Anticipatory Hedging

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Anticipatory hedging is the partial or complete execution of a hedge transaction prior to execution of the actual position. This activity is subject to regulatory requirements that differ among products, exchanges, and regulatory authorities. It's also called a long hedge.[1]

Practice

If allowed, a trader may choose to execute a partial or complete hedge to a trade prior to execution of that trade. This 'pre-hedge' reduces the risk to the executing firm by shifting market impact to the customer and other market participants involved in the security.

Example of an Anticipatory Hedge

Here is an example of anticipatory hedging from a piece by The Bond Market Association's Municipal Financial Products Committee. The piece appeared in the May 8, 2006 issue of "The Bond Buyer." The piece was posted on the Securities Industry and Financial Markets Association's (formerly known as the Bond Market Association's) Web site at the time this MarketsWiki page was started.

Take the case where "an issuer intends to issue $100 million in 30-year fixed-rate bonds. The bond sale is to take place in 12 months. The issuer is subject to debt service limitations and would like to lock in today's interest rates in order to produce budget certainty. To accomplish this, the issuer enters into a swap, payments on which are scheduled to start in 12 months. In the swap, the issuer will pay a fixed rate to the dealer in exchange for receiving a floating rate. In 12 months, the issuer intends to sell the fixed-rate bonds and to terminate the swap before the scheduled payments on the swap are due to start. The swap is sized such that the issuer expects that the change in the swap's mark-to-market value due to market movements will closely approximate the change in the amount of proceeds that the issuer will receive from its fixed-rate bond issue (with the amount of debt service kept constant).

For example, suppose that over the course of the next 12 months, interest rates fall. The issuer makes a $5 million payment to the swap dealer to terminate the swap. The issuer is then able, because of lower rates, to fund the termination payment with bond proceeds while keeping overall debt service at originally projected levels. The issuer ends up with net $100 million of proceeds for projects and the same debt service as budgeted -just as intended."[2]

Anticipatory Hedging and PHLX

The Philadelphia Stock Exchange, Inc.'s (PHLX) Rule 1064, in its original form, sets forth, among other things, the procedures by which a floor broker holding an option order ("original order") may cross it with another order or orders he or she is holding, or, in the case of a public customer order, with a contra side order provided by the originating firm from its own proprietary account ("facilitation order"). Under certain conditions, Rule 1064 provides "participation guarantees" in such crossing or facilitation transactions, entitling the floor broker to cross a certain percentage of the original order with the other order or orders ahead of members of the trading crowd.[3]

Controversy

Controversey arose surrounding the topic after the UK’s Financial Services Authority fined the Deutsche Bank subsidiary Morgan Grenfell £190,000 (E279,923) for “pre-hedging a programme trade that ultimately disadvantaged its customer” in April 2004. Some contended the market became divided on this issue after the incident.[4]

Support Against

References

  1. Anticipatory Hedge. AMEX/Swiss Bank Corp..
  2. Explaining Derivatives Seeing Past the Termination Payment By The Bond Market Association's Municipal Financial Products Committee. SIFMA.
  3. Self-Regulatory Organizations; Philadelphia Stock Exchange, Inc.; Order Granting Approval to Proposed Rule Change Relating to Participation Guarantees for Floor Brokers Representing Crossing and Facilitation Orders in Index Options. 404.gov.
  4. Pre-Hedging Divides the Transition Industry. European Pensions and Investment News.