Hedge me up before you go, go

IFR 1953 29 September to 5 October 2012
6 min read

It’s been a miserable week. All the positive mood which St Mario created in the markets has leaked away by dint of the politicians who forever seem to forget who employs them and for what.

In the depth of the mid-week gloom, I wrote a piece which recalled how darned difficult it can be to hedge in fast-moving markets. As a result, there came bouncing back a number of wonderful anecdotes and memories of how hedging can be as much a matter of luck as it is of skill.

The most delightful came from Marc Philips, known as “Pit Pony” (he’s rather short and very Welsh), a former emerging markets debt trader who in his time was proposed in IFR to be the worst dressed man in the City. Referring to a certain “Gail” who used to run emerging markets trading for a chap called “Alex”, he recalled the following exchange:

Gail: “Marc, are you aware of Alex’s instructions to hedge our interest rate exposure in the back book?”

Marc: “Yes I am … I’m the designated trader for that book. All trades need to be reported to me.”

Gail: “Well, I’ve just bought some Argie FRBs for that book … so hedge them.”

Marc: “FRBs … as in floating-rate bonds, Gail?”

Gail: “Yes … so can you hedge them?”

Marc: “But I’ve no need to … everything in the book was fixed, which we’ve swapped to floating. This is a floater already.”

Gail: “Marc, Alex told you to hedge them … so please do so.”

Marc: “So, whilst everything else in the book is floating, you want me to switch these Argies from floating to fixed … correct?”

Gail: “Marc … I’m not going to argue with you about this … follow Alex’s instructions and DO it.”

I suspect that there are plenty out there who will recognise the Alex and Gail in question and who will find a wry smile overcoming them.

THAT WAS FOLLOWED by a note from Scott Fong, now head of UK sales at the happy house of Natixis and a veteran of more Japanese firms than there are left in the London market now. He came through with this (possibly apocryphal) story.

Japanese boss: “I see you are over your limits (notional US$50m) … please explain why.”

Trader: “Oh that’s easy, Kobayashi-san. I’m long US$25m ABC bonds but short US$25m UST five-years as my hedge.”

Japanese boss: “Hedge? Why you buy bond if you think price will go down?”

HEDGES ARE WONDERFUL things which go some way towards mitigating risk but which can never immunise against it. The recurring joke is that the only perfect hedge is to be found in a Japanese garden, which is witty, but the other old chestnut that the only perfect hedge is a flat book is truer than many would believe. Any other form of hedge is imperfect.

Whether a hedge is created by a long and a short in two similar but different securities or whether the hedge is created, as is common in the credit markets, by holding government bonds against the interest rate risk and credit default swaps against the credit risk, or whether equity positions are hedged in index futures or single stock options or guvvie positions in futures, the hedge is imperfect due to the variable volatility of the long and the short.

Whereas the purpose of a hedge should be to reduce the cost of a movement in the market, it always adds a level of basis risk which is never discussed and rarely measured. If it were, one would not see hedges which are calculated to be perfect.

Hedging has become so overly sophisticated that it is now beginning to trip over its own muscles. Markit’s recent move to add three names for which there is no traded CDS to its North American iTraxx Main because it cannot find 100 credits for which CDS is traded and which meet the conditions for inclusion in the index is a case in point.

Add the names to the index, so goes the theory, and CDS will have to be traded in order to permit arbitrage trading between the index and the basket of components. If that is not a case of the tail wagging the dog, what is?

ON THE SUBJECT of CDS, there have been any number of disasters across the credit market where fairly innocent-looking negative basis trades have gone massively awry as the difference in the liquidity between the cash security and the derivative hedging tool have whip-sawed supposedly hedged holders.

I speak to a reinsurer who seems to spend half his life trying to explain to his own bosses that the hedge isn’t perfect but that an index hedge may prove to be more effective than a single credit CDS hedge as the higher liquidity of the index reduces the basis risk. He’s banging his head against a brick wall – or so it appears to him.

Hedging is evidently mainly understood by those who practice it and to a much lesser extent by those who preach it. It’s much harder to do than to decree.

Sadly, even in 2012, there are still too many bosses who think like our friend, Kobayashi-san.