Hedging

Alexander Denev

Hedging is a topic that we think deserves a separate chapter due to the variety of specific issues it entails. We shall show in this chapter how PGMs can bring insight in choosing better and cheaper hedges to protect against future scenarios that cannot be handled in a satisfactory manner through standard statistical methods.

When it comes to the selection of an optimal portfolio, the best solution for an investor is to include all the asset classes and hedging instruments in the optimisation engine and take the allocation weights obtained in this way. However, hedging can be considered as a separate exercise from asset allocation in the following cases:

• the institution’s core business model does not involve investment in optimal portfolios, eg, a commercial bank lending in variable rates (eg, a fixed spread over the London Interbank Offered Rate (Libor)) may want to hedge its interest rate risk;
• an insurance company or a pension fund that wants to hedge the duration mismatch between assets and liabilities through swap overlays;
• an institution with specific investment mandates and limitations;
• a non-financial institution, eg, a utility company.

Hedging can be done