How to identify risks and choose hedging strategies

A hedge is an investment product designed to offset the risk of adverse price movements in another asset. It usually means taking the opposite position to your main asset but in a related asset or security, often a derivative.

If you are speculating that the price of your core asset will rise – you are going long – you take a contrary position on your hedge to profit if the asset falls in price. If you are speculating that your core asset will fall – you are going short – you take a hedge positon that profits if it rises.

The hedge is designed to protect against market volatility.

But that oversimplifies it. There are lots of ways to hedge a risk and lots of risks you can hedge. And there are many types of hedges. But there are also many risks that you cannot hedge. In fact, the very word risk means different things to different people.

The primary definition of risk in the New Collins Concise Dictionary is, like the dictionary, concise. It is ‘the possibility of incurring misfortune or loss’. The dictionary then defines 'to take or run a risk' as being to proceed in action without regard to the possibility of danger involved.

The world of finance is awash with examples of risk. Our first task is to attempt to explain the broad concept of risk and the individual variations. The second is to suggest ways that risk exposure might be managed, mitigated or hedged.

Words of warning

It is probably appropriate to issue several words of warning. No single article, or even book, can possibly do the subject full justice. No matter how knowledgeable the writer and how comprehensive the writer's efforts, something will be missed, or simply prove impossible.

The diverse nature of market volatility means not every risk is manageable, mitigatable or hedgeable. In some cases the only option might be to decide not to pursue the intended course of action. The best advice might be to walk away from a proposed investment and not look back.

If you want or need a hedge and a hedge is not available, do not invest, cautions one long-term options trader. With some risks, the only way to hedge is not to buy.

The language of risk

Risk has a language all of its own. In his absorbing book, Financial Risk Management for Dummies, Aaron Brown, a risk manager at global investment firm AQR Capital Management at the time of writing the book, and a one-time professional poker player, sums it up neatly.

Although risk is one of the most important facts of life, language about it is extremely limited, he states. It's hard to discuss risk without expressing an opinion. People will say an investor was reckless, foolish or careless for taking a risk that turns out badly.

If things go well, that same person is judged as bold, innovative or a creative thinker. Even before you find out the result, if you like the risk you say the risk taker is shrewd, daring or taking a calculated risk. If you don't like a risk, the risk taker is rolling the dice or speculating.

No one said it was going to be easy

Managing risk, like managing any aspect of a business, is hard, writes Aaron Brown. But the task is made easier by having a well-planned strategy. A good risk management strategy is simple to state, if often difficult to carry out. It includes:

• Learning about the risks in general; learn about the business and the people
• Learning about specific exposures and risks; learn about the details of the portfolio
• Managing people, process, organisation; focus on group dynamics, the human factor
• Implementing damage control to minimise the impact when and if disaster strikes

In purely financial terms the word takes on a specialised meaning. Risk is the expected return above the “risk-free” rate. The risk-free rate is usually referenced to be the T-bill rate of US government securities – a return that is highly secure and typically the smallest available.

So, if an investor is researching an investment that offers a return of 5.5%, and the T-bill rate is 0.5%, the risk return is 5%.

The broadening of risk

General market risk has been broadened and enhanced by the actions of central bankers sponsoring quantitative easing, thereby removing fundamentals from valuations, says M Damian Billy, founder and CEO of Chicago-based private equity specialist Econophy Group.

He knows a thing or two about extreme risk, having served with the US Marines in Vietnam. Market risk has been magnified beyond historical parameters, he adds. He calculates that there is currently $63tr of global debt risk on the table.

“How much more exposure can be added before it is recognised as being fatal to all currencies and economies?” he asks, rhetorically.

M Damian Billy, courtesy of MDB

“At this time, the best hedge is keeping your powder dry if you long the market. At some point sanity will enter the environment and valuations will be adjusted accordingly, which is downward, across all asset classes. None is immune to manipulation or price distortion.”

The managing of risk

Managing risk is not minimising risk but rather managing the trade-off between risk and return, states Thomas S Coleman in his highly technical but very readable book A Practical Guide to Risk Management.

He says that good risk management allows the following possibilities:

• Same return with lower risk
• Higher return with the same risk

Generally the result will be a mix of higher return and lower risk.

Coleman adds that the ultimate goal of risk management is to build a robust yet flexible organisation and set of processes to respond to and withstand unanticipated events.

Thomas S Coleman, courtesy of Thomas S Coleman

Managing risk for crises, tail events or disasters requires the combining of all types of market risk, credit risk, operational risk, liquidity risks and others.

The causes of crises

Generally, Coleman notes, crises or disasters result from the confluence of multiple events and causes. He cites as examples the collapses of Barings, the bank, in 1890 and in 1995 and the Société Générale trading loss in January 2008. He might equally have pointed to The Royal Bank of Scotland and Lehman Brothers later in 2008.

In explaining what can be a tortuously complex subject, he compares the worlds of risk management in skiing (in particular avalanche risk) with financial risk management. This makes it much easier for the lay person to understand the concepts and practices involved in risk management.

A common problem for novice skiers, for example, is simply ignorance of the risks they are taking. There is a clear parallel with novice investors. Except for the asymmetry of payoffs. The penalty for a mistake in avalanche territory is injury, perhaps even death.

The penalty for a mistake in financial markets is losing one's money, or job. But the upside reward in financial markets can be high enough to create incentive problems and so pave the way for overleveraging, investing badly and crashing.

Hedging strategies

“Whatever the investment is, if there is a significant risk you can’t hedge maybe you should pass on the investment, or at least keep some cash in reserve; buy half or two-thirds instead of going all in,” advises Keith Ross, executive chairman of PDQ Enterprises, operator of a US equity trading platform.

Keith Ross, courtesy of pdq

“It is important to remember that the hedge will always have a cost and what many don’t realise is that when they hedge they are not eliminating risk (which most hedgers believe). They are just changing the nature or direction of the risk.”

This echoes a longstanding analogy in the market that links risk with fat. Risk, like fat, cannot be removed or eliminated, merely moved around the system. “You cannot protect yourself from risk,” says Martin Weale, a former member of the Bank of England Monetary Policy Committee.

The growth of leverage

One of the key ways in which risk has evolved over time revolves around leverage. New flavours and forms of risk are typically a variation on the leverage theme. Options give leverage to the call or put buyer and maybe some marginal return to the option writer, but the leveraged return to the option buyer is levered risk to the option seller.

Keith Ross argues that hedging a particular risk, be it interest rate, currency, or other, might not be as important as fully understanding the leverage in a portfolio.

He believes that all the major financial problems of recent decades - from the 1987 Crash, the Long-Term Capital meltdown (LTCM was bailed out in 1998 and dissolved in early 2008) and the sell-off in 2008-09 - were caused by the extent to which the big players were over-leveraged going into the crises.

They then exacerbated the crises with their need to reduce risk by selling on an industrial scale.

Too much leverage

One of the biggest risks is too much leverage, he says. This is not too hard to hedge, he advises. “Reduce the size of the position.”

Almost as a side note, he makes the point that all the financial products were centrally cleared by a third-party clearing facility.

Stocks are traded on exchanges and by broker-dealers who then settle and clear the trades through central clearing facilities such as the DTCC and NSCC (The Depository Trust & Clearing Corporation and the National Securities Clearing Corporation).

These clearing facilities act like a bank clearing cheques. They make sure that the accounts have sufficient funds and securities to meet their obligations. Futures are similar in that they are also centrally cleared.

The clearing facilities are responsible for maintaining margin levels that are sufficient for the volatility of the market.

All such contracts were paid for, settled and delivered during the crisis. The meltdown was in over-the-counter (OTC) contracts that were self-margined and in the end undercollateralised.

Specifics of risk

There are a number of specific risks that can identified. Many have a range of hedging strategies or techniques.

Liquidity risk

Thomas S Coleman divides liquidity risk into two sub-definitions: funding liquidity risk and asset liquidity risk. Funding liquidity refers to the ability to raise or retain the debt for financing leveraged positions. Asset liquidity refers to the ability to buy or sell in the necessary size at the prevailing market price in a timely fashion.

By Alex Gunningham from London, Perfidious Albion (UK plc) (Northern Rock Customers, Golders Green.) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

For banks, liquidity risk means not having cash to hand to meet depositor demand for repayment (see Northern Rock and Lehman Brothers). For investors, it means not being able to sell an asset and turn it into cash.

This will usually, but not necessarily, be a long-term asset such as direct investment in property or an indirect investment via a property fund. Illiquidity can result in forced sales at significantly reduced prices, in turn creating buying opportunities for cash-rich vulture investors.

Private equity investors view this as a “liquidity premium” – the expected increase in return they require because their investment is by definition illiquid. If you own stock, and want a temporary market hedge you could go short the appropriate future or ETF but this then gives rise to tracking risk.

Risk cannot be eliminated, only moved around.

Interest rate risk

This is investor exposure to fluctuating interest rates. Property owners with experience of the mortgage market will have an instinctive understanding of the impact of movement in interest rates, especially if they are sizeable and rapid.

One of the simplest hedges for retail investors is to fix their mortgage rate for as long as practically possible. Fixed rate mortgages are readily available for a range of maturities, even up to 25 years.

Bank of England governor Mark Carney said at the press conference on 2 November 2017, explaining the Monetary Policy Committee’s (MPC's) decision to raise the key official rate from the first time since May 2007, to 0.5%: “Fully 60% of [UK] mortgages are at a fixed rate.”

A range of other interest rate solutions is available to the commercial client. 

Governor Carney, image courtesy of the Governor and Company of the Bank of England

Interest rate swap

An interest rate swap is an agreement between a borrower and a bank to exchange interest payments on terms set out in the contract.

The borrower agrees to pay a pre-agreed fixed rate of interest. In return the borrower will receive from the bank a floating rate that matches the loan. In most cases, the bank will also be the lender.

The aim is to fix the cost of finance for a borrower who has floating rate borrowings. This protects the borrower from sharp increases in short-term interest rates.

Interest rate cap and floor

An interest rate cap is a contractual agreement between the borrower (the buyer) and the bank (the seller). The bank agrees to insure the borrower against a rise in the floating rate of interest above an agreed rate. In exchange, the borrower pays a cash premium to the bank, usually upfront.

The aim is to establish a maximum cost of finance for the floating rate borrower. This enables the borrower to enjoy the benefit of low short-term interest rates until they rise above the cap rate.

An interest rate floor guarantees the rate will not fall below a specified level.

Interest rate swap and floor

An interest rate swap and floor is a combination of an interest rate swap and an interest rate floor. The borrower agrees to pay a fixed rate of interest. In return the borrower receives a floating rate that matches the loan from the bank.

This gives the borrower the flexibility to benefit if the floating rate is below the floor strike rate. The premium for the floor is embedded in the swap rate; there is no upfront cash premium.

This product enables the borrower to benefit from a low interest rate environment. It also limits the potential penalty cost that could arise on early termination if interest rates are lower than at the beginning of the agreement.

Participating swap

A participating swap is an agreement between borrower and bank to exchange interest payments on agreed terms. It combines an interest rate swap with an interest rate cap. A pre-agreed portion of the notional amount is hedged with a swap; the remaining portion is hedged with a cap.

This gives the borrower protection against rising short-term interest rates, but the borrower retains the opportunity to benefit in a low short-term interest rate environment on the capped portion (this is referred to as the participation).

Interest rate swaption

An interest rate swaption is an option that gives a borrower the right - but not the obligation - to enter into an interest rate swap on an agreed date or dates in the future.

A swaption ensures a maximum fixed rate payable in the future. Furthermore, it gives flexibility if the fixed rate does not rise to the swaption strike rate at expiry; in this case, it will not be exercised and the borrower can take advantage of the lower market rates at that time.

Cancellable swap

This is a swap that may be cancelled by the borrower at no cost on an agreed date in the future. It is structured as a combination of an interest rate swap and a receiver’s swaption. The cost of the swaption is embedded into the fixed rate. The strike price is chosen so that it is the same as the fixed rate.

A cancellable swap enables the borrower to protect borrowing costs for a defined period of time while retaining the opportunity to cancel the contract on an agreed date or dates in the future without the potential burden of penalty costs.

Interest rate collar

An interest rate collar is an agreement between borrower and bank. It is a combination structure involving the effective purchase of an interest rate cap and the simultaneous sale of an interest rate floor.

Typically, the premium of the cap is designed to exactly match that of the floor, with the result that they cancel each other out and produce a zero cost collar.

For a borrower who enters into a zero cost collar, a known maximum interest rate payable (the cap strike rate) will be established at the cost of agreeing to pay a known minimum rate. Between those two levels, the cost of finance will remain on a floating rate basis over the agreed period.

End 

Equity risk

When you purchase stock in a company you are assuming equity risk. The investor becomes an owner in the corporation and the return is calculated by price appreciation and dividends. Typically if the company’s earnings grow, the value of the equity will appreciate. Investors expect growth and sit behind creditors. The risk is the stocks does not rise, but falls.

Selling some of the position or perhaps buying put options can reduce some of the risk. Put options give the purchaser the right (but not the obligation) to sell the stock for a specific price over a specific time period.

An investor would pay a premium to purchase the put option and the cost of the option will reduce the return on the investment. A put purchase is very similar to buying insurance. If listed options are available they can reduce the risk, but this also reduces the potential reward.

Credit risk

Credit risk is the risk that the issuer of credit – such as bonds, certificates of deposit, or preferred stock – cannot meet its obligations to pay interest and principal of the debt.

Image courtesy of the Governor and Company of the Bank of England

If the credit exposure is to bonds of a listed company there is an equity cushion from the stock value. Some traders short stock against the credit risk. Credit default swaps enable investors to hedge a specific named credit risk. But again, hedging is not a free lunch and this will lower the return.

Maturity risk

Maturity risk is the risk of a bond portfolio’s duration, the amount of time until the bonds mature. Longer time usually receives a higher yield but is subject to price exposure for a longer period so if rates change, a portfolio with longer maturity will fluctuate more than a portfolio with a shorter maturity.

US Federal Funds rate over 62 years courtesy of Macrotrends

Where are yields going and when will they change direction? Swaps are available here too, but because dealers want to keep them over-the-counter and unregulated because they make so much money trading them they are not really good for customers in the end.

Market risk

What is market risk? Typically one thinks of the risk of equity prices declining but it could be any asset that changes in value; stocks, bonds, real estate, art, commodities, anything.

Photo courtesy of auctioneers Lyon and Turnbull

Lots of hedging options exist including futures, options and exchange-traded funds. If investors can define their market preference/risk precisely it can be created in the market.

Exchange rate risk & currency hedging

Exchange rate risk is the risk that the currency your assets are denominated in will lose value relative to other currencies. There are many possibilities in currency hedging, which is probably the biggest market in the world.

A foreign exchange (FX) forward is a contractual agreement between the client and the bank, or other non-bank provider, to exchange physical amounts in different currencies at a single set date in the future and at a set rate.

A forward transaction differs from a spot transaction in the length of time between the trade date (the day the transaction is confirmed between the counterparties) and the day of settlement (when the currency is actually exchanged); the settlement, or maturity, date is also known as the value date.

Banking traditionalists often describe forward contracts as the expression of interest rate differentials through the relative exchange rates.

Forex forward

An FX forward contract locks in the current exchange rate between two currencies at a set date in the future. This might be done, for instance, if a company is contractually obliged to pay a set amount for the future delivery of goods in a foreign currency, and wishes to lock in the current exchange rate.

Forex swap

When a futures contract is entered into, it has a maturity date. As the maturity date approaches the purchasing party must either take delivery or trade the future for another future with a longer maturity date.

An FX swap (or rollover) allows the client to roll forward the actual exchange of currencies from the maturity date of a forward contract. The client pays the amount due to the counterparty at the prevailing market rate for the currency in question and enters into a new forward.

The aim is to allow the maturity date of a forward contract to be pushed further out or brought back.

Forex option

An FX option is a contract that confers on the holder the right – but not the obligation – to exchange an amount of one currency for another at a pre-agreed rate (the strike rate) on a pre-agreed date.

An FX option sets a maximum (or minimum) exchange rate on a known transaction of a different currency in the future, thereby limiting the potential downside but maintaining the ability to exchange at a more favourable rate.

Forex collar

An FX collar is a combination structure. It involves buying a protective, out-of-the-money option and simultaneously selling another out-of-the-money option on the same notional amount.

An FX collar provides a maximum and minimum exchange rate that the holder can pay, but allows flexibility to benefit from the market rate in between. This is a highly leveraged strategy and makes the most sense when used as a substitute for an actual forward purchase.

Volatility and cashflow trade-off

Effective use of currency hedging calls for consideration of the trade-off between volatility reduction and increased cash flows for each asset class, observes specialist investment firm Record Currency Management.

Hedging decisions should be an integral part of the strategic asset allocation process, it advises, not an afterthought. The best hedge is an income stream in the currency of exposure.

Record says that currency hedging is advisable for international equity allocations of 30% or higher, and that it is essential for allocations of 60% or higher. If not, the diversification benefits of international equities risk being overwhelmed by additional, unrewarded currency volatility.

In simple terms, currency movements can wipe out the underlying gain recorded in the native currency of the investment in question.

Mismatch risk

Keith Ross describes mismatch risk as the very essence of hedging. Mismatch Risk is the risk that the hedge underperforms the asset that is being hedged (or the hedge could overperform too).

Source: Macrotrends

For example, in the recent movements of the US stock market if an investor owned General Electric stock (GE) and was worried about long market exposure and decided to sell the S&P 500 future as a hedge, it turns out that GE stock went down dramatically relative to the S&P 500 and therefore the hedge was mismatched.

The hedge did not offset the loss incurred in the investment. If an investor find a perfect hedge the difference becomes an arbitrage opportunity.

Inflation risk or purchasing power risk

Inflation risk is the risk that nominal cash returns from an investment will be too low to compensate for the loss of purchasing power due to inflation.

That is, the rate of inflation will be higher than the interest rate paid on a cash investment product such as a bank account or government or corporate bond, or the yield from an equity investment.

Inflation-linked government bonds, where available, offer a simple hedge. TIPS - US Treasury inflation-adjusted bonds – promise to return inflation plus 2% or so.

Foreign exchange mismatch risk

No one in their right mind would - however attractive a low interest rate looks - borrow Swiss francs to finance the purchase of a property in Hungary, Poland, Croatia, Romania or Serbia, for example, without a Swiss franc income to shield them from currency fluctuations.

In the case of the Swiss franc, the fluctuation tends to work in just one direction. Its very long-term trend has been to strengthen against virtually every other currency in the world.

Borrowers in a number of eastern European countries including Poland, Croatia, Romania and Serbia ignored this basic rule of currency exposure. Some 550,000 homeowners in Poland alone received a short and very sharp lesson in cross-border economics in January 2015.

In a move that quickly became known as Frankenschock, the Swiss National Bank abandoned its self-imposed ceiling on the franc which had kept it artificially weak. Those borrowers who had not hedged their FX exposure through a forward contract saw their payments rise by around 20% overnight.

Borrowers in Hungary had earlier seen up to €9bn of foreign currency loans converted into forint, their domestic currency, insulating them from the impact of the Frankenschock.

Sophisticates might argue that using the money to buy a property in Switzerland itself could provide a hedge. But because of a combination of other, cultural reasons it would represent only a partial hedge.

Yes, the domestic currency value of the Swiss asset will rise as the Swiss franc strengthens against, say, the forint. But the cost of servicing the underlying debt will rise by a factor of two, three or more.

To put this in a long-term perspective, the pound sterling bought CHF7 in June 1974. In November 2017 it buys around CHF1.30. If a borrower earning sterling had taken out a CHF70,000 mortgage in June 1974 it would have equated to £10,000. In November 2017 it would equal around £53,846.

Entering a forward contract for the funds needed to service the debt will afford a degree of protection. But it will only be postponing the inevitable by 18 to 24 months, depending on how long a forward contract will be made available to a retail buyer. The hedge will eventually run out.

Bear in mind too that property in a country such as Switzerland is most definitely not a liquid asset. Swiss households tend to rent properties for the long term rather than buy, and there are clear legal restrictions on the purchase of property by foreigners.

This can severely restrict the universe of potential buyers. A modest two-bedroom apartment can take two-and-a-half years to sell. This can be seen as the very epitome of illiquidity risk.

Regulatory risk

Regulatory risk is the risk that regulators change the rules during the term of the investment. There could be new taxes, tariffs or changes in margin requirements that all impact the value of the asset.

Global investment firm Schroders points out in a recent note that the Solvency II regulatory regime imposed upon insurance companies has reduced the appeal to those companies of holding equities. Volatility has compounded the problem.

As a result, many insurers are avoiding equity exposure and missing out on the long-term benefits of the asset class. In a low-yield world the potential long-term returns from holding equities are attractive.

However, there is heightened volatility and the risk of sharp downward corrections to contend with, and the capital one must allocate to support an equity investment under Solvency II is often viewed as penal (it is set at a base level of 39%, reflecting the historic value at risk of equities).

Schroders says it believes that many insurers would invest in equities if they were able to protect against excessive downside risk and lighten the capital burden.

Hedging market risk

It argues that the most obvious way to reduce the VaR (value at risk) of an equity exposure is to hedge the market risk. The first port of call for an investor seeking to hedge equity risk is the long-dated put option market.

However, buying a single long-dated put option can be expensive. Investors may not want to pay away too much potential upside for protection. The key driver here is that options are priced on the basis of ‘implied volatility’. But what the market thinks volatility will be in future, not actual volatility.

Because implied volatility is often higher than experienced volatility, one is effectively overpaying for the option. One way to deal with these issues is to replace the single 12-month put option with a series of 12 overlapping puts, each covering one twelfth of the notional underlying equity exposure.

Each month one of these put options will expire, to be replaced by a new 12-month put option, so that a continuing 12-month hedge is maintained. An investor using this strategy will hold 12 put options at any time, rather than one. This strategy is less sensitive to its start date, says Schroders.

Using a conventional annual put strategy means that the initial timing decision can affect annual returns by over 3%, even over a 16-year time horizon. The use of a series of monthly overlapping puts reduces the impact of this decision to less than 0.30%.

Words of wisdom from the market.

Courtesy of George Soros

A number of market players submitted advice based on their own experience. These include the following comments.

• The market is driven by fear. Some people say greed and fear, but greed is just the fear of “not having”.
• If you hedge risk you are basically buying insurance against that risk. For the insurance seller to survive he has to make money over time, if the insurance seller is always making money you are probably paying too much for the insurance or it may be better for you to reduce your position rather than hedge or buy the insurance.
• The antidote to risk is growth. If you are looking for returns above the risk-free rate and can invest in a company that is growing – its “pie” is consistently getting bigger – then you can capture alpha and outperform those that settle for the risk-free rate. The risk is that when the growth cycle stops or reverses your returns will be going backwards.
• Paraphrasing George Soros: Whether or not you believe you have currency risk, you do have currency risk.
• And finally, the hard part of owning stock is deciding not to sell each day.

Recommended further reading

• A Practical Guide to Risk Management by Thomas S Coleman (published by the CFA Institute, ISBN 978-1-934667-41-5).
• Financial Risk Management for Dummies by Aaron Brown (Wiley imprint, ISBN 978-1-119-08220-0, this latter book could easily be the best use for an inexperienced investor to make of the purchase price of £16.99, US$26.99 or C$31.99).
• The Black Swan: The Impact of the Highly Improbable, and Fooled by Randomness, both by Nassim Nicholas Taleb.

With special thanks to hedging solution and derivatives adviser and provider JCRA Group for help with product explanations and accompanying charts.

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