Portfolio Insurance

and finance Allah shmoop What is a hedge ratio Okay

people of future hedge fund managers it's the ratio or

per cent of the total that you're hedging total portfolio

that you're hedging or protecting in you know in a

bad market So let's go through the market numbers here

that we're goingto totally and completely make up But they're

reflective of reality anyway And most reality we're going to

start with the notion that our entire portfolio at the

moment is one security ticker S p y Which more

last represents the S and P 500 That ticker trade

Today it's about 300 bucks a unit We're running a

hedge fund a lucrative one and our investors expect us

to protect their investments in both good and bad markets

So the question How much are we willing to pay

Hey for that portfolio life insurance How far down are

we okay letting this $300 per unit index fund fall

before we hedge it or protected Well pricing matters right

So if we want to protect it for three months

such that even $1 below $300 that are hedges kicked

in Well it'll cost a fortune something like $20 a

share maybe more That's a huge premium to pay for

protection which if the index unit stays flat at $300

for the next three months and change or even goes

up well we've lost 20 divided by 300 there or

about 7% of our portfolios Value way expensive What if

we were okay with it falling to 2 80 but

then protecting it below 2 80 meaning the strike price

of our puts will be a 2 80 right Well

the pricing there is to buy those put options with

a strike of 2 80 which expire in three ish

months Not a cost Eight bucks a share Yes we're

making up the numbers It's still expensive but well maybe

that's digestible aid over three hundred's about two and 1/2

percent change It's that worth it well for you and

realize that that's 10% a year and edges out Maybe

maybe depends how nervous we are what our position is

on where the markets heading the next 90 Well if

we look at the 2 60 strikes well then they

only cost $2 a unit toe fully hedged 100% of

our portfolio then it's less than 1% Maybe we do

that right We're going bye puts the 2 60 strikes

of the market would have to go down well over

10% in the next 90 days to kick those in

And that would be a lot right So we're vastly

generalizing the numbers here in order to present clarity or

conceptual clarity for you people as it relates the notion

of a hedge ratio The bigger question revolves around that

100% figure that is Do we really need to hedge

Ah 100% of our portfolio What if we were okay

with well 20% of it being 100% exposed to the

market totally floating or that 20% of the portfolio is

ah 0% hedged If we're paying $20 a unit to

hedge a $300 strike prices well then only 80% gets

Ah may be a tad more digestible Or what if

we only cared about hedging 50% of the portfolio so

that half is floating and half his head Maybe the

bookie that we're going against is the S and P

500 itself And if it went down 20% we were

only down 10 Maybe our investors would heart us What

do you think Well there's a whole bunch of math

behind these numbers and obviously none of it exists in

a vacuum without logic behind it But it's this percent

of portfolio thing here that we care about in a

hedge ratio because that is the notion of a hedge

ratio How much of our investment universe do we want

to pay to protect And how much are we willing

to pay for that protection And it's always the right

answer Yeah cue the adult diaper company It depends right

Well on what Well on how nervous Nellie our investors

are like how much do we really care about the

volatility of our portfolio Like here's the S and P

500 a chart of it for the last century and

change And yes it went up a lot but naked

it was hugely volatile Do we really care if all

we looked at was the price here and then the

price here it went up a ton While protecting the

volatility was just a waste of money then like buying

a month of term life insurance is a waste in

a month when you don't die So if we don't

care about the volatility then maybe the hedge ratio oughta

be zero or nothing Like why would we buy a

hedge fund at all if we don't care Overtime hedging

is a bad bet in markets that generally go up

And over time the market is up Something like six

out of seven years Right So when you hedge things

you're betting things were going awry here So do you

really want to bet against that system and hedge portfolios

Bet against capitalism Maybe bet against America Yeah probably not

So the next question the next it depends Question Well

how much do the hedges cost That is if you

could buy $1,000,000 term life insurance policy for 10 bucks

a month And even if you had nobody on Earth

you really cared about leaving the money too But maybe

if you got whacked by the 2 30 mid 10

bus what then You'd want to leave a profess Auriol

chair to your all the mater with that 1,000,000 box

and then maybe you'd spend the 10 bucks a month

on while that term life insurance head right But if

it was a few grand a month well then maybe

you're not going to pay life insurance company All that

money maybe you'll just invested instead on your own So

hedge ratios kind of live in the land of it

depends whether you want them at all or what percentage

of your portfolio you want to protect And how much

that portfolio life insurance actually costs like the other depends

It's all about protecting yourself from unforeseen accidents not get