Understanding Hedge Products and Bonds

As the world becomes increasingly risky, there's a growing need to protect financial assets from wars, terrorism, and natural disasters. Avoiding these risks is called hedging, and various hedge products exist for this purpose. The global economic system hasn't found a better place for sudden event preparedness than the Chicago Mercantile Exchange.

Major Hedge Products

Call Options

A call option gives you the right to buy a specific product or financial asset at a predetermined price on a specific date from the option seller. It's a right, not an obligation. Used when you expect prices to rise.

Put Options

A put option gives you the right to sell a specific product or financial asset at a predetermined price on a specific date from the option seller. Again, it's a right, not an obligation. Used when you expect prices to fall.

Swaps

Swaps are essentially bets on future interest rate movements.

For example, suppose someone borrows at a fixed rate and invests at a variable rate. If rates fall, they lose money. They can hedge this risk by entering a swap where they pay a variable rate and receive a fixed rate.

Credit Default Swaps (CDS) are contracts that protect against the default risk of specific corporate bonds. You probably heard a lot about these during the 2008 financial crisis.

Catastrophe bonds also exist. If a disaster specified in the bond occurs, the buyer must pay the agreed amount or lose their capital. Insurance companies use these to diversify natural disaster risks.

Basic Bond Structure

Bonds have an issue price and a coupon rate.

If a bond with a face value of $100,000 is issued with a 10% coupon rate for 10 years, it promises to pay $10,000 in interest annually.

Relationship Between Base Rate and Bond Prices

When the base rate rises, people start thinking bank deposits are more attractive than bonds. Bond demand decreases, and bond prices fall.

Conversely, buying bonds at this point secures a higher yield. In other words, when bond prices drop due to expectations of rate hikes, it's a good time to buy.

Here's a concrete example. There's a bond with a 10% coupon rate, and market rates rise to 2%. People will want to buy bonds at a price that gives them an effective 12% yield.

At this point, the bond price falls below $10,000 / 12% = $83,333. This is because people prefer bank deposits at the same yield.

Long-term vs Short-term Bonds

Long-term bonds carry more risk because they must pay interest over a longer period. That's why long-term bonds typically have higher coupon rates than short-term bonds.

TIPS (Treasury Inflation-Protected Securities)

TIPS are a representative inflation hedge asset.

The face value printed on the bond doesn't actually change. Instead, an adjusted principal concept is used. The face value at issuance is fixed, and the adjusted principal is calculated based on the Consumer Price Index (CPI). Interest payments and maturity redemption are based on this adjusted principal.

For example, suppose a 1-year TIPS is issued with a face value of $1,000.

Face value at issuance: $1,000
CPI rises 3% after 1 year
Adjusted principal: $1,000 × 1.03 = $1,030
Interest is calculated based on $1,030

A useful investment when inflation is a concern.

Convertible Bonds (CB)

Convertible bonds start out just like regular corporate bonds. However, after a certain period when the conversion right activates, investors can convert their bonds to stocks whenever they want. If the stock price rises, convert to stocks and take profits. If the stock price falls, just hold the bond and receive principal plus interest at maturity.

It's a structure that lets you pursue both the stability of bonds and the growth potential of stocks.

Conversion Conditions

The stock conversion conditions for convertible bonds are set at issuance.

Conversion Price: The price applied when converting bonds to stocks. For example, if the conversion price is $10 and the bond face value is $1,000, you can convert to 100 shares.

Conversion Request Period: The period during which conversion rights can be exercised. Usually, conversion becomes possible about 1 year after issuance and must be exercised before maturity.

Refixing Clause: A clause that lowers the conversion price when the stock price drops. This is favorable to investors. For example, if the conversion price is $10 but the stock price drops to $7, the conversion price is also lowered to $7.

If the stock price is higher than the conversion price, convert and take profits. If it's lower, just hold the bond until maturity and receive principal plus interest.