optimising portfolio hedging strategies - cboe

Portfolio Hedging Strategies Alessandro Esposito

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CBOE

Optimising Portfolio Hedging Strategies

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• The case for Consistent Hedging

•Optimizing Hedging Strategies

• Sizing initial trades and managing positions over time

•Cross Asset Hedging

•Conclusions

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The Case for Consistent Hedging Hedging adds convexity to your portfolio

Mitigating the effect of adverse market moves justifies hedging across strategies

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Feb-08 Jun-08 Oct-08 Feb-09 Jun-09 Oct-09 Feb-10 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12 Oct-12 Feb-13 Jun-13

SPXT SPXT + SPX 3M 95% Put

The Case for Consistent Hedging Buying puts simply won’t do the trick

Buying puts simply won’t do the trick Consistent hedging requires a more structured approach

SPX total return chart vs. 3m put hedged portfolio rolled monthly

Source: Bloomberg, Bank of America Merrill Lynch

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The Case for Consistent Hedging Hedging issues are multi-dimensional

• The Term the period over which one wishes to be protected

• The Strike the level from which one wishes to be protected

• Ranges the structure with which one wishes to be protected

• The Premium the optimal size of the hedge(s) versus the size of the portfolio

• The Frequency how often do you re-strike?

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•Conclusions

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Optimising Hedging Strategies The avoidance of market timing risk

Straight Puts

Put Spreads

Calendars Collars

COMPLEXITY

PREDICTABILITY

The complexity of the payout increases the predictability of the hedged strategy

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Optimising Portfolio Hedging Strategies

In order to optimise portfolio hedging strategies, we need to be able to compare them : By evaluating the VaR of the hedged portfolio we are able to size different strategies by evaluating their impact on the risk of the portfolio

Q : How do you compare different strategies ? A : Look at their volatility

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I. COMPUTE VAR OF HEDGES

II. COMPUTE VAR OF

PORTFOLIO & HEDGES

III. SIZE THE TRADE BY REDUCING

HEDGED PORTFOLIO VAR

IV. SANITY CHECK !!

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Optimising Portfolio Hedging Strategies Sizing initial trades requires a four step process

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•Conclusions

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Sizing Initial Trades and Managing Positions Over Time

Using the S&P 500 as our proxy portfolio we target a 10% risk reduction via a 3m 95%/85% put spread

0%

2%

4%

6%

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12%

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20%

0%

20%

40%

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100%

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29-Feb-08 28-Feb-09 28-Feb-10 28-Feb-11 29-Feb-12 28-Feb-13

3m 95p-85p

Index

Hedged Strategy

SPX return chart vs. 3m put spread hedged portfolio rolled daily

Source: Bloomberg, Bank of America Merrill Lynch, Bluebay

• Sizing the put spread to 118% of its notional VaR goes from 0.42 to 0.38. • The Sharpe ratio improves from 0.13 to 0.15 • The high correlation between the portfolio and the hedged strategy indicates the ability to include • hedging as part of portfolio management

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SPX 1m95p 3m95p 12m90p 1m95-85ps 3m 95-85ps 1m95p-12m90p

Sharpe Ratio 0.134 0.16 0.16 0.15 0.15 0.15

Multiplier 0.55 0.40 0.33 1.14 1.18 VaR can't

be improved

• Hedge ratios diminish with longer time horizons for single put trades • Long Calendar put spreads additive to risk

Sizing Initial Trades and Managing Positions Over Time VaR Equivalent Hedging Strategies


Sharpe Ratio and Notional Hedge Ratio of SPX portfolio hedged with different strategies

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1m95p 3m95p 12m90p 1m95-85ps 3m 95-85ps

Hedge Ratio Monthly Rolls

0.20 0.20 0.15 0.40 0.50

Hedge Ratio Daily Rolls 0.55 0.40 0.33 1.14 1.18


• Lower frequency dramatically reduces the hedge ratios • For shorter maturities, option strategies can be additive to VaR

Readily available data demonstrate the impracticality of rolling hedges daily We compare daily vs. monthly rolls

Impact of Re-Hedging over time

Notional Hedge Ratio of SPX portfolio hedged with different strategies, Daily vs. Monthly Roll


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Sizing Initial Trades and Managing Positions Over Time Re-hedging frequency and the impact on returns

• Lower frequency dramatically differentiates returns among strategies

40%

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29-Feb-08 31-Aug-08 28-Feb-09 31-Aug-09 28-Feb-10 31-Aug-10 28-Feb-11 31-Aug-11 29-Feb-12 31-Aug-12 28-Feb-13

SPXT SPXT + SPX 1M 95% Put SPXT + SPX 1M 95%-85% Put Spread

SPXT + SPX 3M 95% Put SPXT + SPX 3M 95%-85% Put Spread SPXT + 12M 90% Put

SPXT + SPX 1M 95% Put - 12M 90% Put

Percentage Cumulative Returns of SPX hedged porfolios for a VaR reduction of 10%, using monthly rolls


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Can hedging become an integral part of your investment process ?

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Jan-00Jul-00Jan-01Jul-01Jan-02Jul-02Jan-03Jul-03Jan-04Jul-04Jan-05Jul-05Jan-06Jul-06Jan-07Jul-07Jan-08Jul-08Jan-09Jul-09Jan-10Jul-10Jan-11Jul-11Jan-12Jul-12Jan-13Jul-13

S&P500 TR

S&P500 TR + 3M 95% Zero Cost Collar

S&P500 TR + 3M 85%-95% Zero Cost Put Spread Collar


Return Risk Sharpe

SPX 1.18% 16.05% -0.07

95% Zero Cost Collar 2.78% 10.71% 0.05

85% - 95% Put Spread Collar 4.38% 12.48% 0.17

Zero Cost Collars can be used to improve Sharpe ratios and returns Hedging becomes part of the investment process


Percentage Cumulative Returns of SPX hedged portfolio using zero cost risk reversals

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•Conclusions

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Cross Asset Hedging

For cross asset hedging regression analysis is used to compare the variables

VIX vs SPX returns over the past year give a Beta of 7.7

This is not a stable relationship over time Rolling correlations need to be monitored

Vix Linear regression regression on SPX returns

Source: Bloomberg

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Cross Asset Hedging

80%

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Sep -09

Nov -09

Jan -10

Mar -10

May -10

Jul -10

Sep -10

Nov -10

Jan -11

Mar -11

May -11

Jul -11

Sep -11

Nov -11

Jan -12

Mar -12

May -12

Jul -12

Sep -12

Nov -12

Jan -13

Mar -13

May -13

Index

Hedged Strategy

• Cross asset hedging can be used in a systematic manner to improve the Sharpe ratio • Changes in correlation across variables make comparisons across hedging strategies more • complex

Using a 2m 100/150% call spread on the VIX we obtain a hedge ratio of 51% using a Beta of 7.7 The Sharpe ratio moves from 0.65 to 0.78

-200%

-100%

0%

100%

60d Corr

30d Corr

Source: Bloomberg, Bank of America Merrill Lynch, Bleubay

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•Conclusions

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CONCLUSIONS

• Hedging can become an integral part of the investment process

• VaR methodologies can be used to compare hedges, including cross asset hedges

• Frequency of re-hedging is a key factor sizing and comparing trades

• Systematic hedging requires more complex payoff

• Correlation changes affect cross asset hedges

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Disclaimer

V2 – Data end June 2013. Published 16 July 2013

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optimising portfolio hedging strategies - cboe

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