In Search of the Perfect Hedge Underlying

Peregrine Securities, 2015

28 Pages Posted: 23 Apr 2016 Last revised: 17 May 2016

See all articles by Emlyn James Flint

Emlyn James Flint

Legae Peresec; Department of Actuarial Science, University of Cape Town

Anthony Seymour

University of Cape Town (UCT)

Florence Chikurunhe

Peregrine Securities

Date Written: September 29, 2015

Abstract

This report attempts to answer the question: What underlying portfolio should one use to hedge an active fund? We introduce a framework which allows us to conduct analysis on simulated realistic active portfolios in order to build intuition as to how hedge mismatch error affects the level of protection from a given hedge. We show that for typical market conditions, hedge effectiveness improves dramatically when using a hedge portfolio that more accurately reflects the underlying portfolio. This has clear consequences for using generic index options to hedge highly active portfolios. We also showcase several active return and tracking error decompositions that allow one to precisely quantify and thus manage the sources of risk and rewards within a given portfolio. We then discuss a mixed integer quadratic programming formulation that enables us to search across a large investment universe in order to find the subset of stocks that most closely replicates a given portfolio’s performance, whilst simultaneously complying with realistic market constraints. Motivated by these three elements, we introduce several alternative hedging methods for the fund manager to implement a better hedge for their active portfolio. In this report, we focus specifically on the use of long-only and long/short custom basket options as a means of creating an appropriate portfolio hedge.

Keywords: hedging error, return decomposition, risk decomposition, mixed integer quadratic programming, basket option pricing, long/short basket options

JEL Classification: C15, G13, C5, C6, C61

Suggested Citation

Flint, Emlyn James and Seymour, Anthony and Chikurunhe, Florence, In Search of the Perfect Hedge Underlying (September 29, 2015). Peregrine Securities, 2015. Available at SSRN: https://ssrn.com/abstract=2767532 or http://dx.doi.org/10.2139/ssrn.2767532

Emlyn James Flint (Contact Author)

Legae Peresec ( email )

15 Cavendish Street
Claremont
Cape Town, Western Cape 7700
South Africa
27117227556 (Phone)

HOME PAGE: http://www.legaeperesec.co.za

Department of Actuarial Science, University of Cape Town ( email )

Actuarial Science Section, University of Cape Town
Private Bag X3, Rondebosch
Cape Town, Western Cape 7701
South Africa
+27 21 650 2475 (Phone)

Anthony Seymour

University of Cape Town (UCT) ( email )

Private Bag X3
Rondebosch, Western Cape 7701
South Africa

Florence Chikurunhe

Peregrine Securities ( email )

21 Main Road
Claremont
Cape Town, Western Cape 7700
South Africa
+27117227551 (Phone)

HOME PAGE: http://www.peregrine.co.za

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