The creative hedge

Portfolio Insurance

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Hedge fund managers have had to endure a tricky few months. With equity markets plunging, volatility hovering close to recent highs and correlation on the rise, the across-the-board gains notched up by the hedge fund industry in 2006 have not been as easy to replicate. In this environment, portfolio insurance, once considered an unnecessary expense, has become increasingly important. But, with rising volatility pushing the price of out-of-the-money index put options to prohibitively high levels, hedge fund managers have been forced to consider cheaper alternatives.

The Chicago Board Options Exchange's Vix index, which measures the market's expectation of 30-day volatility on Standard & Poor's (S&P) 500 index option prices, closed at 30.83% on August 16, 2007, up from a low of 9.89% on January 24, 2007. It subsequently dropped to 16.12% on October 9, but had jumped back to close at 31.01% by January 22, 2008.

Equity markets, meanwhile, have been battered since the start of the year. After weathering much of the turmoil that blighted the credit markets in August and September, the S&P 500 fell to 1,310.50 on January 22, having started the year at 1,468.36 - a 10.75% drop. Likewise, the Dow Jones Eurostoxx 50 index fell 18.68%, from 4,399.72 on December 31, 2007 to 3,577.99 on January 23. This had a noticeable effect on hedge fund portfolios, with the Credit Suisse/Tremont long/short equity hedge fund index down 4.05% in January - the largest fall of any hedge fund strategy.

Increased volatility has caused the price of out-of-the-money index put options to soar. The cost of a 90% put on the Dow Jones Eurostoxx index with three months to expiry has risen from 0.88% on July 2, 2007 - just before the crisis broke - to 3.06% on January 23 (see figure 1). "Implied volatility has increased dramatically during the past months, and if you are looking to buy out-of-the-money index puts now, these could be prohibitively expensive. This forces you to be more creative in how you implement your portfolio insurance," says a portfolio manager at a London-based long/short equity hedge fund.

As a result, banks have become inundated with requests from hedge funds for strategies that offer cheaper protection, either by sacrificing upside or embedding views on correlation into the structure. "In the past six months, we have seen more and more hedge fund clients looking to both lower the cost of their insurance, as well as integrating the impact of correlation in the optimisation of their hedging, with some seeking outright protection in the event of an across-the-board market crash," explains Denis Frances, global head of flow sales at BNP Paribas in London.

Many of the cost-reduction strategies now being employed are not new. But, in the low-volatility environment of the past three years, most funds were happy to settle for plain vanilla index put options - if they bothered to hedge at all. "Back in June last year, when premiums were still in the order of 4% on a six-month put, many funds were happy to just pay that premium. Now that price has increased to about 8% or 9% for a six-month trade, people are definitely trying to cheapen the cost of their hedges," says Gerry Fowler, director of trading floor multi-strategy at Citi in London.

One of the most straightforward cost-reduction strategies has been to use put spreads - the purchase of a put option and simultaneous sale of another put at a lower level. This limits the gains an investor can achieve if the market falls sharply, but the premium received from selling the out-of-the-money put partially finances the purchase of the at-the-money put, leading to substantial cost savings. For example, a six-month at-the-money/90% put spread on the FTSE 250 index would have cost around 3.4% on February 18, compared with 7.7% for a plain vanilla, at-the-money put.

Dealers say put spreads have been among the most requested trades over the past six months, with notional volumes estimated in the tens of billions. But this strategy is not without risk - in particular, a sharp drop in the equity index early in the life of the trade could significantly reduce the benefit of the hedge. Specifically, if the stock market falls and nears the strike on the sold put option early on, the vega of that position would be likely to offset the delta effects of the bought at-the-money put. At the same time, a rise in volatility (and a steepening of skew) would affect the value of the short put more than the long option position, reducing the benefit of the hedge further.

"The problem with put spreads is that if the market falls early in the life of the structure, you may not get much payout due to the negative vega close to the lower put strike, and it can be surprising as to how little protection be degsnefit this structure provides in that scenario," says the London-based long/short equity portfolio manager.

These effects are mitigated if the put spread is near expiry. Nonetheless, some managers have instead opted for risk reversals - the simultaneous purchase of a put option and the sale of a call. In some instances, the sale of the call will finance the purchase of the put. "There is good reason to trade put spreads, but we prefer to trade risk reversals. As volatility has increased a lot, puts are very expensive, but call prices have also gone up to levels where we see value in selling them," explains Andy Song, head of equity derivatives trading at London-based hedge fund CQS.

The disadvantage of risk reversals is that the mark-to-market of the strategy is highly sensitive to gains in the equity market. However, if the fund manager's portfolio is mostly long stocks, the gains in the cash equities portfolio will offset the mark-to-market losses on the hedge, Song adds.

A potentially riskier but considerably cheaper option is knock-out options (or down-and-out puts). These are path-dependent put options that terminate once the market drops below a certain predefined barrier. "With this kind of high volatility and high skew, barrier options such as down-and-out puts have been extremely attractive during November, December and January," says Cyril Levy-Marchal, global head of equity derivatives flow trading at JP Morgan in London. "At the beginning of this year, an at-the-money put with a knockout at 80% on the S&P 500 index, maturing at year end, cost less than 2%. In comparison, an at-the-money put would have cost around 8%, so clearly this has proven quite popular."

While significantly cheaper, the risk is that the stock market drops below the knock-out barrier early on, leaving the hedge fund with no protection. Even if the barrier is not breached, the fund manager would be hit by a negative mark-to-market as the index approaches the knock-out level. "While risk reversals would gain you a positive mark-to-market with market falls, you may not see that gain with a knock-out option, as even though the market is lower, there is a higher possibility that it will knock out. You can't rely on these instruments alone, but as part of an overall portfolio insurance strategy they can make sense," says Song.

Indeed, the sharp drop in equity markets in the first three weeks of January is likely to have caused some of these hedges to knock out. Despite this, some dealers claim now is the perfect time to put on such trades, with many taking the view the market is unlikely to fall a further 20% from current levels. "There is typically a view that as the markets have already come down a lot, there is not much room for it to come down more than another 10% or so, and there are people who are happy to buy a put and have it knock out if the market goes down another 20%," says Shane Edwards, head of equity derivatives structuring at Royal Bank of Scotland (RBS) in London.

Some fund managers have gone one step further by taking a view on correlation to reduce the cost of their hedges. Best-of puts, in particular, have attracted attention over the past few months. This strategy is based on a basket of three equity indexes, with the payout determined by the level of the best-performing index at expiry. A barrier is often embedded into the structure, so the put only knocks in once all three indexes have fallen below a predetermined level. The fund manager is effectively expressing a view that correlation will rise and all indexes will fall in a downward market.

"A best-of-three index put structure that pays out on the index that falls the least is more likely to pay out when correlation increases. This can compensate when realised correlation increases in return for a cheaper structure cost," says the London-based hedge fund manager. "A 10% out-of-the-money best-of-three index put on the Dow Jones Eurostoxx 50, Dax and FTSE 100 indexes may cost only 75% of the weighted average cost of buying puts on those individual indexes, so considerable savings can be achieved."

CQS has also employed this strategy. "The best-of put strategy has been a good option, especially as correlation between indexes appears to have increased recently, and we have traded several of those. However, this only works when there is a risk of a significant fall in markets. If there is only a minor fall, you may not get any payout, and in a meandering market it wouldn't give you the best protection," says Song.

While choosing indexes with lower correlation can reduce the cost of the best-of option, this has to be balanced against the need to acquire an effective hedge for the portfolio. Nonetheless, some fund managers are actively choosing uncorrelated names and indexes as a cheap means of protecting against extreme systemic risk.

"We have seen increased use of best-of puts on a basket of names as a hedge against extreme events," says Jim Josephson, head of flow equity derivatives sales for Europe at Bear Stearns in London. "These structures have the benefit of giving downside protection that really gets an extra kicker from having a long correlation trade also. People can look to low correlation names to include in the basket and therefore lessen the overall cost compared with vanilla puts, in the anticipation that when an extreme environment of systematic risk kicks in and assets became highly correlated on the downside, they will have a big payday. As far as doomsday scenarios go, these structures can offer very plausible and often cheaper hedges."

But as with virtually all option strategies, timing is everything - and that, was particularly true for the volatile month of January. "In January, the market was so volatile that depending on the day on which your best-of put expired, you could have had something or nothing," says Bertrand Delarue, head of derivatives structuring at BNP Paribas in Paris. "That's why we always advise our counterparties to diversify their hedges by buying more maturities and different strikes - so not everything depends on what happens on one day. You may have been right in the aggregate, but you may have just been out of luck on the day the option expires."

A small number of hedge funds are also using variance swaps and conditional variance swaps as a portfolio hedge. Conditional variance swaps allow investors to take a view on volatility, but returns are only recorded on days where the underlying spot price is above or below a predetermined level.

"Because the payout of a variance swap is the accumulated daily realised variance of the underlying asset, it really reflects a similar payout to an at-the-money option that resets and is rehedged every day," says Josephson. "Variance swaps can be an alternative for people who see a relationship between the volatility of an asset and the return of their portfolio. They offer the added attraction of convexity at the wings, where an option portfolio will become linear when the gamma has gone from it. One missing feature is the potential to exercise and dispose of assets that options can offer, but the truth is that, most people are looking for a mark-to-market hedge anyway."

However, the number of hedge funds using variance swaps for portfolio insurance, as opposed to taking directional views on volatility, remains limited, argues JP Morgan's Levy-Marchal. "While trading on the Vix index has certainly picked up in the US, we haven't seen many funds buying one-year variance swaps in Europe. The problem is that, compared with the payout you would get for a put option, the size of the variance swap you would have to buy to create a meaningful return to protect a long/short portfolio is enormous. Overall, there are a lot more people who buy put spreads and barrier options than there are people buying variance swaps for portfolio insurance."

Another way hedge funds are looking to optimise their portfolio hedges is by using sector indexes. So, rather than buy out-of-the-money put options on the Dow Jones Eurostoxx 50 index, a hedge fund manager might express a view that much of the sell-off will be focused in financial stocks by buying a put on the Eurostoxx Banks index. "If you are running a long/short equity fund, your best skill set should be your ability to pick stocks, which by definition means you are looking at something that does not follow the index. To then hedge a portfolio you always believed was going to outperform the index with the index itself is an obvious mismatch," says Bear Stearns' Josephson.

While this is not necessarily a cheaper alternative, activity in options on sector indexes has increased remarkably since August, as hedge funds look to tailor hedges to their portfolios. "Hedge funds are definitely trying to hedge their exposures more precisely. In the past six months, we have seen a huge uptick in demand for mid-cap protection through, for example, the FTSE 250 index, while people are also increasingly using options on sector indexes rather than global indexes," says Fowler. "When investors short the Dow Jones Eurostoxx 50 index, they don't just short financials; they also short strong industrial or utility companies, which have good cashflows they don't necessarily want to short. Using sector indexes allows them to get away from the fairly low correlation of the Eurostoxx index to more specifically hedge their protection."

Dexia Asset Management, which runs several market-neutral long/short equity funds, is one of the funds to significantly increase its use of sector-specific hedges since volatility picked up in August. "When volatility and dispersion increase, global indexes offer a less efficient hedge than sector-specific indexes. Therefore, we adjust the hedges on our portfolio by referencing sector indexes as volatility increases and use global indexes when volatility is low. In 2006, about 60% of our hedges referenced major indexes, such as the Dow Jones Eurostoxx 50 and the FTSE 100. Today, that's only 15%," says Fabrice Cuchet, global head of alternative investments at Dexia Asset Management in Paris.

Continued uncertainty in the direction of equity markets means portfolio insurance will remain a key theme over the coming months. And, with the cost of out-of-the-money index puts still at prohibitively high levels, cost-reduction strategies are likely to play a big part in any portfolio hedge. "Investors don't place a lot of emphasis when market conditions are good and risk aversion is low," says Edwards of RBS. "It is only really after periods of turbulence when volatility, correlation and skew are high and puts are at their most expensive that hedging becomes popular."

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