Hedging and Risk Management Strategies
Core concepts
Hedging reduces unwanted exposure by taking an offsetting position. Candidates must know short hedges (sell futures to protect a long asset or future sale) and long hedges (buy futures to lock a purchase price). Understand hedge ratio and minimum-variance hedge ratio = correlation × (σ_spot / σ_futures), and the concept of basis risk - the residual risk that spot and futures prices do not move perfectly together.
Learn option-based hedges: protective puts (floor), covered calls (capped upside, income), collars (buy put, sell call), and the use of swaps to convert fixed to floating exposure. Know delta hedging: number of options to hedge = position delta / option delta, and that delta changes with the underlying, so hedges must be rebalanced (gamma risk).
Traps
Questions often assume a perfect hedge - it is not. Basis risk remains, and hedging a specific asset with an index future leaves cross-hedge risk. Another trap is confusing the direction of the hedge: a producer worried about falling prices sells futures (short hedge); a consumer worried about rising prices buys futures (long hedge). Watch for over-hedging, which turns a hedge into speculation.
Worked example
A portfolio worth 10 million has beta 1.2 against an index future priced at 4,000 with multiplier 50. Contract value = 200,000. Number of contracts to hedge = (10,000,000 × 1.2) / 200,000 = 60 contracts, sold short. If beta were 1.0, only 50 contracts would be needed.
Rule of thumb
Hedge the exposure, not the view. Size the hedge to the risk being neutralised and monitor basis and delta drift.