The quest for sound hedging and risk transfer in equity markets

In terms of simple hedging procedure, all user groups have the same opportunity to utilise single stock futures (SSFs).

Hedging

Interpolated hedge

The interpolated hedge is a strategy that can be deployed by investors (or funds) wishing to invest sums of money not yet received in total. For example, a pension fund may know it will receive another sum (say $1m) in a month’s time from a new client and use cash in its current account to invest on margin in SSFs, thus giving it the alpha (absolute exposure) to the stock market ahead of actually receiving the money.

Similarly, a retail investor can use SSFs to buy ahead of an event where they know more money will reach their investment account (such as a payment of a bonus of funds from a property they have sold, which will not be settled for a month). Therefore, with an interpolated hedge, SSFs can be an ideal means to gain specific stock exposure ahead of the full monies actually being received by an investor. Once the money is received, the investor can simultaneously sell their SSF position and buy the stock (usually as part of a single transaction on most electronic platforms) to eliminate basis risk.

Classic hedging

The aim of what we refer to as a classic hedge is to basically cover the downside risk in the marketplace. It can be employed by any form of investor, and indeed can be done fairly cost-effectively by retail investors, given the relatively accessible size of most SSFs contracts. By using hedging strategies, funds or investors can protect themselves against downside risk.

Selling SSFs provides the simplest way to cover exposure to a stock, or series of stocks. Of course, such hedges are most usually a direct hedge, in the form of a portfolio that contains, say, Microsoft stock and where the portfolio manager sells futures against that cash position to neutralise the market orientation. This may be for a very short period of time or during some particular event during which the manager expects the share to perform badly. Of course, the portfolio manager can ‘underhedge’ his holding to reduce his upside gains, but leave himself open to some downside risk, instead of a pure hedge where effectively all risk and upside gain is negated.

Likewise, if a fund manager wants to be short term short of a stock in his portfolio, he may choose to sell more futures than correlates directly with his portfolio and therefore have a net short exposure to the stock even if he holds a stash of the underlying cash. The good thing about SSFs is that even for managers with large blocks of a stock that they may not wish to dispose of, as they form a core portfolio-holding, there is always the opportunity to hedge against this holding using SSFs in a simple, cheap, and efficient fashion.

We have already outlined how fund managers can employ hedging and interpolated hedging strategies to benefit their portfolio-positioning. Nevertheless, SSFs have a vast array of advantages for fund managers. True, fund managers may initially find the relative narrowness of the SSF product range a disadvantage, because big funds may often hold more than 100 stocks. However, as liquidity has increased, so the breadth of product range has consistently improved ever since Liffe and Spain’s Financial Futures and Options Exchange (MEFF) really kicked off the SSF revolution in 2000.

Risk transfer

Of course UK fund managers (as well as individual investors) also have the unique advantage that SSFs can save them stamp duty. Lest you might have forgotten, stamp duty is a peculiarly British regressive tax on share-dealing (although various European and other countries apply stamp duties to other transactions, Britain is unique in applying it to share trades). On the other hand, at the time of writing, UK fund managers (and indeed hedge fund managers) have the advantage that they can use over the counter (OTC) traded contracts for difference (CFDs), which can provide even lower levels of margin than European SSFs – and consequently are often preferred to SSF positions.

Equally, when it comes to fine-tuning cash flow within large fund portfolios, SSFs can be very beneficial where funds may be continually subject to redemptions and other cash adjustment. By judiciously employing SSFs, alpha returns can be maximised on the cash-effective basis, and the relative liquidity of SSFs permit traders to exit the market as and when they need to trim their positions.

Another interesting issue with SSFs is how the product also changes some almost fundamental tenets of portfolio management. For instance, by changing how securities-lending revenue can be taxed, by means of judicious use of SSFs in repo transactions to basically move that securities-lending revenue above the line so that it comes into the portfolio’s core return, as opposed to the being merely ‘other income’.

Fund managers do have their gripes about SSFs. For one thing, the contract sizes are often viewed as being too small. Many fund managers therefore prefer large-scale cheaper dealing offered by OTC products, such as equity swaps and CFDs. Similarly, institutional managers often complain about the relatively disparate prices at which orders can be filled on fast-moving futures markets, preferring the homogeneous fills potentially provide by OTC products.

The narrow-based indices now growing as a sister product to SSFs have many advantages for the fund manager and can be a very useful conduit to helping manage risk in an environment where one or two shares in a sector may get very overvalued (or become undervalued) compared with the rest of the sector.

While indexation may help create more and more exchange-traded funds which we expect to see dwarf ‘passive managed’ funds over time, the opportunity to overlay narrow-based index futures with a multiplicity of cash and futures strategies will be a fascinating development, helping fund managers modify their portfolios to get the exposure they desire more easily while endlessly seeking to improve on their alpha.

On the other hand, some fund managers already have an issue with SSFs, because they have traditionally profited from placing pools of their stock in stock-lending positions and garnered an extra income from their holdings. In many respects, this is one bastion of opposition of SSFs that is going to be difficult to break down rapidly, although ultimately, as SSFs permit more tightly held stocks (or other shares where stock is difficult to borrow for whatever reason), the improved transparency of the equity market ought to make it a more reasonably valued place. Of course, speculative manias will continue to happen, crowd theory will remain a key facet to the trading game regardless of what happens with derivative and indeed can products.

Aside from all the juicy speculation out there in financial markets, the issue of risk transfer has long been a focal point of the derivatives business. Of late, various innovations such as Basle II and a host of national regulatory measures have been gradually trying to push trading off OTC and onto exchanges. For instance, in late 2002, the European Union undertakings for collective investment in transferable securities (Ucits) guidelines were further beefed up with a view to controlling risk on OTC instruments by pension fund, unit trust, and mutual fund investors. Given that the issue of meeting pensions obligations for investors remains pivotal for the governments of all the world’s major economies, the issue of ensuring probity in investment will similarly become increasingly important during this decade. This is a boon for all exchange-traded products and indeed specifically for SSFs.

Of course, the whole question of just what is a fair balance in risk management terms for OTC products remains one of the most emotionally charged issues in financial markets. Banks want to retain an adults-only marketplace for their own dealings, and indeed it is difficult to argue that consenting adult institutions ought to be allowed to do their own thing in private, although, given that adult club members have included the likes of Barings Bank and the Bank of Credit and Commerce International (BCCI), one is inclined to be concerned about counterparty risk even if only as a retail banking customer! Then again, as the sage folk would note, while the likes of hedge fund Long Term Capital Management (LTCM) threatened to rip a hole in the world’s banking balance sheets when it collapsed, the (admittedly less expensive) demise of Barings through on-exchange transactions made barely a ripple by comparison, thanks to Nick Leeson’s foibles being entirely on-exchange and therefore central counterparty (CCP) cleared.

Perhaps one of the more interesting issues is how the measures seek to restrict counterparty risk on portfolios so that only 5-10 per cent of assets in any person’s pension scheme are held by one counterparty. Similarly, the guidelines are concerned with the spread of risk that would affect anybody holding, for instance, the bonds, warrants, and cash equity of a particular single company. However, it is perhaps the counterparty risk issue which could become the most significant of OTC equity derivatives markets, and this is ultimately likely to benefit the SSF environment. The issue with CFDs, for instance, is a key one, as pension fund managers may need to split their holdings across multiple managers, whereas they can deal more flexibly via the exchange and clearing house for SSFs. Naturally, the sheer logistics alone of holding multiple CFD positions with different brokers may prove to be an irritant to the unit trusts, presumably leading to greater exchange trade. In particular, whereas SSF positions can in fact be executed through any broker on an exchange such as Euronext.liffe, CFDs need to be executed through the broker with whom they were first opened to ensure offset and closure of existing positions.

True, the overall impact of the Ucits guidelines will not affect the ordinary account holders in CFDs but such moves will push liquidity toward the exchanges if institutions find it more economical to deal through these markets. The economic advantages for trading in the leading SSFs will doubtless start to win over business from the OTC providers. Nevertheless, the flexibility of CFDs in providing access to a wider range of stocks not already listed on exchanges will remain.

Impact

Another aspect in the overall risk transfer issue is of course inextricably linked with CCP. However, regulators are now beginning to tighten up, and in this respect it is pension fund managers and trustees who can find themselves at risk if they make an oversight. For instance, the movement for trustees to be responsible for scrutinising every counterparty in a pension fund portfolio is gaining pace, especially within Europe. In this respect, suddenly the merits of CCP are becoming a great deal more transparent to many trustees who do not wish to run the risk of seeing a supposedly solid counterparty biodegrade. In this respect, once again the advantage appears to lie solidly with SSFs products as opposed to their OTC cousins.

Overall, as more regulations are likely to encourage the use of exchanges for various reasons, it would seem safe to presume that this will be the advantage of all investors seeking sound risk transfer, hedging, and speculative opportunities in equity markets through SSFs.

Patrick Young has been instrumental in the development of single stock futures worldwide; Charles Sidey has considerable experience inboth retail and institutional derivatives brokerage. This article has been reproduced with permission of the authors.