Financial literacy: how to protect your capital in a crisis
Any economy is cyclical - sooner or later moments of decline are replaced by growth, and vice versa. And what happens to the economy during a crisis and how to protect yourself and your capital in such a period? The financial term "hedging" will help us answer this question.
Characteristics of the crisis economy
The dynamics of growth and decrease is determined by a number of economic factors that affect the entire socio-economic system of the country.
All of the above indicators are interconnected and have their own share of influence on the entire economy of the country, expressed through GDP. For example, the stock market usually reacts faster to changes in the socio-economic situation of the country than the GDP. If the market falls, the attractiveness of direct investments in the company will be low, and vice versa. Therefore, most stock indices are considered leading indicators in their economic environment.
Stock market hedging strategies
Hedging is a method of reducing potential risks, which is characterized by opening trades in different markets to compensate for losses.
For example, if you already have long positions in the oil market at the time of its fall and you do not expect the market to recover in the near future, you can open long transactions in the gold or currency market through the US dollar to compensate for part of future losses.
How to identify a hedging instrument? There are three main insurance strategies that involve:
- reverse dynamics
- direct dynamics
- fixed income instruments.
Since hedging implies opening trades in markets with reverse dynamics, in the first strategy one can use a simple enumeration of pairs of financial instruments, the correlation coefficient of which is close to -1. In fact, we need to take the correlated instruments back to positions already opened earlier. With this strategy, you can significantly reduce your losses.
For example, let's take a key European index - Euro Stoxx 50 and Amundi ETF Short Euro Stoxx 50 Daily UCITS ETF (C5S). Their dynamics directly reflects the meaning of hedging. The correlation between them is almost absolute -0.94 and depends directly on the quality of the fund's asset management.
The second hedging strategy implies an opportunity for an investor to use short positions (shorts) - a situation in which an investor, expecting a fall, borrows securities from a broker at a high price, in order to return them later at a reduced price.
As a visual representation of this strategy, you can choose any ETF investment fund on Euro Stoxx 50, for example Deka EURO STOXX 50 ESG UCITS ETF (ELFA). The correlation between them is 0.996. In fact, it is the best fund in the Euro Stoxx 50 globally in terms of matching the performance of the stock index itself.
The last strategy uses fixed income instruments such as bonds, structured notes or P2P lending. Here we need to use portfolio restructuring - a risk management method in which the investor adjusts their portfolio to proportions in accordance with their investment strategy. At the same time, it is important to understand that they do not sell securities, but buy them in addition to the risk-return level they need. If variable-income securities in the portfolio sink, then the investor should increase the share of fixed-income securities in order to offset the expected losses in the future from increased risks.
An example of hedging
Now let's take a look at real examples of these strategies and find out their effectiveness. We will consider stocks and P2P lending as underlying assets.
Let's say we have a notional investment portfolio of €100K, which contains 100 Louis Vuitton securities from the Euro Stoxx 50 index. The purchase of shares was made on January 3 at a price of €731 for the amount of €73K (73.1% of the portfolio). On September 30, the share price reached €610. Therefore, the portfolio's current return is -16.5% (-€12K). Using the strategies described above, we will try to choose the optimal hedge security (stock) from the Euro Stoxx 50 index.
Using the first strategy involves the purchase of securities with the opposite dynamics. In fact, these are papers that are negatively correlated with Louis Vuitton. After going through all 49 pairs of securities of the index, it turns out that the largest inverse correlation with Louis Vuitton is observed in Bayer (-0.509). The yield of such a portfolio will slightly increase to -12.2%. The hedge worked.
The second strategy allows you to short highly correlated stocks in the index. Such a hedge in the case of the correlation approach is Hermes International, whose correlation coefficient with Louis Vuitton is 0.924. The yield of such a portfolio with a short position will be -6.53%. Hedge paper has fully justified itself. In the case of the cointegration equation, the hedge paper is Pernod Ricard. The ultimate return on such a portfolio is -9.34%. The correlation approach with short positions proved to be better than the cointegration.
The third strategy involves the use of fixed income instruments, such as P2P lending. At the moment, the average profitability of the European P2P lending market is approximately 13% per annum. In our example, after buying 100 Louis Vuitton papers, we still have €26,9K cash left to invest in P2P. In 9 months, the P2P portion of our portfolio will return approximately 9.75%, which, in turn, will increase the portfolio return from -16.5% to -9.44%, being the third result of all strategies.
What is the result?
Let's summarize the results of the calculations in a compact table.
The best option for hedging losses was found using the second strategy, based on the short positions of Hermes International securities, which are directly correlated with Louis Vuitton. The less reliable correlation selection approach proved to be better than the cointegration one in terms of growth in the return of the entire portfolio.
But can we expect the same dynamics and connections in the future?
For the second (cointegration) approach - definitely yes, for the correlation - no, which is undoubtedly an advantage of the second. However, both approaches paid off. So, every €1 lost on Louis Vuitton paper is compensated by €0.46 of Hermes International and part of the remaining cash.
In the example above, simple hedging tools were used to better illustrate how insurance works in the stock market. The main problem is that typical hedging instruments are complex. Most often, futures, options, swaps and inverse ETFs are used for this. One needs special knowledge and skills to use them.
A hedge is essentially an investment designed to move in the opposite direction from the underlying asset. It can be applied broadly to minimize losses across all instruments in a portfolio, such as stocks, bonds, gold, or commodities. And it can be used narrowly, to protect a specific position, as was discussed in our example.