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Portfolio hedging

In recent years, global stock markets have risen from record levels to record levels. But share prices do not only rise, they can indeed also drop, as happened recently in the "Corona crisis", for example. In this case, the price losses were so substantial that the term "crash" is certainly applicable. In such a situation, investors are facing the question of whether and how they can hedge their equity portfolios.

There are numerous ways to protect a stock portfolio from price losses during a bear market. The simplest option would certainly be to sell all positions. However, depending on the size of the portfolio, this is associated with high transaction costs and is not very practicable, as the positions have to be rebuilt if an investor wants to continue participating in the market at a later date, which in turn incurs transaction costs. In addition to the costs, there are other reasons why investors prefer to hedge their portfolio or individual equity positions against price losses rather than sell them: for example, an investor may want to continue to exercise his voting rights or not forgo any dividends.

Using simple examples, the following explanations show two ways of hedging a portfolio of Swiss equities worth CHF 100,000 against price falls. A look at the stocks in the portfolio suggests that it should perform similarly to the Swiss Market Index ("SMI"). However, hedging can only ever be carried out approximately, as it is associated with costs and the correlation between the portfolio and the index is hardly 100% in practice.

Portfolio hedging with SMI Mini-Futures / Knock-Out Warrants in two steps

By hedging with SMI Mini-Shorts / Knock-Out Puts the portfolio is "frozen" so to speak. Losses on the portfolio are offset by the increase in value of the SMI Mini-Shorts / Knock-Out Puts.

1. Calculation of the required number of Mini-Futures / Knock-Out Warrants:
The number of SMI Mini-Shorts / Knock-Out Puts required for hedging can be calculated using the following formula:

Number of SMI Mini-Shorts / Knock-Out Puts =
(value of the portfolio / current index level) x ratio

(100,000 / 10,121.45) x 500 = 4,940

4,940 SMI Mini-Shorts / Knock-Out Puts are required for the hedge.

2. Selection of the product:
Please note that SMI Mini-Shorts / Knock-Out Puts have a stop-loss level. If the SMI touches this price level, the products expire and the hedge is no longer intact. The closer the stop-loss level is to the current level of the SMI, the lower is the cost for the individual SMI Mini-Short / Knock-Out Put and consequently for the overall hedging position. However, there is a risk that the hedging position will knock out very quickly. When selecting the SMI Mini-Shorts / Knock-Out Puts used for hedging, it's important to ensure that the stop-loss level is sufficiently far above the current SMI level.

By buying 4,940 SMI Mini-Shorts / Knock-Out Puts, the portfolio is hedged against price declines until the hedging position is sold again or the price of the SMI reaches the stop-loss level and the SMI Mini-Shorts / Knock-Out Puts knock out.

Portfolio hedging with SMI Warrants in two steps

It is also possible to hedge a portfolio against falling prices with SMI Put Warrants. Their value increases disproportionately when the SMI declines. At maturity, the holder of a Put Warrant receives the difference between the higher strike (exercise price) and the lower index level of the SMI (taking into account the ratio).
If, at maturity of an SMI Put Warrant with a strike at 10,000 points, the SMI stands at 8,000 points, the calculation is 10,000 - 8,000 = 2,000. Taking account for the ratio of 100 - only with 100 SMI Put Warrants the entire SMI is traded - an investor receives CHF 20 per SMI Put Warrant.

1. Calculation of the required number of Warrants:
The number of SMI Put Warrants required for hedging can be calculated using the following formula:

Number of SMI Put Warrants =
(value of the portfolio / current index level) x ratio

(100,000 / 10,121.45) x 100 = 988

988 SMI Put Warrants are required for the hedge.

2. Selection of the product
SMI Put Warrants are available with different strikes (exercise prices) and maturities. When selecting SMI Put Warrants for hedging purposes, it needs to be ensured that the selected strike is not too far away from the current SMI level and that the term of the SMI Put Warrant matches the desired hedging horizon.

Hedging with SMI Put Warrants is similar to the principle of an insurance. The purchase price for the SMI Put Warrants corresponds to an insurance premium. If the SMI collapses, the insurance is claimed and the investor is protected from losses. If there is no price collapse and prices rise, the insurance is not claimed.

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