Hedging - a guide to reducing portfolio risk
Summary: Hedging is a risk management strategy that can be used to protect individual positions or your whole portfolio. It involves creating a position that will move in the opposite direction of the initial position and (temporarily) reduce your risk. This can help to give piece of mind during periods of uncertainty, without the need to (partly) liquidate your holdings.
Hedging, explainedHedging a portfolio (or position) means taking an opposite position that reduces the risk of the portfolio. An appealing example is the hedging of currency risk. Suppose a European company knows that in six months it will receive a delivery worth USD 5 million that will have to be paid in USD. In addition, they are satisfied with the current exchange rate of the EUR/USD and can make their cost price calculation on it. By entering a dollar contract which fixes the EUR/USD price in six months, they have hedged their currency risk. Whether the price of the EUR/USD is going up or down does not really matter to them anymore.
When hedging a position, the hedger will search for a product that moves exactly in the opposite direction of the underlying asset. If one rises, the other falls and vice versa. A fully hedged 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. For many private investors, this is often a bridge too far because they deal with risk very differently and some are unaware that hedging is a possibility. However, it’s worth remembering that it is possible to hedge the broader market risk of an equity portfolio – in part or in whole – by using derivatives such as futures on the relevant index. But there are a number of things that you should take into account:
The complexity of your investment portfolio increases. You may, for instance, have to deal with margin
There are costs associated with maintaining the hedge. Think of possible interest costs, the spread, the transaction costs and possible roll-over costs
The upside potential has (largely) disappeared due to the holding of a short future on the index
The portfolio must be (very) well correlated with the index on which you take the future position
A portfolio consisting of a very limited number of stocks may, under normal circumstances, correlate well with the index (on which futures are available). However, a sharp decline in one of the stocks in the portfolio will be noticeable in the portfolio but remain invisible in the futures of the broader market (the hedge). In that case, a loss is incurred on the portfolio that is not offset by the hedge
The contract size of the future: a future might be "too big"
An example...Mr. Smith has a well-diversified investment portfolio in European equities worth EUR 250,000. Now Mr. Smith and his wife are going on a three-week safari where he has no opportunity to monitor his portfolio. He could of course sell the entire portfolio, but that is not his preference. He wants to enter into a contrary transaction via futures on the EuroSTOXX50 index. He chooses the EuroSTOXX50 because it has a good correlation with his portfolio. The index level is 3,700 points.
Number of futures
How many futures does Mr. Smith have to sell short to hedge his portfolio as precisely as possible?
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. Mr. Smith decides to sell six futures.
Graphically, it looks like this:
In the first scenario, the market moves sideways. Both the portfolio and the hedge do not materially change in value. Upon returning from abroad, the hedged position is closed. The Smith family has in any case ensured a relaxing holiday.
2. HigherDuring the period that Smith stays abroad, the index rises 5% from 3,700 to 3,885. The stock portfolio is worth 5% more and that is EUR 12,500. But how much 'loss' has been made on the hedge? The difference is also 185 (the amount the portfolio had increased) and we know that the contract size of the future is 10. In total, Mr. Smith was short six futures. The calculation then is: 185 * 10 * 6 = EUR 11,100. This means that Mr. Smith earned EUR 1,400 (12,500 – 11,100). Remember that, before leaving for safari, Mr. Smith’s portfolio still had a small long position because he bought six contracts, needing 6.74 to cover the entire portfolio.
If the index were to fall 5% to 3,515, it would cost EUR 12,500 on the portfolio side. But the future position has made money. The six futures that Smith is short can be closed 185 points lower with a profit. The calculation: 185 * 10 * 6 = EUR 11,100. In this case, the hedge has largely worked, but because of the small long position remaining, a decline in the market has had a limited negative effect.
When to hedge
One reason to (partially) hedge a portfolio could be a stay abroad. If you have no time, no desire or no internet connection to monitor your portfolio, hedging offers a way to reduce the risk. Another reason may be that you are simply not comfortable with the current market conditions and that you are afraid of a sharp decline. Liquidating the portfolio goes too far, so (temporarily) hedging the portfolio is a very practical alternative.
A well-diversified portfolio can be largely hedged with a short future on a well-correlated index. If you plan to follow this strategy, make sure you understand exactly how futures work. And don't forget to pay attention to the contract size.
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