Over-Hedging

Categories: Derivatives

Hedges cost money. They are basically a form of life (or at least health) insurance for your investment porftolio.

Some of those insurance premiums cost a lot of money. Like...if you could spend, for a year, $1 million to fully hedge a portfolio of $100 million, such that the $1 million you spent covered all losses below a down-8-percent-scenario, you'd spend that life insurance fast. It'd likely be a bargain. In fact, hedge fund managers regularly spend more like 5-10-20 percent of their total portfolios hedging life. If the hedges don't execute, or go in-the-money, then they expire, worthless.

So...you kind of think of them like term life insurance. You only spend on them if you have to. And if they do execute, then something else with your thinking (or life) went terribly wrong.

See: Hedge Ratio.

Related or Semi-related Video

Finance: What is a hedge ratio?6 Views

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and finance Allah shmoop What is a hedge ratio Okay

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people of future hedge fund managers it's the ratio or

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per cent of the total that you're hedging total portfolio

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that you're hedging or protecting in you know in a

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bad market So let's go through the market numbers here

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that we're goingto totally and completely make up But they're

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reflective of reality anyway And most reality we're going to

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start with the notion that our entire portfolio at the

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moment is one security ticker S p y Which more

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last represents the S and P 500 That ticker trade

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Today it's about 300 bucks a unit We're running a

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hedge fund a lucrative one and our investors expect us

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to protect their investments in both good and bad markets

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So the question How much are we willing to pay

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Hey for that portfolio life insurance How far down are

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we okay letting this $300 per unit index fund fall

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before we hedge it or protected Well pricing matters right

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So if we want to protect it for three months

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such that even $1 below $300 that are hedges kicked

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in Well it'll cost a fortune something like $20 a

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share maybe more That's a huge premium to pay for

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protection which if the index unit stays flat at $300

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for the next three months and change or even goes

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up well we've lost 20 divided by 300 there or

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about 7% of our portfolios Value way expensive What if

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we were okay with it falling to 2 80 but

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then protecting it below 2 80 meaning the strike price

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of our puts will be a 2 80 right Well

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the pricing there is to buy those put options with

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a strike of 2 80 which expire in three ish

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months Not a cost Eight bucks a share Yes we're

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making up the numbers It's still expensive but well maybe

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that's digestible aid over three hundred's about two and 1/2

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percent change It's that worth it well for you and

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realize that that's 10% a year and edges out Maybe

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maybe depends how nervous we are what our position is

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on where the markets heading the next 90 Well if

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we look at the 2 60 strikes well then they

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only cost $2 a unit toe fully hedged 100% of

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our portfolio then it's less than 1% Maybe we do

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that right We're going bye puts the 2 60 strikes

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of the market would have to go down well over

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10% in the next 90 days to kick those in

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And that would be a lot right So we're vastly

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generalizing the numbers here in order to present clarity or

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conceptual clarity for you people as it relates the notion

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of a hedge ratio The bigger question revolves around that

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100% figure that is Do we really need to hedge

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Ah 100% of our portfolio What if we were okay

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with well 20% of it being 100% exposed to the

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market totally floating or that 20% of the portfolio is

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ah 0% hedged If we're paying $20 a unit to

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hedge a $300 strike prices well then only 80% gets

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Ah may be a tad more digestible Or what if

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we only cared about hedging 50% of the portfolio so

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that half is floating and half his head Maybe the

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bookie that we're going against is the S and P

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500 itself And if it went down 20% we were

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only down 10 Maybe our investors would heart us What

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do you think Well there's a whole bunch of math

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behind these numbers and obviously none of it exists in

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a vacuum without logic behind it But it's this percent

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of portfolio thing here that we care about in a

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hedge ratio because that is the notion of a hedge

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ratio How much of our investment universe do we want

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to pay to protect And how much are we willing

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to pay for that protection And it's always the right

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answer Yeah cue the adult diaper company It depends right

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Well on what Well on how nervous Nellie our investors

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are like how much do we really care about the

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volatility of our portfolio Like here's the S and P

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500 a chart of it for the last century and

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change And yes it went up a lot but naked

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it was hugely volatile Do we really care if all

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we looked at was the price here and then the

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price here it went up a ton While protecting the

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volatility was just a waste of money then like buying

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a month of term life insurance is a waste in

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a month when you don't die So if we don't

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care about the volatility then maybe the hedge ratio oughta

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be zero or nothing Like why would we buy a

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hedge fund at all if we don't care Overtime hedging

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is a bad bet in markets that generally go up

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And over time the market is up Something like six

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out of seven years Right So when you hedge things

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you're betting things were going awry here So do you

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really want to bet against that system and hedge portfolios

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Bet against capitalism Maybe bet against America Yeah probably not

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So the next question the next it depends Question Well

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how much do the hedges cost That is if you

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could buy $1,000,000 term life insurance policy for 10 bucks

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a month And even if you had nobody on Earth

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you really cared about leaving the money too But maybe

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if you got whacked by the 2 30 mid 10

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bus what then You'd want to leave a profess Auriol

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chair to your all the mater with that 1,000,000 box

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and then maybe you'd spend the 10 bucks a month

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on while that term life insurance head right But if

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it was a few grand a month well then maybe

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you're not going to pay life insurance company All that

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money maybe you'll just invested instead on your own So

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hedge ratios kind of live in the land of it

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depends whether you want them at all or what percentage

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of your portfolio you want to protect And how much

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that portfolio life insurance actually costs like the other depends

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It's all about protecting yourself from unforeseen accidents not get

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