Time to Hedge?

Ryan Rogowski, executive member of the UK Structured Products Association, discusses why structured products are a good hedging solution

What’s that in the sky? A plane? A superhero? No it’s a swarm of black swans.
The dotcom crash, the credit crunch and once unimaginable sovereigns teetering on the edge of default, these so called irregular tail events seem to occur with an unpleasant regularity.

While global markets have rallied in the aftermath of the Lehman Brothers collapse, the global economic recovery still seems fragile at best. Once the preserve of risk managers and esoteric traders in banks, the concept of hedging has now entered the lexicon of the average investor. But what is hedging? And how do you implement it?

As an investment concept, hedging is a very simple idea. When markets and assets fall in value, investors wish to minimise the impact of these scenarios on their portfolios. In essence, they are looking for insurance. The complexity of hedging arises with the plethora of options available to them to undertake this task.

The right solution

From using derivatives such as put options to defensive assets such as gold, investors need to understand a variety of factors to determine which solution most suitably matches their requirements. The factors to be considered can be grouped into two categories: the structure of the hedge (how does the hedge work) and the contents of the hedge (what asset are we using to protect our portfolio of assets).
Put options are perhaps a good starting point in examining hedging tools. They represent a hedge mechanism.

For a fee (premium), an investor will be payed for any fall in an asset below a fixed price (the strike level). For a small fixed cost, a large liability can be protected. However, this type of hedging strategy can be a costly exercise, particularly if the asset does not fall and the contract expires worthless. Instead we can look at other solutions which can either reduce the cost of the hedge or improve its efficiency. We can do this through structured products.

The first step in selecting the correct hedging solution is deciding what to hedge. With any portfolio, there are a multitude of factors which can have a positive or negative influence on the performance of the assets contained within. The investor must examine the correlation between the hedging vehicle and the assets being hedged, the cost of the hedge and the expected duration of the hedge. As we can see, there is a lot to consider!

Correlation. Imagine purchasing an insurance policy to protect against some event, but the payment received when (and if) the event actually occurred was significantly different than the actual loss incurred. A hedge is only useful if it offers meaningful protection when it is required. It must increase in comparable value when the portfolio falls in value. Structured products can be tailored to mimic the behaviour of a portfolio and thus maximise the hedging correlation.

Cost. Your asset falls by 10%, while your hedge rises by 9%. An excellent hedge….except it cost you 15% to protect your portfolio. The hedge was not cost efficient. When volatility is high, option premiums can be expensive. Structured products can utilise different structures such as a zero cost collar to reduce the cost of the hedge. Other products can take advantage of correlation between different indices in falling markets to create a lower cost option.