The perfect hedge

Hedging a portfolio is an illusion, because a near perfect hedge delivers more than a risk-free return consistently.

Aristotle’s Organon is not to tell readers what is true, but rather to give approaches for how to investigate the truth and how to make sense of the world. The primary tool in Aristotle’s tool kit is the syllogism, a three step argument, such as “All woman are mortal; Cleopatra is a woman; therefore Cleopatra is mortal”. Aristotle was also the first one to use the term ‘Hedge’, explaining a financial innovation used by Thales a philosopher from Miletus and his transaction of Olives.

Its origin and purpose

The first modern organised futures exchange began in 1710 at the Dojima Rice Exchange in Osaka, Japan. John C. Hull, Professor of Derivatives and Risk Management detailed the hedge process in his now famous book on options, futures and other derivatives. In the chapter on Hedging with futures, he says, “Many of the participants in the futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. Study of hedging using futures contracts is a study of the ways in which hedges can be constructed so that they perform as close to perfect as possible”.

Hull takes two kinds of cases, hedge and forget i.e. there is no readjustment of a hedge position once it is taken. The aim of hedge is to neutralise the risk as much as possible. Now there is a problem here. The idea of hedge failed for LTCM (Long Term Capital Management). Society failed in its understanding of hedging and calculation of risk. The reason we as a society do not understand risk may not be the only reason we can’t hedge it. We may also not know how to hedge in the first place. The near perfect hedge which Hull illustrates in his book should not diverge more than the risk-free rate of return. If despite following the hedge steps, the strategy can deliver more than the risk-free rate of return, the hedge as John taught us or as the world understands is incorrect.

Performance cycles
Inefficiency in prices is when it diverts far from notional, theoretical value, while efficiency is when markets find its value. Performance cycles are about illustrating how markets move from efficiency to inefficiency. The more visible performance cycles get, the more challenged the idea will be. How can you show the market movement from efficiency to inefficiency? Market technicians have done it for decades. What Orpheus is doing is making the exercise mathematical. We have illustrated cross market cases till now on metals, energy, agro, bonds, global assets, global indices, US sectors, US stocks, CEE indices, Indian stocks and sectors etc.

Today we are carrying a special case, which conventionally would be considered a near perfect hedge. A perfect hedge has no business of making money and it is tough to build a strategy of making profit from such a situation. We have carried similar cases when we carried pairs between Gold-Silver, Oil-Natural Gas, S&P500-Dow30, but they are still not as perfect as buying spot and selling the future on the same asset. This strategy is executed by an investor who wants to insulate a portfolio from unwarranted loss. Conventional knowledge gets renewed with time. Time changes everything.
 

BEES FUTURES
Start day	Absolute	Days	Annualised
03.07.2008	11	65	61
10.10.2008	10	14	254
18.05.2009	3	45	26
08.09.2009	2	51	12
Average	6	44	88
Source: Orpheus Capitals

We have illustrated the case where we have bought Nifty BEES and sold Nifty futures (Indian Index and its future). Since we cannot short NIFTY bees we have taken only cases where we can Short Nifty Futures. Since April 2008, we have illustrated 4 times when one could have shorted Nifty futures and bought Nifty bees making on average 6 per cent and annualised 88 per cent with an average holding period of 44 days. We have illustrated all the cases below. This exercise can be consistently done across time frames. Give us a perfect hedge pair and we would isolate more than risk-free return in it, consistently.

Alpha is infinite just like inefficiency and there is nothing called a hedge. You were never and can never be hedged. The only thing you can do is understand when markets are moving from low inefficiency to extreme inefficiency and when markets for that infinitesimally small moment pass through efficiency. Black and Scholes’ Nobel prize winning model assumes Geometric Brownian motion, which is also known as exponential Brownian motion could not have existed without assuming exponential nature in prices. This brings us back to the Aristotle’s logic.

If markets are inefficient, hedge is a part of market, so hedge should be inefficient.

If nature is exponential, time creates nature, so time should be exponential.

If truth is exponential, time is exponential, then time must be the truth.

The author is Chartered Market Technician and CEO, Orpheus CAPITALS, a global alternative research firm