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Hedging - a guide to reducing portfolio risk
Peter Siks
Summary: Hedging is a risk management strategy that can be used to protect individual positions or your whole portfolio. It involves buying or selling a position that will move in the opposite direction of an existing position and reduce your risk. This can help to give peace of mind during periods of uncertainty, without the need to sell some or all of your holdings.
Hedging explained
Hedging a position or a portfolio means taking an opposite position that reduces the risk of the portfolio. An example is the hedging of currency risk. Suppose a European company must make a payment of USD 5M in six months. The company is exposed to currency exchange risk and if the USD appreciates against the EUR, the European company will have to pay more in 6 months than at the current exchange rate. By entering into a dollar contract which fixes the EUR/USD price in six months, the company has hedged its currency risk. If the USD appreciates, this is no longer a concern for the European company, as the exchange rate was fixed at the time of the contract. However, if the USD depreciates, the company ends up paying more than if it hadn’t entered into that dollar contract.When hedging a position, it is important to find an instrument that moves in the opposite direction of the asset one holds. If one position rises, the other position that is used to hedge falls and vice versa. With a partial hedge, a position is only partially protected, the risk is reduced but not fully eliminated. This can happen when the position used to hedge does not move exactly in the opposite direction of the position it is supposed to hedge. With a full hedge or perfect hedge, the risk is fully eliminated, for example the European company currency hedge mentioned above. In such a case, the position will therefore have (virtually) no downside risk but also (virtually) no upside potential as the positions, theoretically would even each other out.
Hedging open positions is something that happens continuously in the professional trading world, but it isn’t commonly used by private investors, as many are unaware that hedging is a possibility. Hedging is typically done using derivatives such as options or futures and though it’s an attractive option, there are several things that should be considered:
The complexity of your portfolio increases as you might now have added derivatives to the mix. These products are generally more complex than stocks and bonds and require a thorough understanding of their characteristics and risks before use. With derivatives, you may, for instance, now have to deal with margin and margin calls and have to monitor your portfolio more closely, more likely on a daily basis
There are costs associated with trading derivatives and maintaining the hedge. Those costs include interest costs, spread, transaction costs and possible roll-over costs
The upside potential is reduced or even eliminated with full hedges
The instrument used to hedge must be correlated to the existing position or the portfolio for the hedge to be effective
An example
Mr. Smith has a well-diversified investment portfolio in European equities worth EUR 250,000. He is worried that while he is away during his summer vacation, some of his positions might go down over the short term and wants to protect against that. He doesn’t want to sell his portfolio but decides instead to enter into a hedge via futures on the EuroSTOXX50 index. He chooses the EuroSTOXX50 because it has a high correlation with his portfolio. The index level is 3,700 points.
Number of futures
Because the portfolio and the index are positively correlated (i.e., they move in the same direction), the hedge position cannot be to buy the index (i.e. go long) but rather to sell the index which is to enter into a short position. When the existing position and the proposed hedge instrument are negatively correlated (i.e., they move in opposite direction), the hedge position is to go long, not short.
Now that we have established the direction of the hedge position, how many futures does Mr. Smith have to sell short to hedge his portfolio.
The contract size of the future on the EuroSTOXX50 is 10 (you can check this in the order ticket). This means that the exposure of 1 future is EUR 37,000 (at an index level of 3,700). A total of EUR 250,000 must be hedged and 250,000 / 37,000 = 6.74. When selling seven futures, he is therefore left with a small short position. If he were to sell six futures, he would have a small long position left. Let’s assume Mr. Smith decides to sell six futures (37000 * 6).
Scenarios
1. Sideways
In the first scenario, the market moves sideways. Both the portfolio and the hedge do not materially change in value. Upon returning from his vacation, the hedged position is closed. Mr. Smith has in any case ensured a relaxing holiday.2. Higher
During the period that Mr. Smith was away, both the portfolio and the index rise 5% from EUR 250,000 to EUR 262,500 and 3,700 to 3,885 respectively. The stock portfolio gains EUR 12,500. But on the other hand, the index position has lost 5% because it’s a short position, not a long one. The loss is EUR 185 (3885-3700) * 10 (the contract size) * 6 (the number of contracts) or 11,000. Net, this means that Mr. Smith earned EUR 1,400 (12,500 – 11,100). Remember that, Mr. Smith’s portfolio still had a small long uncovered or unhedged position because he bought six contracts, needing 6.74 to cover the entire portfolio.3. Lower
Both the portfolio and the index fall 5% to 237,500 and 3,515 respectively. The portfolio’s loss is EUR 12,500 but the future position has gained money. The six futures that Smith is short can be closed 185 points lower with a profit. The calculation is: (185 * 10 * 6) = EUR 11,100. Net, Mr. smith loss is 1400 (-12,500+11,100) and not the EUR 12,500 it would have been if he had chosen not to hedge his portfolio. In this case, the hedge has largely worked, but because of the small long unhedged position remaining, a decline in the market has had a (limited) negative effect.
When to hedge
Reasons to to (partially) hedge a portfolio could be when one is off the grid (on vacation), one doesn’t have the time nor the desire to monitor a portfolio or simply one is not comfortable with the current market conditions and is afraid of a sharp decline. Liquidating the portfolio might be too much for most, so (temporarily) hedging the portfolio can be a practical alternative.
Conclusion
Hedging isn’t commonplace for retail investors and involves additional costs. It nonetheless has some practical uses and can help reduce some of the risk of loss. A well-diversified portfolio can be largely hedged with a short future with a well-correlated index. If you plan to follow this strategy, make sure you understand exactly how derivatives work.
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