How to benefit from hedging

Performance cycles indicate that hedging could be an opportunity and not just an imperfect risk management technique, says Mukul Pal.

Hedging is one of the first ideas modern finance taught us. Hedging as an exercise was started for a farmer, who wanted to insulate himself from movements in agricultural commodity price.

The commodity prices fluctuate and create a risk. If the actual price of agricultural commodity rises a lot between planting and harvest, the farmer stands to profit, but if the actual price drops, it could lead to a loss.

A hedge allowed the farmer to sell a number of wheat futures contracts equivalent to his crop size at planting time.

This way he could effectively lock in the price of wheat. Now, he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract.

Overtime the risk management shifted to stock prices. Change the farmer for a stock trader, who believes that the stock price of Company A is volatile and could fall. He offsets the position with the index or another sector peer, now if the market falls and the stock, the investor has locked in a price and will not lose.

The aim

In both cases, the aim of the farmer and the stock investor is to reduce risk. None of them expects this strategy to make a profit. Hedging is a risk management strategy between two assets of a pair. In finance, a hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimising one's exposure to unwanted risk. The first thing they taught us in school was that a hedge is not perfect or perfect hedges are rare.

A perfect hedge is the one that completely eliminates risk. Hedging with equity futures uses a technique called beta hedging.

Beta is the sensitivity of a stock against the market. To calculate how much quantity to offset, beta is used. The more sensitive the stock, the larger offsetting value is needed. While the lesser sensitive the stock, the lesser the value of the offsetting leg.

When two different beta stocks are used in a hedge, beta has to be tracked during the period of the hedge and necessary adjustments to be done when required. Simply putting it is a cumbersome process which at the end of it is supposed to reduce risk, imperfectly.

Hedge and forget approach

Investing industry is not alien to the idea of hedging and many readers may have attempted an odd hedge at least once in their investing life.

There are very few studies on hedge "inefficiency" and what are the real results of 'hedge and forget' cases where no beta tracking and adjustments are done over the period of the hedge.

The idea of inefficient pair is linked to the 'hedge and forget' approach. If over the period of the hedge a pair diverges more than the risk-free rate of interest, hedging is an opportunity to profit contrary to popular belief as a risk management approach.

The idea of inefficient pair flies in the face of hedging. If 100 per cent annualised difference between the long and the short leg is what we are hedging against, it really makes sense to profit from them rather than to avoid them.

Hedging and the performance cycle

Hedging as a risk limiting and not a profiting strategy is generational knowledge. Performance cycles prove that hedging or trading pairs is both a cash conserving and profiting strategy provided it is based on performance cycles, time fractals approach.

We highlighted large divergences between Indian sector indices in the first half of 2009 India outlook and then in Grasim and L&T pair a few weeks back.

Cases

Today we look at a few Dow 30 pairs. This is to challenge the idea that inefficiency is not limited to the Indian region but exists globally.

We have taken three Dow 30 pairs, Chevron- Exxon, JP Morgan-American Express and Microsoft-HP. These are high correlation pairs and selling one and buying the other can be based on fundamental reasons or on mean reversion strategies.

The back-tested results are poor in the respective strategies, but tested for performance cyclicality for a period of 18 months the strategy delivered an annualised 70 per cent (Chevron – Exxon), 169 per cent (JP Morgan – American Express), 125 per cent (Microsoft – HP). Out of 17 signals on three pairs, 7 signals delivered more net gain on the pair compared to individual legs.

Conventionally speaking this kind of strategy where net gain on the pair is more than individual legs should be impossible to isolate and very rare.

Back-testing proof is an academic exercise and implementation and trading with real money another, however isolating such high differences between tightly correlated pair without a single large loss does indicate that hedging might be an opportunity for profit rather than an academic technique for risk management.

If hedging is so imperfect, then arbitrage opportunities in markets are limitless just like alpha.

The author is CEO, Orpheus Capitals, a global alternative research firm.