A frequent comment we hear from our clients and the industry is that “We are in the hedging business and not the trading business; once we hedge, we leave those hedges alone”. What I would like to contemplate are the following questions in broad terms:
- If I restructure hedges, am I trading or optimizing?
- “Set it and forget it” is a decision – is it optimal?
- Can we do better through objective data-informed decision making such that we raise the expected value of our enterprise?
Let’s start with the first two on the list above using everyday examples.
Suppose we bought a $30k car in 2015, which depreciated to $15k in Jan 2020. With Covid and supply chain issues, the price appreciated to $25k in Dec 2022. A new car is still selling near its MSRP at $32k. We could do nothing. Or we could sell our used car at $25k (locking in that gain), buy a new car at $32k, and be confident that if markets return to normal, we have a newer car, have crystallized our gains, and very likely have increased our portfolio value (for a small premium paid – the difference between the old and new car).
Another example comes from air travel. Suppose I, as a student, have a flight to Europe on June 15th. However, the airline overbooked for summer travel, and offers me two sweeteners if I take the next flight out – that this trip is now free, and that I have $500 in cash for a future trip. I could turn down the offer for no gain. Or I could take up the airline offer in which case I have increased my personal portfolio value (for a small premium – the inconvenience of going on a later flight and the wasted time).
The last example I’ll share is from housing. Let’s pretend we wanted to buy a house in 2022-2023 but found that renting was 50% cheaper. We could just buy the house since that is our goal. Or we could rent for a few years, knowing that at some point, the buying vs renting gap will close and we can buy the house then (premium – inconvenience).
In each case above, we can be “static,” or we can optimize our decision in a manner that increases our expected portfolio value. As we observed above, the static decision is sub-optimal in each case unless we have additional constraints, such as:
- No money to pay the difference between the new car and the inflated value of the used car
- No flexibility in travel since we could be going for a wedding, or have inflexible onward plans
- Money is not an issue and we have found our dream house
Getting back to hedging. We can decide that restructuring of hedges is off the table (“set it and forget it”) or that hedges can be thoughtfully reconstructed. While we are not adding risk, we could open additional upside and/or increase our downside protection, while increasing the expected value of our enterprise. As we saw in the everyday examples, the static solution is sub-optimal, unless there are additional constraints.
However, if we did decide to restructure our derivative portfolio, how do we accomplish that in a data-informed objective manner?
Mobius Hedge Strategy in Action
Consider a client who executed a collar strategy because they correctly felt there was upside in the market. Fast forward a few months and prices are significantly higher than when the collar was initiated. Not doing anything (“Set it and forget it”) is a higher risk decision, since prices could easily drop down to where they were earlier, leading to a sub-optimal outcome. A simple restructuring could be to convert it to a swap at these higher prices for a small premium outlay, but which locks in these higher prices. What needs to be determined is the cost/benefit of this restructuring – the premium paid relative to the incremental price achieved.
The premium paid frequently leads to pushback. Going back to our everyday examples: we don’t shy from paying a “fare lock” to lock in attractive air fares and we often pay an “option” to lock in the purchase of a house we like. Should we hesitate to pay a small premium to lock in attractive hedges or restructure existing hedges into better ones?
The key is evaluating the attractiveness of this restructuring, which depends on an objective determination of whether price, volatility and skew are cheap or expensive, and its impact on portfolio risk. This is precisely where Mobius excels – helping our clients reach data-informed knowledge-based risk management decisions efficiently, consistent with client objectives and capital plans, while maintaining the client’s risk-reductive strategy.
