The Derivative That Hedged Nothing
An asset manager holds 40 million of a diversified equity portfolio benchmarked to a broad index. Expecting a short-term correction, the manager buys put options on the index with a strike 5% below the current level, expiring in three months, paying 600,000 in premium. The index falls 12% over the period. The manager is pleased, but the portfolio's own value falls 15% because its holdings diverge from the index, and the puts pay out only on the index level. Separately, the manager had sold covered calls on two large holdings to fund the premium and those shares were called away during a rally before the fall.
1. Assess whether the put purchase was an effective hedge and explain the basis risk.
Read the worked answer
The put protected against index moves below the strike, but the portfolio fell more than the index, so part of the loss was unhedged. That gap is basis risk: the hedge instrument (index puts) and the exposure (the actual holdings) are not identical. If the portfolio's beta to the index is above 1, or if its sector mix diverges, the hedge ratio is wrong. A 12% index fall with a 5% out-of-the-money strike gives an intrinsic payoff of about 7% of notional; if the notional matched the portfolio, the payoff is roughly 2.8 million against a 6 million portfolio loss, so the hedge offset less than half.
The manager should have measured beta and tracked error, sized the notional to the portfolio's beta-adjusted exposure, and considered a strike closer to the money or a collar. The premium of 600,000 is also a real cost: the hedge must be judged against the loss avoided net of premium, not by whether the option paid off.
2. Explain how the covered-call overlay interacted with the hedge and what the manager should conclude.
Read the worked answer
The covered calls were sold to fund the put premium, but they cap upside. When the two holdings rallied, the shares were called away, so the portfolio lost exposure to names that then fell - meaning the manager was forced to sell at the strike and did not participate in the subsequent decline with those positions. The combined structure was not a clean hedge: it bought downside protection on an index it did not own and sold upside on stocks it did own, so the payoff depended on the relative performance of the two, not on the portfolio's actual risk.
Conclusion: funding a hedge by selling calls changes the risk profile rather than removing it. The overlay should be designed as a single package with a stated objective (reduce drawdown to a target level at an acceptable cost), tested against scenarios, and monitored for unintended exposures. The manager should also disclose the strategy and its costs to clients.
3. What governance and disclosure issues arise from using this overlay in a client portfolio?
Read the worked answer
Derivatives use must be permitted by the mandate and the IPS, with stated purposes (hedging versus return-seeking) and limits on notional, counterparty, and collateral. The manager should document why the overlay was chosen, the beta and basis assumptions, the maximum cost, and the scenarios in which it underperforms. Client reporting should show the overlay's contribution separately and explain that protection is partial. Fee and expense treatment of premiums and option income should be clear. Counterparty and collateral risk on OTC options, and margin calls on exchange-traded ones, need to be covered. Finally, the manager should have a pre-agreed review trigger - for example, if tracking error or beta drifts, resize the hedge - and should record the decision trail for the client and for compliance.