gui etc. raised the methods of setting a pre-proportion of
risk and income to optimize the hedging. Tang Xiao-hua etc. raised a combination strategy in hedging,
Wang Zheng etc. studied the multi-phase multi-objective programming model, Huang Chang-zheng etc.
established hedging model Based on utility maximization and non-linear model..
Hedging refers to the futures market as a place of offsetting the price risk in any spot market
position by buying or selling futures contracts, With the uncertain world economic situation,
most commodity price fluctuations are very intense, Take oil for example, it price once from the 140
U.S. dollars / barrel in 2009 down to 36 U.S. dollars / barrel in 2008, If the type of crude oil enterprises
fail in effective management of crude oil prices, it is difficult to imagine the what huge impact on their
operating, Now the world is still marred by the negative impact of financial crisis, On the one hand,,
Countries in order to stimulate the their economy have issued a large number of currency, Also the
central bank in China have lowered the lending rates and bank reserve ratio, so the expectations
of inflation around the world, On the other hand, although the Chinese economy began to
rebound gradually, but the world economy remains in the doldrums, under the conditions full of
contradictions macro - economic factors, the small and medium enterprises want to survive ,
they have to concerned about the price volatility impact on the day-to-day operation , For
enterprises hedging is a double-edged sword in its day-to-day operation under the environment
of the word-wide market, well using can be effectively to protect themselves, poor using will
hurt himself .
Providing a channel to avoid the risk is a key function of futures market. The corporate who
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have already used of hedging, which how to effectively use the futures market to manage risk
and achieve enterprise's goals, prevention and management the risks associated with futures
trading, which are contents of this article try to explore .
2 Explore the Reasons of Enterprises in Failure of Hedging
2.1 Violation of the principle of hedging
Hedging must compliance with the principle of transactions in opposite directions Types and
number of commodities, deliver month same or similar, Otherwise, Hedging will not be achieve
the desired results and circumvent the purpose of price risk. Began from the huge oil hedging
losses of China Aviation Oil Holding in 2004,following the failure of Iron ore hedging failure of crude
oil hedging of Sinopec Group Etc. They all have different degrees of violation the four principles of
hedging, In other words a lot of speculation in their hedging, As the majority of small and medium-sized
enterprises due to the lack of hedging professional team ,More vulnerable to the temptations of
speculative and easily breach the principle of hedging, These factors increase the risk of corporate
hedging.
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2.2 Lack of professional qualified personnel and supervision of hedging mechanisms
Hedging not only need to manage, but also more need of organized management system than
speculation. Because the hedging must take such as the spot market and cost factors into
account, so management of it is more complex than speculative, Besides a larger number of
moneys in corporate hedging, once the operator have a false Operation the loss may much
greater than others. Outstanding futures investors are the key factor of the successful completion of
hedging tasks and achieved excellent results. Enterprises should pay attention to the cultivation of the
futures business and risk management professionals, and insisted on continuing education and training,
continued to consolidate and improve the professional level of employees in hedging.
Enterprises requires not only perfect hedge hedging program, More needed to ensure the
effective implementation of programs by a organization system, such as the basic organization
of technical and fundamental analysis risk control Etc., Organizations should also consider the
constraints and supervision among those organizations. Successful in management of hedging
shares the weight no less than 50%, Hedging does not require management, Only consider of
the spot market and futures market offset the risk of price fluctuations, Under the name of the
hedging, does not fully consider of crashing cash flow risk, which result is that enterprises is
forced to bear the risk of repeatedly close position.
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3 Misunderstanding Exist in the Enterprise's Hedging
3.1 Hedging does not require management
Figure1
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The figure I above is a buy future contract for hedging, Traditional view is that hedging do
not need any management ,just To buy or sell the related futures products under the conditions
such as the opposite direction against the spot market the same or similar types of goods
considerable number of commodities deliver at the same or similar month, when reach the
delivery time the futures market or spot market’s profits can subsidize the loss from one of both,
In other words either futures market’s profit to fill the spot market profit loss or the spot market
profits to subsidize the loss of the futures market.
As shown in figure 1,assumption that an enterprise intends to purchase raw materials in a future
time, In order to avoid price fluctuations which may bring some risk to day-to-day operation ,
the enterprises buy Futures contracts at A point ,As a result of market price fluctuations, When
reach the delivery day the futures prices down to the B point, as the futures price and spot
market price in the time of delivery day must at the same level, the spot market prices of raw
materials fell at same rate of futures prices, In accordance with the traditional concept of
hedging which view this kind of hedging is successful, the reason is that the profitability of the
spot market have fully compensated the loss in futures market, Therefore, the majority of small
and medium-sized enterprises when conducting business on future market they do not
concentrate on managing their hedging accounts, But from the perspective of competition, The
enterprise’s hedging is a failure one ,The reason is that the loss of hedging have completely
devoured the benefits which come from the spot market, And compared to the competitors who
not for the hedging , terms, the cost of the hedging enterprise relatively increased, For example,
last year, Air China Limited and other companies to buy crude oil futures for hedging, the
hedging behavior of these enterprises resulted in massive loss.
The same reasoning can be drawn that if a supply companies want to sell their own products
in the future and sell futures contracts for hedging which operations also have similar to the
risk refer to the above. Therefore, the traditional view of hedging that no management needed
in hedging operation will give enterprises a lot of potential risk .So small and medium-sized
enterprises in the practice of hedging not only need management of their hedging accounts, but
also should be guided by professionals, When small and medium-sized enterprises in the
hedging, They should be more concerned about the futures price volatility and setting
appropriate stop-loss point, Lock positions when dramatic fluctuations in futures prices, to
control the loss and lock of profit .
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3.2 Insufficient understanding of margin and day of non-liability settlement system
Figure 2
First of all, investment in the futures have a larger leverage ratio than investment stock, for
example, using 100 RMB compared invest in stocks to invest in futures The leverage multiples
for the stock is 100/100=1, assuming the position of enterprises are 10%,50%,100%, So the
leverage multiples of hedging are 100/ 20*10*2 =4 100/ 50*10*2 =10 100/ 100*10*2
=20, The greater leverage multiples is the greater risk their business will face, as a result of
bulk-type commodities have a general higher price, such as metals and gold futures contracts,
Once the price have a slight fluctuation, Its margin fluctuation is more intense than the
volatility of prices, because of the non-liability settlement system in futures markets, n the case
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of that the rate of position is too high and the margin is very low, when prices in the futures
have a little down the futures positions are easier forced to close, which resulting in the failure
of small and medium enterprises in hedging, Second, the another risk of futures market in
hedging is that when the futures delivery day gradually approached, the system will
automatically raise the margin rate, If when the delivery day is coming and the margin money is
not sufficient for it future contract or previous position rate are already very high, therefore
when the future market price go to the bad direction for hedging enterprises, so the risk that
enterprises face to force close their position has increased tremendously.
4 The Establishment of Small and Medium-sized Enterprises Hedging
Model
4.1 The highest cost-Line model for futures market hedging
Figure 3
The type of A model is applicable to a number of production-oriented enterprises, Because they
only focus on certain products to buy or sell price fluctuations at single-sided, Therefore, these
hedging companies purposes only focus on prevent the declining or raising in prices
fluctuations at one-direction, so enterprises just need to control the hedging positions in one
direction, Linear cost control model is suitable for such as production-oriented enterprises.
When the cost is higher or below than a certain point in futures market they just need to close
or lock their hedging positions. The linear control model as shown in figure 2,When application
of this model for hedging, those enterprises first need to in accordance with their actual
situation to develop a cost-Line, when their cost under the linear they can be very assured to
hold the futures products, on the opposite side when their cost above the linear they must lock
the future positions or square the position, to do so the only drawback may be that because the
frequency of operations will make the operating costs increase tremendously. This model can
help companies control the risk of price fluctuations, so enterprises can operate stability.
4.2 Hedging model of regional cost control
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Figure 4
B-type model is applicable to the trade-oriented enterprises. Because of their concern not only
with the buyer's market but also with seller's market of their products, Therefore the
fluctuations of price is not a simple impact on the day-to-day business operation at one
direction, but have two opposite direction from procurement and sales to influence the
day-to-day business operation, Therefore these enterprises don’t like the A-type enterprises to
develop a determine cost linear to control hedging operations, However, such enterprises can
control their costs within a certain range to ensure the continuing operations of their own
business, The purpose of B-type model is to help trade-oriented enterprises control the cost
within a certain extent, As shown in Figure 3,When futures prices fluctuate within a certain
range enterprises no need to make any operating to their position, But when the price
fluctuations beyond a certain limit they must lock the future positions or square the position, by
this way can help trade-oriented enterprises control the risk of price fluctuations.
4.3 Long or short position regional control hedging model
Figure 5
C-type of long or short position regional control hedging model suitable for any enterprises excluded the
two types of enterprises referred above, they might have not the strict cost control ,so they use future
market for hedging with purpose of increase profit of their own assets ,When these companies make a
hedging in future market they needn’t to calculation of their cost, when enter into the long
position-region, short position hedging lock their position ,when enter into the short position- region,
long position hedging lock their positions.
5 Conclusion
Combination with the current problems of some enterprises in hedging operation, in this paper will the
following recommendations, hope to provide some theoretical guidance to practice in the hedging
1. Correct understanding the hedging principles and strictly carry out
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Futures market tools are used to manage business risks, It can be played as a business profits protector,
In some cases, a good hedge strategy can appropriately increase business profits, However, futures
market under any circumstances can’t be used as a source of profit. At the same time enterprises must
establish a scientific decision-making process, and ensure it has been strictly performed, must avoid the
risk accidents caused by violating of decision-making procedures.
2. Establishment a reliable, independent, and timely reporting system.
Through the establishment of a Risk Management System, from the mechanism can ensure a "free
speech", up-to-date transactions can be timely reporting. independent, refers to that The report and the
trading sector are parallel departments, so they are not subject to the jurisdiction of the transaction
sector Reliable, refers to that the report information besides from the transaction departments, it must be
have another sources (such as brokers) to ensure the authenticity of information; Timely, refers to the
report must have a right frequency fast transfer , the futures transaction requires in strong timing, The
report will loss of its role if the interval both too long or too slow to send
3. Don't take the risk business exceed the capacity of enterprise.
First of all, must consider the financial strength of any enterprises, study the demand for hedging funds,
determine the size of hedging combined with the ability of financing. The risk of cash flow is one of the
most important risks in futures business of hedging ,even though enterprises strictly accordance with the
requirements in hedging operations to lock of cost or profit, However, because the hedging size is too
large, if the future market price have a little fluctuations, Companies may be asked with a high margin
requirements in a short time, induce a margin payment crisis to hedging enterprises which may result
in position be forced to close, thus it can’t reach the purpose of hedging. Second, we must consider the
technical capacity in the futures market, For some complex financial products must ensure real master it
before operation. Enterprises need to train and build their own professional team in hedging.
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References
[1]. Wai M. Kim, H.A Markov Switching Model of the Conditional Volatility of Crude Oil Futures
Prices [J]. Energy Economics, 2002, 24 (1): 71~95.
[2]. Cortazar, G., Schwartz, E. S. Implementing a Stochas-tic Model for Oil Futures Prices [ J]. Energy
Economics, 2003, 25 (3): 215~238.
[3]. Ederington, L. H. The Hedging Performance of the New Futures Markets [J]. Journal of Finance,
1979, 34: 157-170.
[4]. Johnson, L. The Theory of Hedging and Speculation in Commodity Futures [J]. Review of
Financial Studies, 1960, 27: 139-151.
[5]. Myers, R. J, Thompson, S. R. Generalized Optimal Hedge Ratio Estimation [J]. American Journal
of Agricultural Economics, 1989(71): 858-867.
Acknowledgement
ZHANG Yingjing: Institute of Science and Technology, Shanghai Maritime University
No. 1550 Pudong Avenue, Shanghai 1293
200135
Tel 15901697945
E-mail: [email protected]
Sponsored Projects The project of Shanghai Maritime University Key Subjects construction
(2009445318) Shanghai Education Commission Fund 06FZ015 07ZS108 special funds of selecting
and training outstanding young teachers for scientific researches in Shanghai university (600385)
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