Hedging risks

There are 3 types of risks to be broad :

· Directional risk

· Volatility Risk

· Correlation risk

Those who invest in long or short-term are essentially taking the directional risk.

However, we can neutralize the directional risk and simply isolate the other two risks.

For example, a simple pair trading strategy (CSW INFY to go long and short-circuit, for example) are not at risk, or the direction or volatility, but only isolates the correlation risk.

Another example would sell volatility (i.e writing the option) and "delta hedge" stock futures equivalents. This position may not be direct or correlation risk. It will only isolate the volatility risk.

When we talk about strategies ARB, usually refers to the strategies that their risk management, but only have or correlation or volatility risk. Sophisticated models are needed to develop these strategies, implementation and monitoring.

The single "arb-term cash is often referred to as" pure arbitrage ", negating the three types of risks. Therefore, in most cases, these referees generate future cash returns barely above the rate without risk.

In India, futures and the market is still in its infancy. Thus, volatility and correlation risk has not yet been reviewed efficiently. This opens new opportunities to build trading strategies to exploit the differences.

Fast-growing economies often face a rapid rise in the currency. In India, an increase of more than one year of the rupee in the market today is more or less congruent to the GDP growth figure, and there is little reason to expect that the tendency to not be compatible. For the business sector who are dealing with the business beyond the borders of India, which means having to take care costs. A strengthening of the rupee could easily result in getting a price in overseas markets. The consequences are especially severe for small and medium-largest component of the export basket. If there is something desperately needed in this time, there is a goody bag of SOPs from the government, but a viable platform for trading futures contracts on national currencies. This may be part of a hedging strategy to protect the incomes of currency movements. Hedging in the futures market is a stock in trade for large companies today.

These are the smaller players who are more vulnerable to changes in the economic environment that need access to similar instruments in the domestic financial sector. Expecting them to use these platforms overseas is unrealistic.

 

[Dhruv Bindhani]

The text you've provided offers a concise and insightful discussion on risk types in financial markets, particularly focusing on how certain strategies aim to isolate specific risks, and then transitions to a relevant issue in the Indian economy concerning currency risk for exporters.

Let's break down the key points:

Types of Risks in Financial Markets​

You accurately identify the three broad types of risks:

1. Directional Risk: This is the most common and intuitive risk. It's the risk that the price of an asset or market moves against your position. If you're long (expecting prices to rise), you face directional risk if prices fall. If you're short (expecting prices to fall), you face directional risk if prices rise. As you state, long or short-term investors inherently take on this risk.
2. Volatility Risk: This is the risk associated with unexpected or adverse changes in the magnitude of price fluctuations. Even if the market moves in your favored direction, high volatility can lead to larger swings, potentially hitting stop-losses or requiring more capital to maintain a position. This risk is particularly relevant for options traders (e.g., option writers sell volatility).
3. Correlation Risk: This is the risk that the relationship (correlation) between different assets in your portfolio changes in an unfavorable way. For example, if you're trying to hedge one asset with another that historically moves inversely, correlation risk arises if their inverse relationship breaks down, causing both to move in the same undesirable direction. This was a significant factor during the 2008 financial crisis when many assets that were previously thought to be uncorrelated suddenly became highly correlated.

Neutralizing Directional Risk and Isolating Others​

The text correctly explains strategies that aim to eliminate directional risk to focus on volatility or correlation:

• Pair Trading: You provide a good example with "CSW INFY to go long and short-circuit" (likely meaning long one stock and short another related stock, like TCS and Infosys). In a perfectly hedged pair trade, the goal is to profit from the relative movement between the two assets, not their absolute direction. The primary risk remaining is correlation risk – if the expected relationship between CSW and INFY breaks down.
• Selling Volatility with Delta Hedging: Selling an option (writing an option) profits if volatility decreases or stays low. To neutralize directional risk (delta risk), one can "delta hedge" by taking an opposite position in the underlying asset (e.g., stock futures). This creates a position that is theoretically directionally neutral, leaving primarily volatility risk. This is a common strategy for market makers and professional traders.

Arbitrage Strategies (ARB)​

The text clarifies that "ARB" strategies typically refer to those designed to manage directional risk, isolating correlation or volatility risk. This implies that these strategies often exploit mispricings based on assumptions about correlations or volatility levels, rather than outright price direction.

• "Pure Arbitrage": The concept of "pure arbitrage" is introduced as negating all three types of risks, leading to "future cash returns barely above the risk-free rate." This aligns with the theoretical definition of pure arbitrage: a risk-free profit opportunity that arises from temporary market inefficiencies, which are quickly eliminated by arbitrageurs. Because they are risk-free, their returns are commensurately low.

The Indian Context​

The article then shifts to the specific situation in India, which adds a crucial real-world application to the theoretical risk discussion:

• Infancy of Futures Market: The claim that India's futures market is "still in its infancy" and that "volatility and correlation risk has not yet been reviewed efficiently" suggests a less mature market. This can indeed present opportunities for sophisticated traders to exploit mispricings related to these risks, as they might not be as efficiently priced as in more developed markets.
• Rupee Appreciation and Exporters' Plight: The core economic problem highlighted is the rapid appreciation of the Indian Rupee, making Indian exports more expensive and less competitive in overseas markets. This directly impacts the business sector, particularly small and medium enterprises (SMEs) that form a large part of the export basket. This is a classic example of currency risk.
• Need for Currency Futures: The article argues that what is "desperately needed" is a "viable platform for trading futures contracts on national currencies" for smaller players. Large companies already use hedging strategies in the futures market, but the current domestic financial sector might not adequately serve smaller businesses. This is a critical point: accessible and liquid currency hedging instruments are essential for SMEs to protect their revenues from adverse currency movements, which fall under the umbrella of directional risk (specifically, foreign exchange directional risk).

Relevance in 2025 (and looking back):

• Currency Futures in India: The statement about the "infancy" of India's futures market, particularly for currency, might be a bit outdated if the article was written a few years ago. India's currency derivatives market has actually grown significantly since its introduction. Currency futures in India were launched on the NSE in August 2008, and currency options in 2010. By 2025, these markets are quite active and provide considerable liquidity for hedging. While perhaps not as deep as developed markets like the USD/EUR, they are certainly not in their "infancy" anymore in terms of basic availability and volume. However, the efficiency of pricing volatility and correlation risk might still be a nuanced point, and access for all "smaller players" might still have barriers (e.g., awareness, complexity, minimum contract sizes).
• Rupee Volatility and Exporters: The issue of rupee appreciation or depreciation and its impact on exporters remains a perpetual concern for the Indian economy. Governments constantly evaluate "SOPs" (Standard Operating Procedures or schemes) like RoDTEP (Remission of Duties and Taxes on Exported Products) to support exporters. However, direct financial instruments like currency futures remain critical for individual firms to manage their specific exposures.
• The gap for SMEs: The article's call for easier access to hedging instruments for smaller players is still highly relevant. While platforms exist, the practical challenges for SMEs in understanding, accessing, and utilizing complex financial instruments for hedging remain. This highlights a persistent need for financial literacy and accessible products tailored to their scale.

In conclusion, the article provides a strong foundation for understanding financial risks and hedging strategies, and effectively connects these theoretical concepts to a pressing economic issue faced by Indian exporters, emphasizing the ongoing need for robust and accessible financial tools.