Hedging a Multi-Asset Portfolio
A global portfolio is exposed to US stocks, European stocks, the euro and crude oil all at once. Switch on the hedges one by one and watch total risk come apart piece by piece.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
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Text version · Hedging Strategies, lesson 8: “Hedging a Multi-Asset Portfolio”
A global portfolio is exposed to US stocks, European stocks, the euro and crude oil all at once. Switch on the hedges one by one and watch total risk come apart piece by piece.
A portfolio = several risks stacked together
A European stock carries both European market risk and euro exchange-rate risk; an energy stock follows both oil prices and the market. First break the portfolio into several risk factors, then pair each factor with a hedging instrument.
Factors are linked to each other
The correlation between US and European stocks is high: hedging only US stocks also cuts European stock risk a fair bit. risk contribution already accounts for this link, so use its size to decide what to hedge first, and watch out for hedging the same thing twice.
The longer it runs, the worse value the hedge is
The first tool usually removes a big chunk of risk; each one after that removes less and less, while the cost stays the same. In practice people often hedge only the few biggest contributors and let diversification absorb the small risks left over.
Key takeaways
- Real portfolios are exposed to several risk factors at once (stocks, currencies, commodities…), and each major factor needs a matching hedge.
- Factors are correlated: hedging one also lowers the risk of related factors, so when stacking hedges, watch out for double hedging.
- Hedge the biggest risk contributors first. Each additional hedge does less, but it costs just as much.
- Once every market factor is hedged, what's left is each stock's own risk, which market instruments can't hedge.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Before turning on any tool, see which piece contributes the most risk and how much; then click "Hedge the biggest piece first" three times: which piece is removed at each step? How far does total risk fall?
- Turn on all four tools: what risk is left? Why can't index futures or forwards touch it?
- Switch to "S&P futures only": why is the amount sold bigger than the US stock exposure? Did the euro and oil risks change?
- In the stress test, choose "Euro crash": with only the euro forward on, how is the European stock portfolio's loss offset?
Quiz and explanations
- 1. Risk contributions: US stocks 55%, crude oil 20%, euro 15%, individual stocks 10%. If you can only put on one hedge first, which do you choose?
- Answer: Index futures to hedge US stocks.Removing the biggest chunk of risk first has the most effect.
- 2. Once every market factor is hedged, what risk is left in the portfolio?
- Answer: Each stock's own idiosyncratic risk.A company's own good or bad news can't be hedged with index or currency instruments.
- 3. Adding hedges in turn: total risk 100 → 45 after hedging US stocks → 33 adding crude → 28 adding European stocks → 26 adding the euro. Which step does the least?
- Answer: Adding the euro.The last step only cuts 2. Each additional hedge does less but costs just as much, so in practice people often hedge only the biggest few.
Terms in this lesson
- correlation (Correlation): How much two prices move together, from −1 to 1; the closer to 1, the more in sync.
- idiosyncratic risk (Idiosyncratic Risk): Risk specific to one company (earnings, accidents and so on) that market instruments can't hedge; only diversification helps.
- risk contribution (Risk Contribution): An exposure's share of the portfolio's total risk, taking its correlations with the other exposures into account.
- risk factor (Risk Factor): A common force that moves the prices of many assets at once, such as the market, exchange rates or oil prices.