How to Build a Diversified Hedging Portfolio Using a Delta 1 or < 1 Approach
When I talk about building a diversified hedging portfolio as a business, I often use the analogy of building an investment portfolio as an individual.
With an individual investment portfolio, a mix of different, non-correlated asset classes (i.e. stocks, bonds, etc.) is used by wealth management advisers to minimize risk and maximize long-term results—no matter if it’s a bull or bear market.
Similarly, with a diversified hedging portfolio, a mix of non-correlated tools is used to minimize volatility and maximize business results—regardless of how the market behaves.
The idea? Companies with commodity exposure that grow and thrive over time are NOT the ones that attempt to time market decisions and guess short-term directional biases, but instead those that have a disciplined and proactive risk management approach, and ultimately make money in every market environment.
How do they do it? The graphic below provides a start to the explanation.
From a buyer perspective:
An effective diversified hedging portfolio uses a mix of different tools:
- No hedge
- Tailored strategies (i.e., over-the-counter strategies, which we’ll get to in a moment)
Why this combination of tools?
- The non-correlated behavior of these tools mitigates and spreads risk evenly across the board.
- The combination reduces cost and volatility and increases odds for financial success—all factors almost every business looks for in its business performance.
- The potential outcome of each tool is different, which complements the other’s weaknesses.
Most of these tools are commonly known to financial markets with the exception of tailored (OTC) solutions. These tools can bring opportunities if used in an appropriate portion of the hedging book and with a lower or neutral relative leverage to a future.
Let’s compare tailored solutions against the other tools in the mix:
Just like the other tools, tailored solutions have their advantages and disadvantages:
- Tailored tenor, size
- Ability to achieve price targets not available in current markets
- Ability to allow for opportunistic pricing
- May include leverage
- May not cover all the quantity ordered
- Proactive stress testing and management may be needed
In recent financial history, there have been plenty of cases where hedging portfolios got into trouble with unpredictable outcomes. Industry professionals have experienced volatile cycles and seen the consequences of market participants severely affected by positions taken in the name of hedging.
Most of these cases have included one of the following common factors:
- Excess of taken positions: In other words, the company overall hedged exposure that ended up being too large relative to what the company was supposed to cover.
- Concentration of tools: Companies used a disproportional concentration of positions in one or too few tools, making the portfolio exposed.
So, if we’re focusing on using these tailored (OTC) solutions to mitigate risk and maximize performance, one specific possibility comes to mind: A Delta 1 or < 1 approach.
What does a Delta 1 or < 1 tailored solution mean?
- Removing or minimizing the leverage from a tailored (OTC) solution to match a company’s hedging policy tolerance, while still taking advantage of its positive contribution.
- That the potential outcome may not be greater than an equal quantity of a futures/forwards position.
A consumer looking to buy September 2020 Corn with the following objectives:
- Have a Cap at 415 cents-bushel relative to today’s market of $400 (September 2020 Chicago Board of Trade (CBOT) Corn future price as of September 13, 2019)
- Have unlimited downside potential savings in case markets fall
- No leverage (short options) involved on the strategy
- No premium cost for the strategy
Here’s what the designed tailored (OTC) solution would look like:
Modified Capped Average
How does it work? Every day, during the strategy period, the CBOT closing price for the September 2020 future is:
- At or above 415, the price taken for the average that day is 415 cents/bushel (cap).
- Below 415, the price taken for the average that day is the market closing price (downside savings potential).
- On expiration date, the buyer will settle the resulting average versus the futures closing price.
- The strategy is designed with no premium cost for the buyer and with no leverage (no short options).
At the end of the day, using a Delta One strategy within your hedging performance can help you better mitigate risk. It can also help you maximize performance regardless of the market conditions.
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