Framing a Hedge Objective: The Six Things to Write

A hedge objective is six lines, written before any contract has been looked at. Line one is the item at risk. Line two is the quantity and the direction that hurts. Line three is the date it stops mattering. Line four is the move in the other direction being handed over. Line five is what has to be fundable on a bad day. Line six is what is still left.

Every decision that comes after this one is easier or harder depending on how completely those six lines were filled in, and filling them in takes about twenty minutes. The twenty minutes are worth spending because four of the six lines get filled in anyway. The four get filled in afterwards, from memory, on a day when something has already happened, by somebody who by then has a reason to remember it a particular way.

Here is the everyday version first. A household has one salary arriving and a school fee due in March. Somebody in that household could write four things on the back of an envelope: which bill the money covers, how much of it, when it is needed, and what happens if the fee goes up before March. Nobody writes it, because everyone in the room already knows. Then the fee goes up in February and the conversation starts from nothing, at speed, with the money already half spent. A hedge objectiveThe written statement of what is at risk and what would be handed over in order to change it. is that envelope, written for a price that will not sit still, and almost all of its value comes from existing before the day it is needed rather than after it.

Two things about the sheet before the lines themselves. The first is the order. The item comes before the quantity, the quantity before the date, and no contract is mentioned until line five. The order is not an accident: what is at risk gets written down before anything is chosen to put against it, and a sheet that starts from a contract and then hunts for something to attach it to has been filled in backwards. The second is the scope of a step. A step on this sheet says what to write on the line and where the answer is found, and nothing else. How much of a move an offset catches, how many units go against a holding, how margin behaves from one day to the next: each of those is covered separately, and each is named at the line that reaches for it and then left alone.

What goes on the first line, and how specific does it have to be?

Line one is the item, and the standard for it is one word long: specific. Not the market, not the sector, not the currency in general, but the thing whose price actually reaches this party's own position. A category is not an item. A sheet with metals written on line one could belong to a foundry, a scrap dealer, a jewellery shop or a wire mill, and not one of those four would recognise the other three's problem in it.

There is a test for whether the line is finished, and it is worth applying literally rather than in the imagination. The sheet goes to somebody who has never met this party, and that person is asked to point at the thing. If they can point, the line is done. If they have to ask which one, it is not, and no amount of care on the five lines below will repair it, because every one of those five is a fact about whatever line one names.

Beside the line, in the margin, goes where the number came from: this party's own record of what it holds, what it owes, or what it has already agreed to. The margin note is small and it does two jobs. The note stops line one being an opinion, and it means that when somebody asks four months later where the figure came from, the answer is on the sheet rather than inside somebody's memory.

On the invented case carried through this walkthrough, line one reads: one unit of the reference asset, held. The reference asset pays nothing at all while it is held, which gets written on the line rather than assumed, because an item that pays something while it is held is a different item and produces different arithmetic everywhere it appears. The spot priceThe price for taking delivery of the thing today, rather than on some later date. of that unit is Rs 2,000.00/-. The size of the exposureThe part of what a party holds or has agreed to whose value moves with a price that party does not control. is also Rs 2,000.00/-, and those two figures agree for one plain reason: the quantity is one unit, and one unit multiplied by Rs 2,000.00/- is Rs 2,000.00/-. The two figures are not the same number because one was copied into the other.

Worth noticing what line one did not need. The financing rate carried through this sequence is 6.50 per cent a year, and no part of line one used it. The first three lines of a hedge objective can be written in full by somebody who has never seen a contract price in their life, because those three lines are a description of the party rather than of any instrument. Describing an exposure, and describing one in another currency or in a financing cost, is covered separately. Line one does not need that either. Line one needs a thing somebody can point at.

How do the quantity and the direction that hurts get written down?

Line two carries two things, and it carries them on one line rather than on two, because splitting them is how one of them gets lost. The quantity goes in units of the thing itself rather than in money, because money moves while the units sit still. One unit is one unit in March and one unit in September. The rupee value of that unit is a different figure every week, so a line written in rupees needs rewriting every week and quietly stops being true in between, while a line written in units stays true until somebody buys or sells something.

The directionWhich way the price has to move for this particular party to be worse off. is a single word, up or down, and there is a reason not to wave it through as obvious. A party who holds the thing is hurt by a fall, and a party who has agreed to buy it is hurt by a rise, so the identical item on line one produces opposite line twos for two people sitting in the same room. Direction is not a property of the thing. Direction is a property of the position standing behind the thing, and it has to be written down rather than inferred by whoever picks the sheet up next.

The everyday version is on any street with a grain shop on it. A household that has bought a year of rice at the start of the season is worse off when rice gets cheaper, because it is holding rice it has already paid for. The shop across the road that has promised to supply rice next month at a price already agreed is worse off when rice gets dearer. Same grain, same street, opposite lines, and neither party could have worked out the other's line from the word rice.

One more thing goes in the margin beside line two: whether the quantity is fixed, or will change before the date on line three. A quantity that is going to move is not a fault on the sheet. A moving quantity is simply a different line four and a different line six. Finding that out while writing line two costs nothing. Finding it out later costs whatever the difference turns out to be.

How is the date the exposure stops mattering fixed?

Line three is a date, and it is a date about this party's own affairs. The date is the day the thing is sold, delivered, paid for or consumed, and it has nothing whatever to do with any contract. The horizonThe date on which the exposure stops mattering to this particular party, for that party's own reasons. is set by the party's own plans for the item, not by the contracts that happen to be available.

Write the real date rather than a convenient one, and here is the temptation to watch for. Writing a date that a contract happens to run to is very easy because it makes line six look empty, and a sheet with an empty line six feels finished. A convenient date does not make line six empty. The convenient date moves the mismatch out of the one place on the sheet that was built to record it. The mismatch still exists, and it is now nowhere in writing.

The reason is stated here and explained elsewhere: the dates a contract runs to are set by the exchange under the framework of the Securities and Exchange Board of India (SEBI) at sebi.gov.in, they move, and nothing about them makes them contain this party's date. So line three is written from the party's own calendar, and any distance between that date and the dates available gets recorded three lines further down, where it belongs.

In the margin beside line three goes how certain the date is, in one word. Firm, likely, or an estimate. One word rather than a paragraph, because the point is not to be precise about the uncertainty. The point is that the next person to read the sheet knows immediately whether line three is a fact or a plan.

On the invented case, line three reads six months from today, being the day this holder sells the unit. The six months is a fact about this holder and about nothing else, and it would still be the date if no contract on the item existed at all.

What is being handed over, and why is that a line on the sheet?

Line four is the line almost nobody writes, and a sheet with line four left blank is not a finished sheet. Such a sheet is a half sheet, and the half that is missing is always the same half.

The work for it has already been done two lines up. Take line two, reverse the direction, and write down what happens to this party if the price moves that way instead. Reversing the direction is the whole instruction. Line two says a fall hurts; line four says what a rise now costs, and it costs it in the form of something given up rather than something lost. Handing overAgreeing in advance to give up a move in the other direction, rather than discovering later that it has gone. is the right phrase for it precisely because nobody comes and takes it: it was agreed, in writing, on this line.

Vagueness here is what makes the line skippable, so the line takes a fixed form of words. If the price moves the other way by a stated amount, this party gives up a stated amount, and that is agreed now rather than suffered later. Both amounts get written as figures. Where the contract covers the whole quantity on line two, the two sides of line four come out the same size at the final date of the contract, and at that date only. Line four is written about that moment, and the moment gets written on the line with it, because on any earlier day the two sides are not equal. How an offset produces the symmetry, and what it does in the months before that date, is covered separately. Line four records the symmetry rather than accounting for it.

On the invented case, line four reads: if the price rises by Rs 80.00/-, which is a 4.0 per cent move on the Rs 2,000.00/- spot price, that Rs 80.00/- is handed over rather than kept. The Rs 80.00/- is not a figure anybody remembered. The figure is 4.0 per cent of Rs 2,000.00/-, worked out where it is used, and it is written with its base attached because 4.0 per cent of some other number is some other amount. A ratio without its base is not a figure at all.

Notice what line four does to the sentence people say about all of this. Before line four is written, the sheet reads as a description of a danger being dealt with. After line four is written, the same sheet reads as an exchange: one thing given up in return for another. An objective that names only what is to be stopped is half an objective, and line four is the missing half. Both halves end up on the same sheet, in the same handwriting, before any contract has been looked at, which is the only moment at which reading them together costs nothing at all.

What has to be fundable on a bad day, and where does that number come from?

Line five asks a plain question: on the day this position moves against the holder, where does the cash come from, and can it come from anywhere other than the thing being covered? The answer on line five is written as an amount and a source, never as a reassurance. The phrase it will be managed is not an entry. A figure and the name of the account it comes out of is an entry. Something being fundableCapable of being paid on the day it is called, out of a source that is not the thing being covered. is a fact about a specific pot of money, not a feeling about the balance sheet as a whole.

On the invented case, line five reads: Rs 160.00/- of initial marginThe amount a party puts down before it is allowed to carry a position at all, held against the position while it is open. on one unit, at an initial margin percentage of 8.0 per cent invented for teaching, plus whatever further amount is called when the position moves against this holder, out of a source that is not the unit being covered. The Rs 160.00/- is that 8.0 per cent of Rs 2,000.00/-, worked out where it is used rather than carried over from anywhere. Line five is also the first line on this sheet that knows a contract exists at all, and that follows from the order: the four lines above it describe the party, and only this one describes an arrangement.

The clause about the source is the whole of line five. Selling the unit ends the arrangement the position was part of and leaves this holder short on one side with nothing at all on the other, so the unit cannot be sold to fund a call on the position written against it. A source that dies on the bad day is not a source. Line five is the line that catches that, and it catches it by insisting on a name rather than a number alone.

The everyday version is a wedding. The hall is booked, the deposit is paid, and the caterer asks for the balance on a day nobody wrote down. A household that already has an answer to where does that come from has a very different week from a household that has not, and the difference between them is not the amount. The difference is whether the question got asked while there was still time to answer it calmly.

In the margin beside line five goes the reason the figure on it is looked up rather than remembered. The margin actually required, and the further margin that can be called during a single day, are set by clearing corporations under SEBI's framework at sebi.gov.in. Margins differ by contract and by day, and they move. The 8.0 per cent above is a teaching figure that gives the arithmetic something to run on; it is not a requirement, and it is not a reading of one. How margin behaves from one day to the next is covered separately.

What is still left once all six lines are filled in?

Line six is one line with three places to look, and its only job is to make sure that none of the three gets discovered later. Line six records. Line six does not solve. Every one of the three is covered separately and in full, and line six is not the place where any of them gets worked out.

1. The dateIf the contract ends on a different day from line three, something is left over on the day this party actually needs the cover. Line three stays exactly as written; the gap gets recorded here.
2. The quantityIf line two does not divide into whole contracts, a remainderThe part of a quantity that does not fit into whole contracts, and therefore stays where it was. stays uncovered. Contracts come in sizes somebody else decided, and the size of one contract and the units it stands on are set by the exchange under SEBI's framework at sebi.gov.in.
3. The thingIf no contract exists on the item on line one, then whatever gets used instead is not that item, and the distance between the two moves for reasons of its own. A missing contract is the one of the three that a sheet cannot resolve on its own, and the closing block below says why.

Line six is for the person who reads the sheet in four months. Writing which of the three applies here means that person is not the first to notice, and does not notice on the day it is happening. Not being the first to notice is the entire ambition of the line. A residualWhatever is still at risk once every line of the sheet has been filled in. that has been written down behaves very differently from one that has not, and the ambition is a reasonable one.

On the invented case, line six reads: the contract taken here runs twelve months and line three says six, so the days between the two are left over. The twelve months is a teaching assumption rather than a specification of anything at all; the dates a contract runs to are set by the exchange under SEBI's framework at sebi.gov.in and are named here without a value. How much the gap between the two dates leaves behind is covered separately.

There is a division running down the sheet that is easier to see once all six lines exist, and it is worth naming before the finished example. Lines one, two and three come straight off this party's own records, while the figures standing behind lines five and six have to be looked up on the day they are needed, because they belong to somebody else and they move. The distinction is not a small one. The distinction decides who can fill in which part of the sheet, and it decides which parts go stale.

What does the sheet look like once every line is filled in?

A blank form teaches nothing, so here is the same form with every line filled in on the invented case, and every figure on it recomputed from the spot price and the invented margin percentage. The shape of a finished sheet is most of what this walkthrough hands over, so the table repays one reading as a whole before the note underneath it.

Now read that sheet as one worked instance and as nothing more. Not one line on it is a setting for anybody to copy. Line three says six months because this invented holder sells in six months, and line one says one unit because this invented holder has one unit. Change either of those and every line below it changes with it. The sheet is a shape to fill in, not a set of answers to reuse, and the difference between those two readings is the difference between a framework and a recommendation.

What can the sixth line not tell the reader?

Here is where a reader most wants the sheet to hand over something it cannot. Having written a specific item on line one, the natural next question is which contract moves with that item, and how closely. Nothing in these figures measures two things moving together, and no line on this sheet can produce that measure.

The reason is not modesty, it is arithmetic. There is one reference asset in these figures and no second priced thing standing beside it. There is no run of prices for anything, over any period. There is no distribution, no probability and no record of how far apart two things have drifted before. So there is no honest route from this sheet to a number describing how well one thing would track another, and producing one would mean inventing the evidence for it and then presenting the invention as a finding.

The list of what somebody would have to hold before that question could be answered at all is short enough to write on the same sheet. Two priced things rather than one. A run of both prices over a stated period rather than a single price on a single day. And some tested account of what moves the distance between them, so that the run of prices is being read rather than merely counted. None of those three exists here, and the absence is named rather than filled with a plausible figure. The sixth line therefore ends in a question the reader takes away with them, and that is the correct place for it to end.

Is a completed sheet a decision to do anything?

No. Six filled lines produce a description, and a description is a thing to look at rather than a thing to act on. A framework is the place a reader is most likely to feel carried along by the process itself: the lines get filled in, the sixth one closes, and the natural next motion is to do something.

The sheet could not support that motion. There is no outcome anywhere in these figures: no history, no distribution, no record of how any arrangement turned out. Whether an arrangement built on this sheet would have been a good one is therefore unanswerable here, a covered position cannot be compared against an uncovered one on how either fared, and six filled lines are not evidence of having been careful. Understanding a mechanism is not a reason to use it, and being able to describe an exchange is not a reason to make it.

Two things can be said: who would be asked next, and what they would want in hand. Lines one, two and three are the only lines on the sheet that can be checked against a record, so the people qualified to answer will want those three in writing before they say anything at all. And what has to be written down and kept before a position is treated as a hedge rather than as a position taken on its own is set by SEBI at sebi.gov.in, along with the conditions on which it is treated as one at all. Both are named here without a value, and confirming either means going to the source.

Filling in a sheet is not a reason to act on it.

The reference asset, the holder, every price, every date and every unit count in this guide are invented for teaching.
Educational material. Not advice on any investment, tax, budget or market position.