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Hedging: reducing portfolio risk in a turbulent market environment

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Hedging: reducing portfolio risk in a turbulent market environment

The main stock market indices continue to show uncertainty and are affected by the most pessimistic data on inflation, which continues to increase both in Europe and in the United States. In this context, market participants are concerned about fluctuations in their investments and to avoid liquidating all positions in the portfolio there is a risk management strategy that can be used to hedge individual positions or the entire portfolio.
We are talking aboutHedging, or the portfolio hedge that involves the creation of a position that will move in the opposite direction to the initial position and (temporarily) reduce the risk for the investor during market declines. Basically, a hedging transaction is usually carried out by means of l” purchase or transfer of one or more contracts the value of which is linked to the same source of risk that affects the value of the position to be hedged. I’m transactions that allow you to protect yourself from the risks associated with another investment. Such contracts are typically referred to as derivative instruments futures and optionsbecause they are securities whose price is based on the market value of other assets.

Exchange rate hedging

We have said that hedging a portfolio (or a position) means taking an opposite position that reduces the risk of the portfolio itself, an example of this is hedging currency risk. Suppose a European company knows that in six months it will receive a $ 5 million delivery that must be paid for in dollars.
Executives are satisfied with the current exchange rate of theEur/Usd and they can calculate the cost price on it by signing a dollar contract that fixes the Eur / Usd price in six months. In this way the company has hedged its exchange risk and therefore for the company in question the fluctuations of the Eur / Usd exchange rate no longer have much importance.

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How hedging works

When hedging a position, the hedger will look for a product that moves exactly in the opposite direction of the underlying asset and therefore if one goes up, the other goes down and vice versa. As the BG Saxo analystshedging open positions is something that happens frequently in the professional trading world and “a fully hedged position will practically not involve any downside or upside risk as the positions would theoretically hedge each other”.

It is important to remember that it is possible to hedge the broader market risk of an equity portfolio using derivatives such as i futures on the benchmark indexbut there are a number of things to keep in mind:
– Portfolio complexity may increase.
– There are costs associated with maintaining coverage. Think of the possible interest costs, the spread, the transaction costs and the possible roll-over costs.
– The upside potential has largely disappeared due to holding a futures short on the index.
– The portfolio must be very well correlated with the index on which the position is taken for a “perfect” hedge.
– A portfolio consisting of a very limited number of stocks may, under normal circumstances, be well correlated with the index (and its future). However, a sharp decline in one of the stocks in the portfolio will be evident in the portfolio but will not have the same proportional impact on its future (for hedging purposes). In this case, a loss occurs on the portfolio which is not offset by the future.
– The size of the futures contract is potentially large.

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A practical example

Mr. Rossi has a well-diversified investment portfolio in European equities worth € 250,000. Now Mr. Rossi and his wife are going on a three week safari during which they do not have the opportunity to monitor their portfolio. He could obviously sell the entire portfolio, but that is a choice that is discarded. He therefore hypothesizes to carry out an opposite operation (and therefore for sale) through a futures contract on the Euro Stoxx 50 index. The choice falls on this future because its portfolio has a good correlation. (The index level is at 3,700 points).

How many futures does Mr. Rossi have to short to hedge his portfolio as accurately as possible?
The size of the Euro Stoxx 50 futures contract is 10 (see the instrument’s trading ticket). This means that the exposure of 1 future is 37,000 euros, this at an index level of 3,700.
So to hedge a 250,000 euro portfolio, according to the 250,000 / 37,000 ratio, the number of contracts to sell is 6.74.
By selling 7 futures, you would then be left with a small potentially short position. If you were to sell 6 futures instead, a small long position would remain. Mr. Rossi finally decides to sell 6 futures.
Graphically the situation looks like this:

Possible scenarios

In the first scenario, the market moves sideways. Both the portfolio and the hedge do not change significantly in value. Upon returning from abroad, the covered position is closed and the Rossi family has in any case ensured a relaxing holiday.

During the period in which Mr. Rossi stays abroad, the index rises by 5% from 3,700 to 3,885. The equity portfolio is worth 5% more and that is 12,500 euros.
The difference is also 185 points (the amount by which the portfolio was increased) and we know that the size of the futures contract is 10. In total, Mr. Rossi was short of 6 futures. The calculation, therefore, is: 185 * 10 * 6 = 11,100 euros. This means that he still earned 1,400 euros (12,500 – 11,100). This is because with hedging of 6 futures, the positive difference is due to the long exposure remaining on the portfolio.

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If the index dropped 5% to 3,515, it would cost 12,500 euros on the portfolio side. But the futures position generated profit. The 6 futures where Mr. Rossi is short can be closed with a profit of 185 points. The calculation: 185 * 10 * 6 = 11,100 euros. In this case, the hedging has largely worked, but due to the small long position remaining, a market decline had a limited negative effect.

When to cover up?

A reason to hedge (partially or totally) a portfolio could be a stay abroad, the inability to monitor the portfolio consistently and the concern in facing an uncertain and / or volatile market trend. From this point of view, hedging always offers a way to reduce your risk.

A well-diversified portfolio can be largely hedged with a future on a well-correlated index. However, it is important to remember that if you are going to follow this strategy you need to make sure you understand exactly how Futures work and what the contract size is.

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