Hedging: insurance you pay for with return

Hedging is not a way to make money, nor is it protection against loss in general. It is a trade that transfers a risk named in advance to the other side of the market, and you pay for that transfer: with a premium, with the cost of funding, with the price difference between the contract and the asset, sometimes simply with the upside you give up. A properly constructed hedge makes the portfolio's result more predictable and, almost always, more modest. If the expected return has not fallen after hedging, you have most likely hedged the wrong risk — or hedged nothing at all.

What exactly you are buying when you hedge

A hedge is always targeted. You cannot "insure a portfolio" — you can only close off a specific source of volatility: a fall in the price of an individual security, the exchange rate of the currency in which the issuer's revenue is counted, a move in the interest rate that drives the price of a long-dated bond issue. The first thing worth putting into words before any trade is a sentence of the form "I lose money when this happens". If the sentence cannot be written, there is nothing to hedge, and the derivatives contract in the portfolio becomes not insurance but a second independent bet.

A less obvious point follows from this: hedging and diversification solve different problems. Diversification spreads risk across many unrelated sources and leaves you with the average result. A hedge leaves the risk exactly where it was, but sells it outward at a price set by the market. The easiest way to see which securities your risk is actually made of is the snapshot of the equity market; for the debt part of the portfolio the starting point is the list of OFZ, where sensitivity to the interest rate differs between issues more than their names suggest.

What the price of the insurance is made of

The direct part of the cost is visible straight away — it is the option premium or the spread in the order book at which you enter and exit. The indirect part is usually larger.

A future on a share or an index does not trade at the price of the underlying asset but at a premium or a discount, in which the market prices the cost of money until expiry and the expected dividends. By selling a future against your own shares, you give that premium away. If a record date for the share falls within the life of the contract, the arithmetic changes once more: payment dates are convenient to check against the calendar —

— and in the dividends section.

Initial margin is also a cost, even though it does not look like an expense. The money behind the position is not working, and variation margin is debited daily, regardless of what is happening to the main asset. The classic way to lose on a successful hedge: the insurance paid off, but to keep the position open you had to sell part of the portfolio at the wrong moment.

And finally: the loss on the hedge and the gain on the underlying asset fall into different calculation categories, so the result "before tax" and the result "after" may diverge. The general framework is 13%; the specifics of your own case are best clarified with your broker, since the platform has no data on your accounting.

Basis risk: why a hedge does not close the position completely

The instrument you hedge with almost never matches what you are protecting. An index future against a portfolio of individual shares, a currency contract against an exporter, an issue with one duration against an issue with another — a mismatch remains everywhere, and that mismatch is what is called basis risk. It does not disappear; it is simply smaller than the original risk.

The mismatch grows when the market stops behaving as it does in calm times: the correlations the calculation relied on change faster than the position does. That is why a hedge built on the historical relationship between assets has to be tested on events, not on averages. The instrument card — SBER — shows the parameters of the security, but the link between its moves and the index is something you assess yourself and revise when the market regime changes.

A derivatives contract lives by the calendar

A future and an option have an end date, and it is not aligned with your horizon. A hedge longer than one contract has to be rolled: you close the expiring contract and open the next, each time paying the spread and a new premium. A series of rolls over a long horizon can eat up more than the risk being protected — a frequent reason why a "permanently hedged" portfolio lags behind without any visible disaster.

A separate word on the debt part: in bonds, a mechanism similar in effect to expiry is built into the security itself. A missed put date changes the terms in such a way that a hedge built around the issue loses its meaning — see how a put option on a bond works. Corporate dates are convenient to keep in one place: the events calendar and financial reports.

When there is no need to hedge

If the horizon is long and the money will not be needed by a specific date, price swings are not a risk but a condition of how the instrument works, and there is no reason to pay to remove them. If the position's share of the portfolio is small, the cost of the hedge will outweigh the effect. If you cannot name the event you are protecting against — see the beginning of the article.

A sensible alternative to derivatives contracts is to change the composition of the portfolio itself: reduce the position, shift duration in bonds, use funds with the exposure you need. This is cheaper and does not require daily maintenance.

A check before the trade

Step 1 — name the risk and the date by which it matters. Step 2 — choose the instrument and write down honestly what mismatch with the underlying asset remains. Step 3 — calculate how much the position costs to maintain until the required date, including rolls and margin. Step 4 — define the exit condition in advance: a hedge held "just in case" with no criterion for closing it turns into a permanent tax on return.

The terms encountered above are explained in the glossary; events and the market's reaction to them are covered in the news.