Hedge Design: A Systematic Approach

Abstract

Equity derivatives offer fund managers a great deal of flexibility in managing the risk of a portfolio and shaping the overall future return distribution. It can, however, be difficult for fund managers to decide on an appropriate protection strategy, both in terms of the proportion of equity to hedge and the specific instruments to be used. A simulation and optimization platform has been developed at Peregrine Securities that allows the hedge decision problem to be approached via optimization so that a portfolio consistent with the risk and return preferences of the fund manager can be found.We motivate the need for such a report and describe the suggested process for finding an optimal allocation. Furthermore, representative sections from the hedge decision report are shown to highlight the factors that need to be considered. We also discuss an interesting and useful extension to the platform that enables the analysis of portfolios relative to a benchmark. In addition to relative returns, we are also able to incorporate information about the current value of the portfolio relative to the benchmark in the hedging decision process through an analysis of the funding level.