SG Tail Risk Hedges

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Macro Commodities Forex Rates Equity Credit Derivatives

Feb 17, 2011

Credit

Special Topic

www.sgresearch.com

The Art of Hedging A primer on the hedging of tail risk

Head of US Credit Strategy

Stephen Antczak, CFA

(1) 212 278 7803 [email protected]

Credit Strategist

Jung Lee (1) 212 278 6672

[email protected]

Who (should use hedges)? Once the domain of risk managers and fringe thinkers on

trading desks, far more are now wary of tail risk in the wake of the recent financial crisis. In

fact, Google “tail risk” and one will receive over 45 million hits! (And there were only about 20

million hits when we started this article a few weeks ago!) In our view, it is important for all

investors to be mindful of the potential for a severe and unexpected drop in valuations.

What (are they)? In some ways tail risk hedges can be thought of as insurance policies.

That said, almost all hedges tend to have some risks that a traditional insurance policy may

not have, such as correlation, liquidity, and mark-to-market risks.

Where (to implement)? In our experience there is no single best hedge, but efficient

hedging vehicles can be found in most market segments. The optimal one depends on both

investor-specific factors (e.g., constraints, market expectations, etc.) and hedge-specific

factors (e.g., cost, correlation, etc.).

When (does hedging make sense)? In theory, tail risk is a negative event that happens

infrequently – the once in a lifetime flood, so to speak. But in reality tail events seem to occur

far more frequently than in theory. In this article we discuss why this might be the case.

How (to pay for them)? We outline two general approaches: unfunded and funded

hedges. An unfunded hedge is comparable in many ways to the purchase of an insurance

policy. A funded hedge uses long exposure in one market to pay for short positions that may

be more vulnerable to a tail event.

Bubbles can be beautiful...until POP!

Source: SG Cross Asset Research, Getty Images

The Art of Hedging

Feb 17, 2011 2

Table of Contents

Introduction ............................................................................................... 3

Step-by-step guide to hedging ............................................................................................ 4

Part 1: The Need to Hedge... ...................................................................... 5

How often do tail events occur? .......................................................................................... 5

Why the difference between theory and reality? ................................................................. 5

Part 2: Overview of Select Tail Risks.......................................................... 8

Risk #1: Stock market downturn .......................................................................................... 8

Risk #2: Sovereign credit risk .............................................................................................. 9

Risk #3: Economic downturn ............................................................................................. 10

Part 3: Generic Challenges Facing Hedgers............................................. 11

Challenge #1: Correlation ................................................................................................... 11

Challenge #2: Cost ............................................................................................................. 13

Challenge #3: Slippage ....................................................................................................... 13

Challenge #4: Reliance on history ..................................................................................... 15

Part 4: Unfunded Hedges (i.e., Insurance) ................................................ 16

Just pay the premium ......................................................................................................... 16

Assessing the effectiveness of various hedging vehicles ................................................. 16

Part 5: Funded Hedges (i.e., Alpha Trades) .............................................. 20

Searching for an asymmetric payoff profile... ................................................................... 20

Risk #1: Sovereign fiscal imbalances ................................................................................ 22

Risk #2: Economic downturn ............................................................................................. 25

Part 6: Trade-Specific Risks .................................................................... 28

Part 7: A “Live” Just-in-Case Hedge ........................................................ 30

Long VIX + long HY + limited defaults = asymmetric profile ............................................ 30

Summary ................................................................................................. 32

The Art of Hedging

Feb 17, 2011 3

Introduction

A brief overview

The recent financial crisis has created an increased focus on “tail risk.” Once the domain of

risk managers and fringe thinkers on trading desks, it has become a common phrase amongst

the lexicon on trading floors. And for that matter, it is a common phrase even away from

trading floors — Google “tail risk” and one receives over 45 million hits! (And there were only

about 20 million hits when we started this article a few weeks ago!) A number of hedge funds

have recently been created solely to take advantage of tail risk (e.g., Bloomberg article titled

“PIMCO sells black swan protection as Wall Street markets fear” on July 20, 2010).

In this article, we first discuss why tail events seem to occur with such regularity (by some

definitions eight times in the last twenty years!). We find that one or all of three characteristics

(leverage, transient funding, and the influence of “non-economic” objectives and constraints

on investment decisions) are associated with many, if not most, tail events. We also provide

some background on three specific tail risks (sharp decline in equities, public sector fiscal

imbalances, and an economic downturn).

With regard to constructing hedges we next highlight four key challenges that most

hedges face: (1) correlation between the portfolio being protected and the hedge vehicle, (2)

cost, (3) the potential for slippage, and (4) the reliance on historical relationships, as these

relationships can be transitory over time.

We then consider two very broadly defined hedging strategies — unfunded and funded

approaches — and note that both types typically face the challenges highlighted above. We

define unfunded hedges as those for which an investor is willing to dedicate a certain amount

of capital to protect his or her portfolio. In some respects, unfunded strategies are comparable

to insurance policies.

Funded strategies tend to be utilized by market participants who are unable or unwilling to pay

the cost of insurance outright. They nonetheless require a hedge, and therefore want (or need)

to go long an asset to pay for insurance. Funded hedges tend to become more popular

when the catalyst for a market setback is difficult to predict, as performance can lag if a

premium is continuously being paid to protect against an event that does not occur.

We then assess the effectiveness of various unfunded strategies in the context of the first risk

introduced above (decline in the S&P) and various funded packages in the contexts of the

second (sovereign credit event) and third risks (economic downturn). We also discuss a

funded trade package that may be attractive in the current environment.

Lastly, we discuss trade-specific hedge risks, such as counterparty risk. We find that

funded hedges can be more risky than unfunded approaches, in large part because they have

more “moving” parts, but they are not necessarily less effective.

We would like to thank Sandeep Mody, a trader on our high-grade desk, for his

comments and insights with regard to hedging tail risk.

The Art of Hedging

Feb 17, 2011 4

Step-by-step guide to hedging

In our view, there is no perfect hedging vehicle or approach, but we do believe that a checklist

can be fairly useful when constructing one.

Step #1: To hedge or not?

A credit portfolio manager sees a high likelihood of a tail event occurring. Does this mean that

he should necessarily hedge? Perhaps, but not necessarily, as there are a number of factors

that could warrant not hedging. Suppose that this portfolio manager handles 25% of an

endowment’s capital. What happens if the endowment also expects a tail event and shifts the

75% of funds that are not handled by this credit manager into cash? If the credit manager also

hedges, the endowment may very well be overhedged. Or what if the portfolio manager

anticipates a sharp pickup in defaults, but comes to this conclusion after the consensus

does? It may already be priced in (Chart 1).

Step #2: Decide what to hedge

Even if an investor decides that it is worthwhile to hedge, it is almost as important, in our view,

to understand exactly what is to be hedged. One type of tail event (e.g., sovereign default)

could require a very different type of hedge than another (e.g., BP oil spill).

Step #3: Identify challenges to watch out for

There are a number of challenges that could have some influence on the efficiency of virtually

all hedge vehicles. These include the correlation between the hedging vehicle and the asset

being hedged, the cost of the hedge, the potential for slippage between the hedged asset and

the hedge itself, and the reliance on historical data to anticipate potential future performance.

Step #4: To fund or not?

Given that hedges are in some ways comparable to insurance policies, an important choice

must be made with regard to how to pay the premium. One could simply dedicate a certain

amount of capital to pay for insurance and “write off” the premium. The downside, though, is

that it is quite possible to underperform benchmarks or competitors if a tail event does not

occur. Conversely, one could fund the hedge by going long an asset that is less sensitive to a

tail event than the hedge, but there is a trade-off as new risk factors can be introduced.

Step #5: Crafting an efficient hedge

Finding an efficient hedge to a large extent involves balancing the payoff potential in the event

of a tail scenario with challenges such as cost. In addition, one can often use scenario

analysis to identify downside risk with which one is comfortable.

Step #6: Identify trade-specific risks

While we identified four generic challenges that can influence the typical hedge, there can be

a number of trade-specific risks that are important to consider as well. For example, some

hedges may have significant counterparty risk, liquidity can be far more of a factor for some

hedges than others, etc.

Chart 1: U.S. spec-grade default

rate vs. high-yield index spread

0%

3%

6%

9%

12%

15%

0 bp

500 bp

1000 bp

1500 bp

2000 bp

2500 bp

'96 '99 '01 '04 '06 '09

HY Index (LHS)HY Default Rate (RHS)

Source: SG Cross Asset Research,

Bloomberg, Moody’s

Note: As of January 31, 2011

default rates are LTM

The Art of Hedging

Feb 17, 2011 5

Part 1: The Need to Hedge...

How often do tail events occur?

In theory, tail risk should happen infrequently — the once in a lifetime storm, so to speak – but

reality may be a bit different than theory in terms of the frequency of tail events. In Figure 1 we

present a sample of some catalysts for major downturns over the last twenty years. Figure 1

shows that we have seen catalysts for major downward moves fairly frequently – essentially

every three years or so.

Figure 1: “Tail events” can occur on a fairly regular basis

1990 1995 2000 2005 2010

Asian Currency Crisis

Dot-com Bubble

Real Estate Bubble

S&L Crisis

Mexican Peso Crisis

Russian Financial

Crisis

European

Sovereign

Crisis

Fall of LTCM

Source: SG Cross Asset Research

Why the difference between theory and reality? While there is no single reason that can account for what seems to be relatively frequent tail

events, three ingredients do seem to be well represented among most observations — excess

leverage (be it financial, operational, etc.) combined with unstable access to funding and

potentially non-economic investment objectives/constraints. Events ranging from the Russian

default to the U.S. real estate bubble shared some of these characteristics, in our view.

With regard to non-economic objectives and constraints, for a variety of reasons the actions

of many market participants are often influenced by somewhat arbitrary factors that are not

necessarily related to investment efficiency. For example, the performance of many market

participants is measured on a quarterly or annual basis, and as a result they may have limited

capacity to “sit on cash.” Cash inflows into the bond markets were robust in ’10 and even

while many portfolio managers did not see particularly attractive value they did not have the

option of holding high cash balances. In essence, some investors had to buy. But in our

experience valuations supported by “reluctant participants” can be susceptible should

volatility or uncertainty edge higher. These investors can look to re-deploy capital to their

respective comfort zones quickly.

The factor detailed above go hand in hand with the market’s tendency to be lulled by

incremental movements, in our view. That is, if one has to put money to work, is investing in

an LBO with 4.5 turns of leverage really all that different from one with 4 turns? Is 5 turns really

all that different from 4.5 turns? The problem is that over time the investment community

can find itself a long, long way from shore, so to speak. Is 8.5 turns really all that

different from 8 turns? No, but it is very different from 4 turns…

The Art of Hedging

Feb 17, 2011 6

Lastly, the financing of assets is not necessarily done on a matched-maturity basis. If funding

becomes more difficult, forced selling can very well ensue and snowball out of control.

Mismatched funding can take many paths to influence valuations (ex: hedge fund withdrawals,

heightened collateral requirements, etc.).

These characteristics (incrementalism, reluctant participation, and mismatched funding) were

well exhibited in the recent housing market crisis. With regard to leverage, Chart 2 shows that

the amount of lower-quality mortgage supply that was originated over the past decade grew

gradually, but that over time growth became extreme relative to the original starting point. In

the ’01 and ’02 period Alt-A supply (note that in terms of quality Alt-A is one notch above

subprime) was averaging about $2.0 bn per month. This number continually edged higher in

the following years — on average $4.4 bn in ’03 and $6.1 bn in ’04. This was still manageable,

but before long the average monthly supply was $15 bn!

And leverage can come in many forms. The robust amount of low-quality mortgage bonds

issued was not the only source of housing market leverage in the last decade. If we define

leverage as loss exposure to a change in “underlying” valuations (house prices, in this

example), then the structured product market boosted leverage in the system severely as well.

Consider common structures back then (Figure 2). Essentially, a pool of lower-quality

mortgage loans was used to create an asset-backed security, and the mezzanine “slice” of

this bond was used to create another, more levered bond (ABS CDO). And then a slice of

mezzanine debt from the ABS CDO was used to create another security (CDO-squared), of

which the net effect was an even smaller equity base supporting an even larger debt amount.

So where did we end up? To put the resulting leverage into perspective, in order to wipe out

the entire CDO-squared – all the way through the triple-A tranche – the default rate would only

have to hit a 13.4% pace (assuming a 50% recovery and significant overcollateralization).

Note that the percentage of seriously delinquent subprime loans is 27.7% as of 3Q ’10,

according to Bloomberg (“seriously delinquent” percentage is defined as the non-seasonally

adjusted rate of loans that are 90 or more days delinquent or in the process of foreclosure).

Figure 2: How did we get here? Little by little…

AAA

AA

A

BBB

BB, NR

Subprime

Mortgage

Loans

Borrower Credit

Borr

ower

Dow

n Pa

ymen

t

Good Bad

Hig

h

L

ow

Senior AAA

Junior AAA

AA

A

BBB

NR

Senior AAA

Junior AAA

AA

A

BBB

NR

ABS

Mezz ABS CDO

CDO2


Chart 2: Monthly Alt-A mortgage

supply, 2001-07

$ bn

$7 bn

$14 bn

$21 bn

$28 bn

'01 '02 '03 '04 '05 '06 '07

Source: SG Cross Asset Research, Bloomberg

The Art of Hedging

Feb 17, 2011 7

And at the same time, the number of “reluctant participants” may have been rising as well – by

many metrics valuations were quite full – which may have left prices in the mortgage market

particularly susceptible to any rise in volatility or uncertainty. With regard to transitory funding,

Chart 3 shows total assets in money market funds relative to the total return performance of a

broad portfolio of mortgage bonds. When volatility edged higher investors increasingly looked

to “park” in cash, and valuations of mortgage bonds had little support and declined soon

after.

Chart 3: Total assets in the money market funds vs. the VIX and a portfolio of mortgage bonds

$1.0 bn

$1.5 bn

$2.0 bn

$2.5 bn

$3.0 bn

$3.5 bn

$4.0 bn

-20

-10

0

10

20

30

40

50

2002 2003 2004 2005 2006 2007 2008 2009 2010

VIX (LHS) ABS TR % (LHS) Money Market Funds Cash (RHS)


Note: As of 4Q 10; returns are last 4-quarter rolling average

Key takeaway

There has been an increased focus on tail events, in part because they appear to arise more

frequently than expected. We believe that to a large extent this is a function of three factors.

First, market participants’ actions may be influenced by factors not necessarily related to

investment efficiency, and can “force” investors to take actions unwillingly. Valuations

supported by such “reluctant participants” can be susceptible to any increase in volatility or

uncertainty. Second, investors have a tendency to move incrementally, and over time the risk

profile of a particular asset class or market segment can increase dramatically and

“unnoticed.” Third, financing can often be mismatched relative to the assets being supported.

As such, we believe that it is important for investors to always be mindful of the potential for

an unexpected drop in valuations as well as ways to protect against possible declines.

The Art of Hedging

Feb 17, 2011 8

Part 2: Overview of Select Tail Risks

History suggests there may be an innumerable number of tail risk possibilities – Tulip mania?

South Sea? Silver? Internet? Housing? In our view, it is very difficult to identify bubbles, much

less predict when one may burst. However, this does not mean that potential bubbles

cannot be effectively hedged, in our opinion.

The goal of this article is to provide a framework for hedging tail risk, and in this regard we

“model” three specific risks to be hedged: (1) a severe stock market downturn, (2) a sovereign

credit event, and (3) an economic downturn. Below we provide an overview of these tail

events.

Risk #1: Stock market downturn

Many investors, whether they are equity market investors or not, are very cognizant of the

performance of the stock market. Because of the depth and breadth of the investor base in

this space and the relative liquidity of the stock market, many believe that the equities are an

important barometer of risk appetites across all markets. If valuations in the broader stock

market encounter pressure, then valuations may well be pressured in other markets as well.

And meaningful declines in the stock market (defined as the S&P 500) are not all that

infrequent. Over the past 25 years and based on monthly data, for example, the S&P 500 has

experienced two-standard deviation declines 12 times and three-standard deviation declines

3 times (Chart 4).

In addition, the equity market tends to be correlated with (or even lead) various economic

metrics. For example, in Chart 5 we overlay historical S&P 500 index levels with corporate

profits and we see two very similar trends. As such, one could expect a decline in the equity

valuations at times of or in periods leading up to economic downturns, and a softer economic

backdrop could very well have implications for other markets.

Key point: Hedging potential equity market tail events can be important for investors in

virtually all asset classes.

Chart 4: The S&P 500 has incurred price declines that

exceeded 2-standard deviations 12 times in the past 25 years

Chart 5: S&P 500 tends to mirror select economic metrics fairly

closely

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

'85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09

1-SD 2-SD 3-SD

$0. tn

$0.2 tn

$0.4 tn

$0.6 tn

$0.8 tn

$1. tn

$1.2 tn

$1.4 tn

$1.6 tn

$1.8 tn

0

200

400

600

800

1000

1200

1400

1600

1800

'81 '83 '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11

Corp Profit (RHS) S&P 500 (LHS)


Note As of December 31, 2010; monthly change since 1985


Note: As of January 31, 2011 for SPX, 3Q 10 for corporate profits; corporate profits include

inventory valuation adjustments and capital consumption adjustments, SAAR

The Art of Hedging

Feb 17, 2011 9

Risk #2: Sovereign credit risk

While the fear of a sovereign default has certainly waned in recent trading, public sector fiscal

imbalances within many developed countries have increased since the most recent financial

crisis, and some worry that the problem could once again become a market focal point and

weigh on valuations. To illustrate the magnitude of the problem, Chart 6 shows how drastically

the gross debt outstanding for the U.S. and Portugal has risen since the pre-crisis period. It is

worth noting that many public sector entities fit a similar profile.

And history suggests that any public sector credit event could have a meaningful spillover

effect on valuations elsewhere. For example, when sovereign fears spiked in the spring of ’10,

spread levels for many European financials jumped as there was worry that their sovereign

exposure would require meaningful asset writedowns. Even more distant markets, such as the

U.S. high-yield market and the S&P 500, were pressured considerably (Chart 7).

With regard to the likelihood that a sovereign credit event could be a source of tail risk looking

forward, at current levels it appears that the market is still pricing in a fairly high chance.

Greece, Portugal, Ireland, Spain, or Italy CDS spread levels, for example, suggest that there

may be a 50%+ chance that at least one of them experiences a credit event over the next year

(Table 1). For reference, several years ago the chance was almost nonexistent. (Note:

calculations are based on one-year CDS spreads, a 70% recovery rate, and the assumption

that spread premiums are entirely compensation for credit risk; data limitations prevent us

from making an accurate excess spread estimate.)

Key point: In effect, the market is saying that the potential for a sovereign credit event has

lessened relative to previous levels, but it has certainly not gone away and a hedge may be

warranted.

Chart 7: Sovereign fears had a significant spillover effect into

other assets / markets

Table 1: The chance that at least one of these sovereigns will

experience a credit event is currently north of 50%

-20%

0%

20%

40%

60%

80%

100%

120%

1-Apr 15-Apr 29-Apr 13-May 27-May 10-Jun 24-Jun 8-Jul 22-Jul

iTraxx SovX WE iTraxx Sub-Fin CDX.HY S&P 500

Jan 1, 2007

Feb 7, 2011

Default

Prob

Change Issuer Default

Prob

1Y CDS

Sprd

Default

Prob

Greece 0.1% 974 bp 32.5% +29.4%

Ireland 0.0% 598 bp 19.9% +16.3%

Portugal 0.1% 293 bp 9.8% +8.6%

Spain 0.0% 176 bp 5.9% +4.6%

Italy 0.1% 87 bp 2.9% +1.8%

Prob of 1+

credit event 0.3%

55.4%

+45.7%

Source: SG Cross Asset Research, Bloomberg, Markit

Note: Indexed to April 1, 2010


Note: We assume 70% recovery rate.

Chart 6: Public sector fiscal

imbalances have increased

dramatically in recent years

3

5

7

9

11

13

15

40

60

80

100

120

140

160

'96 '98 '00 '02 '04 '06 '08 '10

Portug (LHS)

US (RHS)€ bn $ tn


Note: gross debt level

The Art of Hedging

Feb 17, 2011 10

Risk #3: Economic downturn

Most asset classes are, at least to some extent, influenced by the broad economic backdrop.

For example, one key metric of the economic environment is consumer confidence, and Chart

8 shows that there is a fairly high correlation between this economic metric and equity market

performance.

But there are many different components of the overall economic background, and as a result

hedging an unexpected “downturn” can be challenging. For example, Chart 9 shows retail

sales (ex auto) and corporate profits – two very important components of the broader

economy with the potential to significantly influence corporate valuations - have been doing

very different things in recent quarters. Specifically, during the March ’09 to September ’10

period retail sales growth remained essentially flat, while corporate profits growth was up

44%. Is the economic backdrop good or bad?

Key point: Hedging economic tail risk can be important, but can also be very challenging for a

variety of reasons. These include the number of different economic metrics as well as the

sensitivity of various asset valuations to these economic sub-components.

Chart 8: S&P 500 vs. consumer confidence,

1993 - current

Chart 9: Changes in corporate profits and retail

sales (ex auto) since Q1 ’09

0

20

40

60

80

100

120

140

160

200

400

600

800

1000

1200

1400

1600

1800

'93 '94 '95 '97 '98 '99 '01 '02 '03 '05 '06 '07 '09 '10

S&P 500 (LHS) Cons Conf (RHS)

0%

10%

20%

30%

40%

50%

Q1 09 Q2 09 Q3 09 Q4 09 Q1 10 Q2 10 Q3 10

Corporate Profits Reail ex Auto




The Art of Hedging

Feb 17, 2011 11

Part 3: Generic Challenges Facing Hedgers

As noted earlier, there is no perfect hedge. Before attempting to craft an “efficient” hedge for

the three tail risks identified in the previous section we first want to discuss several challenges

that one must often face, in our view. In this section we discuss four: (1) the correlation

between the portfolio being protected and the hedge vehicle, (2) cost, (3) the potential for

slippage, and (4) the reliance on historical relationships, as these relationships can be

transitory over time.

Challenge #1: Correlation

The first challenge that we focus on is correlation, or the chance that the portfolio being

hedged and the hedging vehicle itself do not move in the same direction and / or by the same

magnitude as expected. Said differently, imagine purchasing an insurance policy to protect

against some event, but the payment received when (and if) the event actually occurred was

meaningfully different than the actual loss incurred.

To better put this risk into perspective we consider how specific hedging vehicles have

performed historically relative to equity market selloffs (we acknowledge the narrow definition

of risk). In particular, Rebecca Cheong from the SG GEF Financial Engineering and Advisory

group examined price changes for the S&P 500 and the Russell 2000 stock indexes over the

past 30 years relative to a variety of hedging tools, such as the 10-year Treasury and spot

gold (Table 2).

The observations in Table 2 represent periods in which either S&P 500 or Russell 2000

valuations (or both) declined by 20% or more. Movements of the various hedging tools

presented in this table are considered to be at least partially successful if their values changed

by 10% or more (and move in the right direction!).

Table 2: Performance of various hedging vehicles over the past 30 years

Risk Assets (%)

Typical Tail Hedge Instruments (%)

Period

S&P 500 Rus 2000

Gold Dollar

(DXY) 10Y Trsy VIX CDX.IG

Feb-80 Mar-80 -17 -27

-32 12 -14 47

Jun-81 Sep-81 -16 -23

-13 3 -4 47

Oct-87 Nov-87 -31 -39

4 -8 10 332

Jul-90 Oct-90 -20 -30

10 -9 -3 111

Apr-98 Oct-98 -15 -37

-5 -9 8 130 246

Mar-00 Apr-00 -4 -25

-8 6 3 74 38

Jan-01 Apr-01 -20 -17

9 6 2 58 14

Jul-01 Sep-01 -22 -26

8 -6 6 127 23

Mar-02 Jul-02 -32 -28

4 -7 8 148 48

Aug-02 Oct-02 -19 -20

-12 -2 4 52 22

Oct-07 Mar-08 -17 -21

31 -9 11 85 240

Aug-08 Mar-09 -48 -54

22 17 9 164 75

Apr-10 Jul-10 -16 -20

7 6 6 93 54

Average

2 0 4 113 84

% of Times Up

62 46 77 100 100


The Art of Hedging

Feb 17, 2011 12

This study provides three noteworthy points, in our view:

1) Positive performance is not a given: Of the thirteen times that the stock market declined

20% or more over the past 30 years, we see that there are many instances in which

various hedging tools did not even move in the “right” direction. For example, while gold

can be a beneficiary of a “flight-to-quality” bid during times of turmoil, it nonetheless

would not have been an efficient hedge against a decline in equity prices. Spot gold

experienced only three observations of “material” movement in the correct direction. And

the changes in the value of dollar was essentially a coin flip during times of significant

negative changes in equity valuations — up 46% of the time, down 54%.

Side note: What makes the VIX and CDX.IG indexes special?

The VIX and the CDX.IG indexes may have many special features, but two that really stand out

are the tendency of these vehicles to gap, and for such gaps to be in the “right” direction (i.e.,

asymmetric payoff profile). With regard to the tendency to gap, we examined how many times

the value of the S&P 500 (for reference), VIX, and CDX.IG indexes rose or fell by more than

25% of their respective one-year rolling averages (Charts 10-12). By this metric, we see that

extreme observations for the S&P 500 are fairly infrequent (4%), particularly when compared

to the VIX (28%) or CDX.IG (43%). Note that we have a longer time series for the S&P 500 and

the VIX than for CDX.IG.

With regard to asymmetry, we looked at the percent changes for the VIX index and CDX.IG

spread over two-week holding periods. We focused on only those observations that moved by

15% or more (Table 3). For the VIX index we find that the number of times since ’97 that the

level increased by 15% or more in a two-week period significantly outnumbers the number of

times the level declined by 15% or more (459 vs. 337, respectively). We find a similar trend for

CDX.IG (71 times for spread tightening by 15% or more vs. 156 times spread widening by

15% or more) using data going back to late ’04.

Key point: A tendency to exhibit large and asymmetric movements are important

characteristics of any hedging vehicle.

Chart 10: S&P 500 – few observations

that are more than 25% from 1-year

rolling average

Chart 11: VIX – many observations that

are more than 25% from 1-year rolling

average

Chart 12: CDX.IG – many observations

that are more than 25% from 1-year

rolling average

600

800

1000

1200

1400

1600

'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10

1-yr Rolling Avg 1Y Roll Avg ± 25%+

0

20

40

60

80

100

'97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10


0 bp

50 bp

100 bp

150 bp

200 bp

250 bp

300 bp

'05 '06 '07 '08 '09 '10


Source: SG Cross Asset Research;

Note: As of February 10, 2011





Table 3: Asymmetry! “Large”

moves by the VIX or CDX.IG

(spread) tend to be higher, not

lower

2-week Change VIX CDX.IG

-15% or more 337 71

+15% or more 459 146

Ratio 2.1 1.4


Note: CDX.IG data since Nov ’04; VIX data

since Jan ’97; 2-week changes

The Art of Hedging

Feb 17, 2011 13

2) How about magnitude? Even if the direction of movements between a portfolio being

hedged and the hedge itself is highly connected, differences in the magnitude of

movements can limit effectiveness as well. For example, Treasuries tend to benefit from a

flight-to-quality during periods of severe stress; Table 2 (p. 11) shows that the 10-year

Treasury moved in the “right” direction 77% of the time. That said, the rise in price of the

10-year seemed fairly modest in comparison to the fall in stock market valuations (e.g., on

average the 10-year Treasury price rose 4% vs. a decline in the S&P 500 of 21%). One

may have to buy an awful lot of Treasuries to hedge, which can present new problems.

3) And the most effective performers are… Solely in the context of correlation we found

the VIX and the CDX.IG indexes to be efficient. In terms of consistency, both vehicles

moved in the “right” direction each time the S&P 500 and/or the Russell indexes

experienced declines of 20% or more, and in terms of magnitude, on average the VIX and

the CDX.IG hedges were “in-the-money” by 113% and 84%, respectively.

Challenge #2: Cost

The second key challenge that hedgers may face is cost; that is, it may not matter how closely

a hedge vehicle tracks the portfolio that one is protecting or by how much the hedge could

move should a tail event occur if the cost is too expensive. Our trading desk notes that purely

in the context of correlation short-tenor, at-the-money S&P 500 puts may be a compelling way

to protect against declines in the S&P 500, but when cost is taken into consideration this

hedging vehicle can be far less efficient.

To get a better sense of the relative cost of various hedging tools, we consider seven typical

vehicles, such as S&P 500 puts and call options on the VIX index, in the context of equity

market tail risk. In Chart 13, we present the cost1 of each of these tools and we see that the

range is very, very dramatic. For example, the cost of options can be fairly high (e.g., S&P 500

put), while the cost of others tends to be more modest (e.g., CDX.IG). Some hedges actually

pay investors to hedge (e.g., Treasuries). Note that in terms of hedge ratio we risk-weight each

of the tools in Chart 13.

Challenge #3: Slippage

The relationship between the S&P 500 and various hedging vehicles may very well exhibit a

high correlation most of the time, and the cost may be fairly low as well. But does this mean

that it is an efficient hedge? Not necessarily...

Another key factor to consider is the potential for infrequent but meaningful “slippage.” To

illustrate, suppose that an investor used the high-yield index to protect against a sharp decline

in equities. One reason for this decision was the relative cheapness of the hedge. Suppose an

investor implemented this hedge on January 2, 2009. Over the following year the S&P 500

rallied about 20%, so ideally the high-yield market would have rallied by the same

amount or less.

1 We assume a 30-day holding period, and the notional amount of each hedge is weighted so that each exhibits the same risk. We

use theoretical (calculated) prices for options.

Chart 13: Cost of various hedging

tools can be meaningfully

different

-$30,000

-$20,000

-$10,000

$0

$10,000

$20,000

$30,000

$40,000



The Art of Hedging

Feb 17, 2011 14

But it didn’t! A “unique” event occurred and the high-yield market benefited from a return of

liquidity to the marketplace and many issuers were able to refinance their upcoming

maturities. As a result, the probability of default for the typical high-yield company tumbled

drastically (Chart 14) and the total return of the high-yield space was 56% in ’09. As such, our

investor’s portfolio gains would have been wiped out and she would have actually incurred a

loss of 36% (S&P +20% – HY +56% = -36%, assuming a notional hedge ratio; Chart 15).

Chart 14: Default rate for the typical high-yield

company tumbled in 2009

Chart 15: Hedging the S&P 500 with the high-

yield market in ’09 could have resulted in a loss

of 36%

0%

2%

4%

6%

8%

10%

12%

14%

16%

'71 '73 '76 '78 '81 '83 '86 '88 '91 '93 '96 '98 '01 '03 '06 '08

-60%

-45%

-30%

-15%

0%

15%

30%

Jan-09 Mar-09 May-09 Jul-09 Sep-09 Nov-09

S&P 500 PR HY Index TR

Source: SG Cross Asset Research, Moody’s



Side note: Cost, correlation, and slippage in the real world

In 2007 volatility across the marketplace was edging higher, signs of an economic slowdown

were emerging, and investors were more and more worried about a potential housing market

bubble, among other concerns. By early 2008 many were increasingly worried about the

exposure of select banks and brokers to these and other problems. To protect against these

risks some investors looked to buy protection in the CDS market on banks and brokers that

they viewed as particularly vulnerable (e.g., Bear Stearns). Suppose that an equity investor

purchased 5-year protection on Bear in early 2008.

Turns out, there were (at least) two problems with this hedge. First, Bear Stearns protection

was fairly expensive — 5-year CDS was trading at about 315 bp in the first trading session of

March ’08, relative to approximately 165 bp for the typical name in the high-grade market. As

such, if challenges in the banking system did not magnify purchasing this “insurance” could

have weighed on performance somewhat.

The second and more significant problem was slippage relative to the S&P 500. Irrespective of

the historical correlation between Bear CDS and the S&P 500, a unique event rendered

correlation somewhat meaningless. Again, suppose that an investor purchased Bear Stearns

CDS at 315 bp in early March. On March 24th, the Federal Reserve deemed Bear Stearns “too

big to fail” and took the unusual approach of encouraging JPMorgan to absorb Bear. A slight

exaggeration, but in effect Bear’s default risk instantly became JPMorgan default risk (far

lower!), and Bear CDS rallied to 186 bp by end of the day. In effect, the hedge would have

ended up costing our investor far more than the amount her S&P 500 position had

rallied.

Chart 16: Bear Stearns vs.

JPMorgan 5-year CDS spreads

0

200

400

600

800

Jan-08 Feb-08 Mar-08

BSC JPMbp


Bloomberg, Markit

Note: Data in Q1 ’08

The Art of Hedging

Feb 17, 2011 15

Challenge #4: Reliance on history

Past performance is not an indicator of future returns, the old saying goes. But history is

often used to determine how a potential hedge vehicle is likely to perform relative to a

particular portfolio. Unfortunately historical relationships can be transient.

To illustrate, in Charts 17 and 18 we present the relationship between the 10-year Treasury

and the S&P 500 during two different periods, 1970-79 and 2001-10. Chart 17 plots these two

assets during the 1970s, and we see that the correlation was -19%; based on this data one

would certainly not expect the 10-year Treasury to be an effective stock market hedging

vehicle. However, the relationship has not been stable over time, and Chart 18 shows the

correlation between these two markets has increased sharply over the past decade. Trend

reversals occur and can be very dangerous.

Chart 17: S&P 500 and 10-year Treasury were

negatively correlated during the 1970s…

Chart 18: …but had a positive correlation over

the past decade

5%

6%

7%

8%

9%

10%

11%

12%

55

65

75

85

95

105

115

125

'70 '71 '72 '73 '74 '75 '76 '77 '78 '79

SPX (LHS) 10Y Trsy (RHS)

1%

2%

3%

4%

5%

6%

600

800

1000

1200

1400

1600

'01 '02 '03 '04 '05 '06 '07 '08 '09 '10

SPX (LHS) 10Y Trsy (RHS)

Source: SG Cross Asset Research, Bloomberg Source: SG Cross Asset Research, Bloomberg

The Art of Hedging

Feb 17, 2011 16

Part 4: Unfunded Hedges (i.e., Insurance)

Just pay the premium

An investor utilizing an unfunded hedging strategy is essentially looking to purchase an

insurance policy. In this section we consider the effectiveness of various unfunded hedging

vehicles in the context of the four challenges introduced in the previous section. We define tail

risk as a sharp decline in the S&P 500; as noted earlier, over the past 25 years the S&P 500

has experienced two-standard deviation declines 12 times and three- standard deviation

declines three times (Chart 19).

Chart 19: The S&P 500 has incurred price declines that exceeded two-standard deviations 12

times in the past 25 years

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

'85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09

1-SD 2-SD 3-SD


Note As of December 31, 2010; monthly change since 1985

Assessing the effectiveness of various hedging vehicles

The seven common hedging vehicles that we evaluate are Treasury, Treasury future, HY

index, CDX. IG, CDX.HY, SPX put, and VIX call hedges. We find that there is no “perfect”

hedge, and a trade-off is required based on a particular investor’s preferences, objectives,

and constraints.

Before beginning, there are four calculation details to note. First, the performance of each

hedging vehicle is based on a base case expectation. In particular, we assume that the most

likely market environment is that the S&P 500 is range-bound (70% chance that returns are

stuck in the -2% to +2% range), but with a meaningful chance (30%) that the S&P 500

falls by up to 15%. Hedge performance is based on these probabilities and magnitudes, and

as we will show later alternative scenarios can change results meaningfully.

Second, in terms of the weighting of each hedge vehicle, notional sizes are determined in

a risk equivalent context. That is, in dollar terms we calculate the P&L range for a $10 mm

investment in the Treasury market in each scenario that we evaluate. We then back out

notional weightings for the other hedge vehicles to generate the same risk profile (P&L range).

The Art of Hedging

Feb 17, 2011 17

Third, the expected P&L for each hedge is based on their betas relative to the S&P 500 since

’05 (daily observations). We calculate four separate betas for each hedging tool – fairly modest

bullish moves in the SPX (gains of less than 7.5%), more extreme bullish moves (SPX gains of

7.5% or more), and we use the same approach to determine betas in bear markets (SPX

declines of up to 7.5% and more than 7.5%). Lastly, the horizon is 30 days.

Key point: For those interested in these modeling templates, please contact us directly.

Finding #1: Payoff profiles can vary dramatically

In Chart 20 we present the P&L for the seven hedges. We find that in absolute dollar terms the

effectiveness of the various hedges varies dramatically — the range of P&Ls was $40k.

By this measure of effectiveness the Treasury market hedge (long cash or futures) was the

best performer, as it earned money in a status quo scenario (coupon clip), but also benefited

from a flight-to-quality in more bearish scenarios. Interestingly, the S&P put comes in the sixth

place, in part because it is fairly expensive. The cash high-yield cash market came in the last

place, in part because it is a fairly expensive hedge and can be driven by factors that can have

less of an impact on equities (e.g., defaults).

Chart 20: P&L for various hedge vehicles in our base case scenario (70% chance of being

range-bound, 30% chance of S&P 500 falling by up to 15%)

$0

$5,000

$10,000

$15,000

$20,000

$25,000

$30,000

$35,000

$40,000

$45,000


Note: As of January 21, 2011; We assume a 30-day holding period, and the notional amount of each hedge is weighted so that each exhibits the

same risk. We use theoretical (calculated) prices for options to calculate the return

Finding #2: But what is success?

But this does not mean that Treasuries are the best hedge per se. That is, a P&L of $42k may

go a long way to offsetting any loss we may incur due to falling equity prices, but remember

that the notional exposure required to generate this return is $10 mm! In comparison, the put

position only requires a notional exposure of $43k. In the context of return on notional

exposure, the put position would outperform dramatically, 33.8% versus 0.4% (Table 4).

Some investors may not have any constraints in terms of how much notional exposure they

can have to a particular position, or how much balance sheet that they can tie up with any

particular trade, etc., but many do face some of these constraints and the best hedge for

these market participants may be something less “capital-intensive.” (We acknowledge that

collateral requirements for Treasuries are modest, but we do not explicitly consider the impact

of leverage in this analysis.)

Table 4: Return on notional

exposure

Asset P&L

($k)

Notional

($k)

Return

(%)

Trsy 42.4 10,000 0.4

T30 Fut 42.3 6,700 0.6

HY Index 2.4 3,800 0.1

CDX.IG 20.8 8,400 0.2

CDX.HY 16.1 2,375 0.7

SPX Put 14.6 43.1 33.8

VIX Call 22.6 69.3 32.6



The Art of Hedging

Feb 17, 2011 18

Finding #3: And our base case could be wrong...

Another important consideration is performance should our base case scenario be incorrect.

Recall that our base case was that a range-bound market was most likely (70%), but that

there was a 30% chance that the S&P declines by up to 15%. How would performance look if

the chance of improved valuations was much higher and stocks rallied instead of falling

sharply?

In Chart 21 we present P&L for our various hedges in an environment in which stocks rally by

5%. Perhaps the most important point here is that the susceptibility to an incorrect market call

is limited for some vehicles, but not for others. For example, the most that the S&P put can

lose is the option premium ($43k; note that this is different from the option cost shown on p.13

which reflects the cost for only the 1-month holding period). Conversely, the high-yield hedge

(cash) loses $64k, in part due to the coupon paid ($22k) but also due to a mark-to-market loss

of $42k. Treasury hedges do well in this scenario, primarily because there is no upfront cost

for the hedge — a coupon is earned with this hedge, not paid.

Chart 21: P&L for various hedge vehicles in a moderately bullish scenario (S&P 500 up 5%)

-$70,000

-$60,000

-$50,000

-$40,000

-$30,000

-$20,000

-$10,000

$0

$10,000


Note: As of January 21, 2011; We assume a 30-day holding period, and the notional amount of each hedge is weighted so that each exhibits the

same risk. We use theoretical (calculated) prices for options to calculate the return

Finding #4: What about slippage?

In the context of some risks the Treasury hedge appears to be particularly effective, but the

tool can be especially vulnerable to others, such as slippage. That is, the historic relationship

between stocks and Treasuries might be fairly strong, but the Treasury market can be far

more sensitive to factors such as monetary policy and inflation expectations than the equity

market. As a result slippage can be dramatic at some points in time.

To illustrate, suppose that an investor bought a 30-year Treasury position to protect against a

potential stock market setback on January 15, 2009. Over the next several months, equities

performed well, but Treasuries sold off far more than their beta (vs. the S&P 500) would

suggest primarily because the bond market began anticipating and pricing in more inflation.

As a result, the hedge would have lost 25% over the next few months, which is significantly

more than the stock market gain of 9.6% (Chart 22).

Chart 22: S&P 500 vs. 30-year

Treasury price

$95

$105

$115

$125

$135

600

700

800

900

1000

Jan-09 Mar-09 May-09

S&P 500 (LHS) 30Y T (RHS)


Note: From January 15, 2009 to June 15, 2009

The Art of Hedging

Feb 17, 2011 19

Key takeaway

Unfortunately, there does not seem to be a perfect hedging vehicle to minimize exposure to

tail risk. Four key challenges tend to impact the effectiveness of most hedges — cost,

correlation, slippage, and reliance on historical relationship. In effect, investors must weigh

these challenges (and others) with their own market expectations, objectives, and constraints.

That said, we examined a variety of hedging vehicles in several different scenarios, and found

that in the context of these challenges the CDX.IG and the VIX indexes can be

particularly effective. Vehicles such as Treasuries can do well in most scenarios, but do have

significant slippage risk, and the performance of some options (e.g., short-tenor, at-the-money

S&P puts) can be constrained by cost.

The Art of Hedging

Feb 17, 2011 20

Part 5: Funded Hedges (i.e., Alpha Trades)

Searching for an asymmetric payoff profile...

In the previous section we examined unfunded hedges, which in some respects are

comparable to the outright purchase of an insurance policy. The cost of the policy is obviously

a concern, but not necessarily an investor’s primary concern. In this section we introduce

funded hedges, or package trades in which some long exposure is used to pay for the cost of

insurance. As a result the net hedge cost declines, but there is a trade-off as other

challenges can become more intense and new ones introduced. For example,

counterparty risk can be an important consideration when employing a funded hedge strategy.

The reason why many market participants use funded hedges tends to result from two factors.

First, the impossibility of being able to accurately predict the timing of a tail event. In

practice, at best one may be able to do is anticipate a higher (lower) probability of an event

occurring over a given time frame. Second, the performance of many investors is

measured against a benchmark index or relative to the performance of competitors over

fairly short time. As such, if a tail event does not occur fairly quickly the relative performance

of an investor using an unfunded strategy will likely be negative, at least by some metrics.

Suppose that back in early ’95 an equity investor that was benchmarked against the S&P 500

on an annual basis was worried about “irrational exuberance.” She shorted the segment of the

stock market that she believed was most irrational – the NASDAQ. Unfortunately for this

investor, while the equity market may very well have been irrational, such irrationality lasted for

five more years. By early 2000 the NASDAQ had rallied 500% from early ’95 levels, and this

investor would have lagged her benchmark by over 300%(Chart 23).

In this section, we evaluate funded hedges in the context of two specific risks (sovereign risk,

economic downturn), but before proceeding there are three important points to make:

1) Focus, focus, focus: As a rule of thumb, unfunded hedges tend to protect portfolios

against a wider variety of events than funded hedges, and this is primarily because

funded hedge packages have both long and short elements (as opposed to an

unfunded hedge with just short exposure). Essentially, the goal of a funded package is

to short an asset that is particularly sensitive to a specific problem, and go long an

asset that is fairly immune.

2) Use scenarios more than history: In the previous section our analysis of hedge

efficiency was to a large extent based on history — if the S&P 500 moves by X amount

then hedge XYZ can be expected to move by Y amount. But funded hedges rely more

heavily on scenario analysis than historical relationships. In essence, the goal is to

construct a package that provides an asymmetric payoff profile across a wide variety

of potential scenarios with a tolerable amount of downside risk. In this regard, more

qualitative analysis may be needed.

3) Additional risk factors introduced: Funded packages also have more “moving parts”

than unfunded packages and as a result additional risks can come into play. For

example, counterparty, mark-to-market, and liquidity risks, to name a few, can all be

found in abundance in funded hedges.

Chart 23: Nasdaq vs. S&P 500,

1995 – 2000

0%

100%

200%

300%

400%

500%

600%

'95 '96 '97 '98 '99 '00

Nasdaq S&P 500


The Art of Hedging

Feb 17, 2011 21

Again, in this section we provide two examples of funded hedges. We first focus on a

sovereign risk hedge, and then a hedging vehicle to protect against an economic downturn.

We find that while funded hedges have more “moving parts” and potential risks than

unfunded hedges do, these risks can often be managed and results very effective.

Side note: Searching for asymmetry...a starting point

The VIX index reflects a market estimate of future volatility, and is based on the weighted

average of the implied volatilities for various S&P 500 options. The VIX index generally tends

to be sensitive to a fairly wide range of risks. Our colleagues in the SG Financial Engineering

and Advisory team have tested a variety of VIX hedging strategies and advocate selectively

using out-of-the-money VIX options (2-month forward, 1x2 hedge ratio) to establish an

affordable hedge in a very liquid market. They have done extensive back-testing on when and

how to specifically implement this hedge, and we encourage readers to contact them directly

for more details (Ramón Verástegui at 212-278-7548 or Rebecca Cheong at 212-278-5302).

With regard to testing for an asymmetric payoff profile, we looked at the performance of a

delta-neutral VIX hedge when volatility spiked and then declined in the spring of ’10 (Chart 24).

During the May 4th to June 18th the VIX spiked from 23.8 to 45.8, and then proceeded to fall

back down to 23.9, ending the six week period virtually unchanged.

We considered July contracts, which were two months forward at the time, selling out-of-the-

money 27.5 strikes and buying 32.5 strikes, and again, using a delta-neutral hedge ratio. We

first looked at performance assuming that we timed the market perfectly (e.g., established the

package near the lows on May 4th and unwound at the highs on May 20th; Table 5). We then

considered performance using the opposite assumption – established and unwound the VIX

package at the absolute worst times. The P&L was $0.46 from May 4th to May 20th when the

VIX spiked 22 pts, but lost a fairly modest $0.24 when the VIX tumbled by about the same

amount.

Key point: A starting point! An essentially flat carry position with an asymmetric payoff profile.

Table 5: The payoff profile using delta-neutral hedge ratios was asymmetric in spring ’10

Period 1: May 4th (VIX at 23.84) to May 20

th (VIX at 45.79)

Position Call Option May 4th Price May 20th Price Hedge Ratio P&L

Short 7/10 Strike 27.5 $3.10 $10.00 1.00 -$6.90

Long 7/10 Strike 32.5 $2.10 $7.51 1.36 $7.36

Carry $0.24

Total P&L

$0.46

Period 2: May 20th (VIX at 45.79) to Jun 18

th (VIX at 23.95)

Position Call Option May 20th Price June 18th Price Hedge Ratio P&L

Short 7/10 Strike 50 $2.66 $0.45 1.00 $2.21

Long 7/10 Strike 55 $2.10 $0.25 1.33 -$2.45

Carry

-$0.12

Total P&L

-$0.24

Net Gain

+$0.22


Chart 24: We look at periods

where the VIX spiked (pd. 1) and

then fell back down (pd. 2) in ’10

10

15

20

25

30

35

40

45

50

May-10 May-10 Jun-10 Jun-10

PD. 1 PD. 2


The Art of Hedging

Feb 17, 2011 22

Risk #1: Sovereign fiscal imbalances

While for many decades the focus of fiscal solvency has been in the emerging markets,

sovereign default is now a risk factor in many developed economies as well. Concerns about

fiscal discipline have waned somewhat since the crisis levels in ’10, but public debt levels

have spiked in recent years (Chart 25) and some do not believe that all governments have the

political wherewithal to solve the challenge.

A sovereign risk hedge

Investment objective: Hedge sovereign credit risk using a FTD package to reduce cost

Trade detail: Long exposure to select corporates with limited near-term risk, short issuers

that are directly or indirectly linked to sovereign problems

Investment horizon: 1 year

One lower cost strategy to protect against a potential sovereign credit event is to go long

names with little direct risk to public sector fiscal imbalances and fairly limited near-term risk

in general. The income from this portfolio could be used to pay for short exposure to issuers

with significant direct exposure to the sovereign problem and / or other near-term challenges.

Consider the package presented in Table 6. The short side of this package is comprised of

names that have at least some of the following characteristics:

(1) a direct link to the weak credit profile of the public sector (e.g., Spain)

(2) meaningful maturities coming due in the near term (total of $295 bn through ’12).

Refinancing could be a significant challenge should sovereign fears rise further and market

participants begin to worry about a spillover into the banking system

(3) more cyclical names that (as of September ’10) could be particularly vulnerable to an

economic slowdown caused by sovereign concerns (e.g., Heidelberg-Cement; more

cyclical, significant upcoming maturities)

Table 6: First to default package trade – long exposure to select names with little near-term default risk can be used to fund short

exposure to names that may be susceptible to a sovereign credit event

LONG EXPOSURE

(Single Name CDS)

VS.

SHORT EXPOSURE

(First-to-Default Package)

Issuer 1Y CDS

Sprd (bp) Notional

’10-’12 Debt

Maturities Issuer

1Y CDS

Sprd (bp) Notional

’10-’12 Debt

Maturities

Amkor Technology 170 $10 mm $0.04 bn Heidelberg-Cement 265 — $2.2 bn

Health Management 152 $10 mm $0 Metro AG 90 — $2.3 bn

JC Penny 110 $10 mm $0.20 bn Portugal 367 — $23.2 bn

Office Depot 321 $10 mm $0 Spain 243 — $263.4 bn

Wendy’s 119 $10 mm $0 Wendel 205 — $3.6 bn

Sum 1170 $10 mm

Income 970 $50 mm $0.24 bn Cost 819 $10 mm $295 bn


Note: As of September 14, 2010; for HEI, MEO, and WENDEL, exchange rate of 1.2998 used to calculate USD spreads

x 70%

Chart 25: Public sector fiscal

imbalances have increased

dramatically in recent years

3

5

7

9

11

13

15

40

60

80

100

120

140

160

'96 '98 '00 '02 '04 '06 '08 '10

Portug (LHS)

US (RHS)€ bn $ tn


Note: gross debt level

The Art of Hedging

Feb 17, 2011 23

The cost of this portfolio at a time when sovereign fears were particularly intense (mid-

September ’10) was 1170 bp, based on 1-year CDS (as of September 14, 2010). To overcome

this fairly prohibitive cost one could use a 1-year first-to-default structure (FTD); FTD

packages pay those with short exposure in the event that any one of the names in the

structure defaults, but only one. There is no additional payment should two or three names

(etc.) experience a credit event.

The benefit of using this structure is that it costs relatively little to establish a short position; as

of mid-September ’10 the cost was approximately 70% of the portfolio’s sum-of-spreads

(1170 bp). So our hypothetical investor only had to come up with 819 bp to pay for short

exposure to the basket of vulnerable names (1170 bp * 70% = 819 bp).

This short position can be funded with long exposure to select names that appear to

have little near-term default risk. Part of the reason is simply because the names highlighted

in Table 6 (previous page) have little or no debt coming due in the near-term. Three of the five

names have no upcoming maturities through ’12, and in aggregate only about $240 mm will

mature during this period.

In addition, the average implied default rate is far lower for the long positions than for the short

positions (0.7% versus 3.0% average implied default rates, assuming 40% recovery for

corporates and 70% recovery for sovereign names). The market did not perceive all that much

near-term risk for the long candidates (again, as of last fall).

Key point: Short exposures appear to be more vulnerable to spread-widening catalysts, and

the position is positive carry (151 bp, as of last fall).

But doesn’t this package have a lot of risk...?

This trade package can benefit in the event of a sovereign credit event, but it does have risks

that should be considered. For example, an FTD is an over-the-counter derivative product and

is subject to non-standard prices that a bank or other dealer may provide upon unwinding,

and as such the package is vulnerable to illiquidity. This risk is tempered, however, because of

the fairly short tenor of the package — worst case, an investor can hold to maturity (1-year).

The aggregate delta mismatch is also a risk, but there are several factors that help to offset it.

Specifically, the short tenor of the package limits the impact in absolute dollar terms, and the

range-bound spread environment that the market was in can help to limit the severity of

mismatch as well. Chart 26 shows that the high-grade market had been trading in a very tight

range. If spreads do not move, delta mismatches do not matter.

And the notional mismatch — $50 mm vs. $10 mm — is also a potential challenge. But let’s

take a step back from the FTD package itself and consider the riskiness of the underlying

constituents. From a credit perspective, what is more risky - a $100 mm Treasury position or

$10 mm exposure to First Data (rated B3/B/B) paper? Large exposure to a low probability

event or small exposure to a high probability event? In a risk-adjusted context, one could

argue that the Treasury position or large exposure to an event with low probability are less

risky.

Chart 26: CDX.IG S14 1-year

index spread level

0

10

20

30

40

50

60

70

80

May-10 Jul-10 Sep-10

bp


Note: As of September 14, 2010

The Art of Hedging

Feb 17, 2011 24

Can these trade packages actually work?

While there are more moving parts with these relatively complicated packages, they can be

very efficient hedging vehicles. For example, we marked-to-market the FTD trade package

(three months after initiation i.e., December 15, 2010). Table 7 shows that this package was

deeply in-the-money, with the long portion of the portfolio 429 bp tighter and the short portion

109 wider. In dollar terms this translates into a gain of $2.3 mm, which could go a long way to

offsetting any sovereign-induced decline in a portfolio.

Table 7: Can these packages actually work? When marked-to-market in December ’10, the package was in the money by $2.3 mm

LONG EXPOSURE

(Single Name CDS)

VS.

SHORT EXPOSURE

(First-to-Default Package)

Issuer 1Y CDS

Sprd (bp) Notional

’10-’12 Debt

Maturities Issuer

1Y CDS

Sprd (bp) Notional

’10-’12 Debt

Maturities

Amkor Technology 170 $10 mm $0.04 bn Heidelberg-Cement 265 — $2.2 bn

Health Management 152 $10 mm $0 Metro AG 90 — $2.3 bn

JC Penny 110 $10 mm $0.20 bn Portugal 367 — $23.2 bn

Office Depot 321 $10 mm $0 Spain 243 — $263.4 bn

Wendy’s 119 $10 mm $0 Wendel 205 — $3.6 bn

Sum 1170 $10 mm

Income 970 $50 mm $0.24 bn Cost 819 $10 mm $295 bn

Income 541 $50 mm — Cost 928 $10 mm —


Note: As of September 14 and December 15, 2010; for HEI, MEO, and WENDEL, exchange rate of 1.2998 (Sep) and 1.3214 (Dec) used to calculate USD spreads

Tightened 429 bp Widened 109 bp

The Art of Hedging

Feb 17, 2011 25

Risk #2: Economic downturn

One of the biggest risks that portfolio managers in virtually all asset classes face is exposure

to a severe economic downturn. That said, we believe that “cheap” and effective economic

downturn hedges can be found. In this section we present an example of a positive carry

package with an asymmetric payoff profile that existed in the credit space when heading into

the latest recession. The favorable payoff profile resulted in large part from a unique

combination of sector specific characteristics and the shape of select CDS curves.

Investment objective: Use steep credit curves in the homebuilder space to establish a

positive carry package with an asymmetric payoff profile

Trade detail: 3-yr / 5-yr KBH curve flattener

Investment horizon: 1 year

The backdrop…

With regard to sector characteristics, in the credit market all sectors tend to suffer heading

into and during the early portion of recessions, but the extent of suffering can vary sharply. To

illustrate, Chart 27 highlights the total returns of cyclical and non-cyclical sectors in the high-

yield market in 2008. On average the cyclical sectors generated a total return of -32% in ’08,

while the non-cyclicals were far more resilient (-16%). So from this perspective shorting select

cyclical sectors may have been the most effective trade.

But which one? For unique reasons at any given point in time some sectors may be even more

vulnerable than others heading into an economic downturn. As noted above there were

numerous challenges in the economic backdrop back in early ’07, but many of the challenges

centered around a potential bubble in the housing market. So ideally, back in ’08 shorting

cyclical companies with exposure to the housing market, such as the homebuilding space,

might have been a good hedge.

But what about the cost? Turns out, the cost of shorting the typical homebuilder heading into

the last recession was not prohibitive either. Despite appearing to be more vulnerable to a

slowdown, on average spreads in the homebuilder space were about the same as those in

most other sectors. Chart 28 shows that the typical homebuilder (292 bp) was essentially

trading at the same level as the typical cyclical (298 bp) and the typical non-cyclical (273 bp).

Chart 27: Total returns of cyclical and non-cyclical sectors in

the high yield market, 2008

Chart 28: Spreads of cyclical and non-cyclical sectors in the

high yield market, 2007

-45%

-40%

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

Cyclical Sectors Non-Cyclical Sectors

Average: -32%

Average: -16%

0 bp

50 bp

100 bp

150 bp

200 bp

250 bp

300 bp

350 bp

400 bp

450 bp

Cyclical Sectors Non-Cyclical Sectors

Average: 298 bpAverage: 273 bp

Source: SG Cross Asset Research, Bloomberg Source: SG Cross Asset Research, Bloomberg Note: As of January 2, 2007

The Art of Hedging

Feb 17, 2011 26

Key point: Homebuilders appeared to be particularly vulnerable to an economic downturn yet

spread levels were very much in-line with the typical names in the market. Affordability is a

good starting point for an effective hedge...

Searching for asymmetry…

But the challenge is to craft a trade package that does not cost much, if anything, and has an

asymmetric payoff profile. In this regard we can take advantage of the fact that many

homebuilders had very steep credit curves prior to the last recession. For example, KB

Homes, a benchmark issuer in the homebuilding space, had a 3-year / 5-year spread slope of

104 bp heading into the last recession (Chart 29), relative to about 100 bp for the typical high-

yield name.

The steep curve enabled a potential investor to duration-weight a curve flattener and still earn

positive carry. In effect, one could buy (go short) $15 mm of 3-year KBH protection and sell

(go long) $10 mm protection in the 5-year tenor and be duration-neutral and still earn 49 bp in

carry (Table 8). The curve flattener, when combined with the potential susceptibility of this

name to an economic downturn and its fairly tight spread levels, resulted in a package with an

asymmetric payoff profile.

Chart 29: KBH CDS curve on March 15, 2007 Table 8: KBH 3-yr / 5-yr curve flattener

0 bp

50 bp

100 bp

150 bp

200 bp

250 bp

300 bp

350 bp

1Y 3Y 5Y 7Y 10Y

Action Curve

Notional

Amt Duration Spread

BUY 3-YR $15 mm 2.9 111 bp

SELL 5-YR $10 mm 4.4 215 bp

Carry +49 bp

ROE 19%

Source: SG Cross Asset Research, Markit Source: SG Cross Asset Research, Bloomberg, Markit

Note: As of March 15, 2007; We assume a lower risk profile fund and

calculate the initial margin to be $250k, based on the gross notional

amount

Consider the following four scenarios:

1) Status quo: Again, the steep slope of the KBH credit curve enabled a potential hedger

to implement a duration weighted 3s/5s curve flattener (hedge ratio of about 1.5x) and

still earn 49 bp (Table 8). And such, results are modestly favorable in a status quo

scenario, particularly in a ROE context (as the position requires little collateral)

2) Coin flip: If the economy did not slow down and valuations simply “bounce around”

the position should be fairly immune because it is duration-matched

3) Bullish: The package would likely be susceptible if an economic downturn did not

occur and spreads tightened, but this risk is mitigated in part by positive carry and

already tight spread levels. How much tighter can the front-end get?

The Art of Hedging

Feb 17, 2011 27

4) Bearish: As a rule of thumb, credit curves typically flatten sharply when default risk

increases, and default risk rises when the economy slows (Charts 30 and 31). This

package is well positioned to benefit, not only due to the disproportionate change in

CDS spreads (short-tenor spreads under more pressure than longer-tenor ones), but

also because of the disproportionate amount of protection bought and sold ($15 mm

vs. $10 mm)

Chart 30: GS 3Y / 7Y curve vs. default rate Chart 31: JCP 3Y / 7Y curve vs. GDP

-100 bp

-75 bp

-50 bp

-25 bp

0 bp

25 bp

50 bp

0%

3%

6%

9%

12%

15%

18%

'05 '06 '07 '08 '09 '10 '11

Default Rate (LHS) 3Y/7Y CDS Curve (RHS)

-100 bp

-50 bp

0 bp

50 bp

100 bp

150 bp

-9%

-6%

-3%

0%

3%

6%

'05 '06 '07 '08 '09 '10 '11

GDP (LHS) 3Y/7Y CDS Curve (RHS)

Source: SG Cross Asset Research, Markit, Moody’s

Note: As of January 18, 2011; default rates are LTM US Spec-grade data;

it matched with 1-year forward dates of GS CDS curve

Source: SG Cross Asset Research, Markit


And the results are…

We price the KBH trade package after a one-year holding period (as of March 14, 2008). Chart

32 shows that the KBH curve inverted sharply — 3-year protection widened 407 bp while 5-

year protection increased 251 bp — and Table 9 shows that this package generated a positive

P&L of $0.3 mm (ROE of 122%).

Chart 32: KBH CDS curve on March 14, 2008 Table 9: Return on KBH curve flattener

0 bp

100 bp

200 bp

300 bp

400 bp

500 bp

600 bp

1Y 3Y 5Y 7Y 10Y

Mar '08 Mar '07

Action Curve

Notional

Amt

Sprd

Change Dollar Return

BUY 3-YR $15 mm +407 bp +$1.1 mm

SELL 5-YR $10 mm +265 bp -$0.8 mm

Net Return +$0.3 mm

ROE 122%

Source: SG Cross Asset Research, Markit Source: SG Cross Asset Research, Bloomberg, Markit

Note: As of March 14, 2008; We assume a lower risk profile fund and

calculate the initial margin to be $250k, based on the gross notional

amount

Key takeaway

As a rule of thumb funded hedges have more “moving parts” and potential risks than

unfunded hedges do. That said, the risks can often be managed, in our experience. In this

section we examined using funded hedges to manage two specific risks — public sector fiscal

imbalances and an economic downturn — and found positive carry hedges that in theory

offered an asymmetric payoff profile. We then marked-to-market these packages, and

found that theory was consistent with reality.

The Art of Hedging

Feb 17, 2011 28

Part 6: Trade-Specific Risks

Be aware of multiple moving parts

As discussed above, most hedges face at least to some extent four generic challenges. In

addition, many packages also have trade-specific challenges / risks as well. For example, if an

investor purchases protection via the CDX.IG index he / she may be exposed to mark-to-

market risk. Investors that mark portfolios to market are subject to potentially large

movements in P&L that may cause a position to trigger a stop / loss. As we discussed in an

earlier section, in 2007 market volatility was increasing and investors sought to buy protection

in the CDS market on banks and brokers that they viewed as particularly vulnerable. But

ensuing spread widening was certainly not one directional, and some investors could have

been forced out of positions (stop loss) even if they ultimately finished in-the-money.

And the sovereign hedge described previously most certainly has liquidity risk (i.e., bid / ask

spread could widen sharply if the package holder tried to unwind the position) as well as

counterparty risk. With regard to liquidity risk, an investor seeking to capture the P&L of a

particular trade that is in-the-money should consider the sizing and appropriate execution

costs upon entering and exiting a position in a normal versus a stressed scenario. As a

subset of liquidity risk, positions that are purchased on margin are particularly susceptible, as

changes in margin or collateral requirements during stressful market periods can be dramatic.

The important point is that there are a large number of trade-specific risks that need to

be accounted for. We do not attempt to identify or analyze all potential risks within various

hedges (probably an impossible task, in our view), but we do walk through one specific

example in this section. In particular, we calculate a potential cost of counterparty risk for the

Bear Stearns hedge described on page 14.

The cost of counterparty risk

It may be possible to control counterparty risk via regular reviews of trading partners,

collateral requirements, etc., but however controlled it can be it probably cannot be

completely eliminated. Earlier we walked through an example where an investor bought CDS

protection on Bear Stearns as a hedge (p. 14). Using the same example, assume again that

the investor bought 5-year CDS protection on Bear in early March ’08 at 315 bp, but add the

wrinkle that the position was purchased from Lehman. The key question is whether or not

Lehman will be around to provide compensation should Bear default. Note that Lehman CDS

was trading at 228 bp at the time.

Counterparty risk is to a large extent a function of two factors: (1) the joint probability of

default (i.e., Bear and Lehman both experience a default) and (2) the size of a loss in the event

of a default, which depends on recoveries for both Bear and Lehman; that is, if Bear defaults

our investor would be owed a certain amount by Lehman, but if Lehman also defaults this

claim probably would not be paid in full.

We rely on the following equation to calculate how much this counterparty risk costs in terms

of basis point.

Cost tyCounterpar = Duration

) Recovery-(1 ×) Recovery - (1 × 100 × Prob Default Joint

BSC

LEHBSC

Chart 33: Default probabilities

over 5-year period, March ’08

0%

5%

10%

15%

20%

25%

1 2 3 4 5

Year

BSC LEH

Joint


Note: As of March 3, 2008

The Art of Hedging

Feb 17, 2011 29

If we assume recovery rates of 40% for both Bear and Lehman, and that 5-year CDS spread

levels are entirely compensation for credit risk, the implied default rate is 23.1% for Bear

Stearns and 17.3% for Lehman. As such, the extra compensation that investors should

receive for counterparty risk is about 36 bp.

bp 36 = 4.0

40%) - (1 × 40%) - (1 × 100 × 4.0%

Key point: The cost of Bear protection was probably higher than the nominal spread of 315

bp. By some metrics the cost of counterparty risk alone is 36 bp, pushing the true cost to 351

bp (315 bp + 36 bp).

Joint Def Prob = Def ProbBSC x Def ProbLEH

4.0% = 23.1% x 17.3%

The Art of Hedging

Feb 17, 2011 30

Part 7: A “Live” Just-in-Case Hedge

Long VIX + long HY + limited defaults = asymmetric profile

Investment objective: An inexpensive just-in-case package to protect against generic tail risk

Trade detail: Long short-tenor high-yield risk to fund VIX call options

Investment horizon: 3 months

Two trends that are firmly established in the current market environment are declining volatility

in the equity market and a limited near-term default risk. We believe that investors who are

looking to hedge certain types of tail risk can take advantage. The opportunity stems from the

fact that valuations for shorter-tenor high-yield issuers in particular tend to be driven by

default risk, which we see as very low in the near-term, while the VIX index is far more

susceptible to other risks (e.g., headline risk).

To illustrate, in Chart 34 we present the price performance of the VIX index juxtaposed against

a broad portfolio of short maturity high-yield bonds (maturities in the 1-year to 3-year tenor)

during the ’04 to mid-’07 period. Default risk was limited during that period, and many market

participants believe that the current environment is in many ways comparable in other ways as

well (i.e., solid corporate profits, tight spreads, etc.). For more detail on this topic, please refer

to the Credit Market Insights dated October 14, 2010.

But while default risk was limited during this period, there was certainly other risk. And

what was susceptible to “other” risk? Surely not credit...it was the VIX. Chart 34 shows that

the VIX index spiked a number of times during this period, while the price of the high-yield

basket never dropped below $97. This is despite the fact that the Fed was aggressively

tightening monetary policy (Chart 35).

In Table 10 (next page) we present a VIX / high-yield package. Specifically, we advocate using

$10 mm notional of an “old” CDX.HY index (Series 11), which currently trades at a spread of

231 bp, to buy 210 VIX contracts that expire in July ’11 and have a strike of 25. We assume a

three-month investment horizon, and as such the options are sold rather than held to maturity

to minimize decay. It is also worth noting that there are many other variations of this particular

hedge that could be crafted (e.g., using a portfolio of specific bonds rather than the index).

Chart 34: VIX vs. high-yield cash index (1-3 year maturities) Chart 35: Fed funds rate vs. high-yield cash index (1-3 year

maturities)

8

10

12

14

16

18

20

22

24

26

$0

$20

$40

$60

$80

$100

$120

Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07

HY Index - 1 to 3 yr (LHS) VIX (RHS)

0%

1%

2%

3%

4%

5%

6%

$94

$96

$98

$100

$102

$104

$106

Jan-04 Jun-04 Nov-04 Apr-05 Sep-05 Feb-06 Jul-06 Dec-06 May-07

HY Index, 1-3 yr (LHS) Fed Fund Rates (RHS)

Source: SG Cross Asset Research, Bloomberg Note: As of May 15, 2007 Source: SG Cross Asset Research, Bloomberg, Markit Note: As of May 15, 2007

The Art of Hedging

Feb 17, 2011 31

Table 10: Use CDX.HY Series 11 5-year index to fund VIX call options

Action Asset Maturity Initial

Level Initial Position Cash Flow

Sell CDX.HY S11 5-year December 20, 2013 231 bp $10 mm $57,750

Buy VIX Strike 25 Call July 20, 2011 $2.70 210 contracts -$56,700

Carry

+$1,050


Note: As of February 3, 2011; Carry does not include the time decay

We believe that the long portion of this package will be protected by several factors in

the near-term. First, we see the modest likelihood of a sharp rise in the default rate in the

period ahead. Part of the reason for this view is that corporate cash balances are high, near-

term maturities are already termed out, the focus of corporate managers is still reasonably

balanced between shareholders and bondholders, among others. We also believe that the

long portion of the package will benefit from significant diversification and survival of the fittest

(bad credits either defaulted or termed out already). In addition, mark-to-market risk is limited

by the fairly modest duration and positive carry of the package.

As noted above the short side of the hedge tends to be far more sensitive to non-default

risk. To illustrate, in Table 11 we present six occurrences during the ’04 to mid-’07 period

when headline risk rose. For each period we observe the price change of modestly out-of-the

money 6-month VIX call options and compare it to the total return of the short-dated high-

yield index during the same periods. We assume a three-month holding period.

Key point: Of the six periods in which headline risk rose in the last non-default period, this

hedge produced consistently positive returns.

Table 11: VIX call options outperformed when headline risk rose in the 2004-07 period

Period

VIX Call Option

VIX Call PR

($)

HY Index TR

($) Beginning End

VIX Chg Beg Price ($) End Price ($)

1/24/2007 3/5/2007 +9.7 0.13 3.40 +3.27 +0.62

5/10/2006 6/13/2006 +12.0 0.38 5.88 +5.50 +0.58

9/16/2005 10/13/2005 +5.3 0.76 2.55 +1.79 -1.02

4/12/2005 4/28/2005 +5.6 0.39 2.71 +2.32 -0.79

4/23/2004 5/17/2004 +6.0 0.70 2.51 +1.81 -1.99

3/4/2004 3/22/2004 +7.2 0.42 3.05 +2.63 +0.45

Average

+7.6

+2.89 -0.36


Note: All option prices are calculated theoretical prices, using OTM 6-month call option;

The Art of Hedging

Feb 17, 2011 32

Summary

Tail events occur more frequently than expected

Tail events tend to occur more often than one might expect. One reason may be because the

actions of investors can be influenced by factors that are not necessarily related to investment

efficiency. For example, portfolio managers may be forced to put money to work even if they

do not see attractive value because their performance is measured on a short-term basis.

In addition, market participants tend to move incrementally over time. In the near-term, any

modest increase in risk exposure may appear to be reasonable, but over a longer time period

one can find that his / her risk profile (i.e., leverage) has changed dramatically. Also, the

financing of risk assets and / or operations tends to be transitory (i.e., not maturity matched),

and the lack of stable access to financing can cause any modest change in valuations to

snowball.

There is no perfect hedge

In our experience there is no perfect hedge, and each has pros and cons. Four challenges that

should be considered for most hedge vehicles are correlation, cost, slippage, and the reliance

on history. Correlation risk simply reflects the likelihood that a hedged asset and the hedging

vehicle do not move in the same direction and magnitude. Cost is an obvious challenge since

a high cost could overwhelm any positive elements that a particular hedge provides.

In addition, even if two assets are highly correlated in general there is always the potential for

“slippage” from such a relationship. Slippage can be induced by the sensitivity of the hedge or

the hedged asset to a unique development. Lastly, investors often rely on historical

performance of hedging vehicles relative to the asset being hedged, but these relationships

can be transitory over time.

Two hedging strategies

We consider two broadly defined hedging strategies, unfunded and funded approaches. We

define unfunded hedges as those for which an investor is willing to dedicate a certain amount

of capital to protect his / her portfolio. In some respects, unfunded strategies are comparable

to insurance policies. The cost of the policy is obviously a concern, but it is not necessarily an

investor’s primary concern. Funded hedges are packages in which some long exposure is

used to pay for the cost of insurance. Funded hedges typically become more popular when

the timing of any potential negative catalyst is difficult to ascertain.

Table 12: Select characteristics of unfunded and funded hedges

Unfunded hedges

Funded hedges

Definition Investors dedicate capital to protect

portfolios

Long exposure is used to pay for the cost of

insurance

Primary concern Loss prevention

Cost, asymmetric payoff profile, loss

prevention

Goal Protect portfolios against a wide

variety of events

Protect an asset against a fairly specific

problem with a “high” chance of occurring

Hedge modeling History (to a large extent)

Scenario analysis (to a large extent)

Key concerns

(albeit not all)

Cost, correlation, slippage, reliance on

historical relationship

Cost, correlation, slippage, reliance on

historical relationship, introduction of

additional risks due to more “moving parts”


The Art of Hedging

Feb 17, 2011 33

Efficiency of select hedges

We examine select hedges in the context of three risk factors — a decline in the S&P 500,

heightened sovereign risk, and an economic downturn. We first evaluate seven unfunded

hedges in the setting of declining equity prices and find that while there is no perfect hedge

for all investors, various VIX strategies and CDX.IG can be efficient in a fairly wide range of

scenarios.

With regard to funded hedges, we examine two. We first consider using a first-to-default

package to protect against sovereign risk, and then focus on using a curve flattener to protect

against an economic downturn. We find that while funded hedges have more “moving parts”

and potential risks than unfunded hedges do, these risks can often be managed and hedge

results can be effective.

A “live” just-in-case hedge

Two trends that are firmly established in the current corporate market environment are

declining equity market volatility and limited near-term defaults. We believe that investors who

are looking to hedge certain types of tail risk can take advantage. The opportunity stems from

the fact that valuations for shorter-tenor high-yield issuers in particular tend to be driven by

default risk, which we see as very low in the near-term, while the VIX index is far more

susceptible to other risks (e.g., headline risk).

We advocate using exposure to an “old” CDX.HY index to fund the purchase of modestly out-

of-the-money VIX call options, although many variations of this hedge could be crafted. We

believe that the long portion of this package will be protected by the modest likelihood of a

near-term pickup in defaults and limited mark-to-market risk (pull-to-par, modest duration),

among others. The short side of the hedge (VIX calls) tends to be far more sensitive to non-

default risk. We looked at the performance of this hedge during the ’04 to mid-’07 period, a

time that many believe is similar to the current environment, and found consistently positive

results.

The Art of Hedging

Feb 17, 2011 34

APPENDIX

ANALYST CERTIFICATION

Each author of this research report hereby certifies that (i) the views expressed in the research report accurately reflect his or

her personal views about any and all of the subject securities or issuers and (ii) no part of his or her compensation was, is, or

will be related, directly or indirectly, to the specific recommendations or views expressed in this report: Stephen Antczak,

CFA, Jung Lee

EXPLANATION OF CREDIT RATINGS

SG credit research may contain both a credit opinion of the company and ratings on individual bonds issued by the company.

Credit Opinion:

Positive: Indicates expectations of a general improvement of the issuer's credit quality over the next six to twelve months,

with credit quality expected to be materially stronger by the end of the designated time horizon.

Stable: Indicates expectations of a generally stable trend in the issuer's credit quality over the next six to twelve months,

with credit quality expected to be essentially unchanged by the end of the designated time horizon.

Negative: Indicates expectations of a general deterioration of the issuer's credit quality over the next six to twelve months,

with the credit quality expected to be materially weaker by the end of the designated time horizon.

Individual Bond Ratings:

Buy: Indicates likely to outperform its iBoxx subsector by 5% or more

Hold: Indicates likely to be within 5% of the performance of its subsector

Sell: Indicates likely to underperform its subsector by 5% or more

CONFLICTS OF INTEREST

This research contains the views, opinions and recommendations of Société Générale (SG) credit research analysts and/or

strategists. To the extent that this research contains trade ideas based on macro views of economic market conditions or

relative value, it may differ from the fundamental credit opinions and recommendations contained in credit sector or company

research reports and from the views and opinions of other departments of SG and its affiliates. Credit research analysts

and/or strategists routinely consult with SG trading desk personnel in formulating views, opinions and recommendations in

preparing research. Trading desks may trade, or have traded, as principal on the basis of the research analyst(s) views and

reports. Therefore, this research may not be independent from the proprietary interest of SG trading desks which may conflict

with your interests. In addition, research analysts receive compensation based, in part, on the quality and accuracy of their

analysis, client feedback, trading desk and firm revenues and competitive factors. As a general matter, SG and/or its affiliates

normally make a market and trade as principal in fixed income securities discussed in research reports.

IMPORTANT DISCLOSURES

Metro SG acted as exclusive financial advisor to Metro to divest its business activities in Morocco.

Metro SG is advisor to HTM Group for the potential acquisition of 'Saturn' stores in France owned by Metro

Group.

Wendel SG acted as joint bookrunner in Wendel's senior bond issue (tap) (4.875% 26/05/16 EUR).

SG or its affiliates act as market maker or liquidity provider in the equities securities of HeidelbergCement, Metro.

SG or its affiliates expect to receive or intend to seek compensation for investment banking services in the next 3 months

from Metro, Wendel.

SG or its affiliates have received compensation for investment banking services in the past 12 months from Metro, Wendel.

SG or its affiliates managed or co-managed in the past 12 months a public offering of securities of Wendel.

SGCIB received compensation for products and services other than investment banking services in the past 12 months from

HeidelbergCement, Wendel.

IMPORTANT DISCLAMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities

and has been obtained from, or is based upon, sources believed to be reliable but is not guaranteed as to accuracy or completeness. SG does, from

time to time, deal, trade in, profit from, hold, act as market-makers or advisers, brokers or bankers in relation to the securities, or derivatives thereof, of

persons, firms or entities mentioned in this document and may be represented on the board of such persons, firms or entities. SG does, from time to

time, act as a principal trader in debt securities that may be referred to in this report and may hold debt securities positions. Employees of SG, or

individuals connected to them, may from time to time have a position in or hold any of the investments or related investments mentioned in this

document. SG is under no obligation to disclose or take account of this document when advising or dealing with or on behalf of customers. The views

The Art of Hedging

Feb 17, 2011 35

of SG reflected in this document may change without notice. In addition, SG may issue other reports that are inconsistent with, and reach different

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