Module X·Article IV·~2 min read
Hedging an Investment Portfolio
Derivatives and Hedging
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Hedging is a strategy for reducing risk by taking a position that offsets losses on the main position during adverse market movements. The goal of hedging is not to maximize returns, but to manage risk within set parameters. For an institutional investor, hedging is an integral part of portfolio management.
Hedging an equity portfolio through index futures: this is the simplest and most liquid instrument. Calculation of hedge ratio: number of contracts = (Portfolio Value × Beta) / (Futures Price × Multiplier). The portfolio's beta shows its sensitivity to the market. Partial hedging reduces beta, complete hedging brings it to zero. Alternatives: put options on the index (paying a premium but receiving convexity — portfolio insurance), variance swaps (volatility hedge), collar (buying a put plus selling a call — reduces hedging costs).
Hedging interest rate risk. Duration matching: selecting assets and liabilities with identical duration eliminates interest rate risk. DV01 (Dollar Value of 01bp) shows the change in portfolio value when the rate moves by 1 basis point. Hedging through IRS: selling an interest rate swap (receive fixed, pay floating) reduces a bond portfolio's duration. Treasury futures are a liquid instrument for quickly adjusting duration.
Currency hedging: FX forwards and swaps are the main instruments. Static hedge — a one-time forward for the entire expected cash flow. Dynamic rolling hedge — short forwards are constantly rolled; more flexible, but requires active management. The optimal hedge ratio in currency management depends on the correlation between the currency and the underlying asset.
Limitations and costs of hedging: transaction costs (bid-ask spread, commissions) reduce returns. Basis risk — the correlation between the hedge and the hedged asset is not 1. Roll costs — significant expenses may arise with futures rolls in contango. Opportunity cost — a hedge limits both potential losses and gains. Dynamic hedging (delta hedging of options) requires constant rebalancing and is sensitive to price gaps.
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