hedging
Taking an equity position apart into its risks (market, funding, dividends, currency, borrow, counterparty) and matching each with a hedge and its price.
concept note · live ratesthe rule I keep coming back to
A hedge doesn't remove risk. It swaps a risk you don't want for one you understand better, at a price. So the useful question is never "is this hedged?" but "which risk did I keep, which did I sell, and what did I pay?"
No single policy covers fire, flood, theft and a burst pipe. You buy one for each, and each has a premium and an excess. Hedging a position is the same. Market risk, rate risk, dividend risk and currency risk each need their own tool, each tool has a cost, and each leaves something uncovered.
risk by risk
| Risk | What it feels like | The hedge | What the hedge costs |
|---|---|---|---|
| Market (beta) | the whole market falls and your picks fall with it | short index futures or an index swap, sized by beta | roll and basis; you also give up market upside |
| Funding rate | SOFR or HIBOR rises and your floating leg costs more | fix the funding leg, or pay fixed on an overnight index swap (OIS) | you lock in today's forward rates even if rates fall |
| Financing spread | the dealer reprices your spread at the next review | term-lock the spread for 3–12 months | a slightly higher spread, and fees to exit early |
| Dividends | a company cuts its dividend that futures or a swap had priced in | dividend futures or dividend swaps (HKEX lists HSI dividend futures) | thin liquidity beyond major indices |
| Currency | your HKD stock is fine, but the USD value moves | FX forward, or a quanto swap that pays in USD | forward points ≈ the rate gap; a quanto prices in correlation |
| Borrow / recall | the lender wants the shares back, or the fee spikes | term borrow, several lenders, or short the index instead | a higher fee; an index short doesn't hedge the single name |
| Counterparty | your dealer gets into trouble | daily collateral under a CSA, more than one prime broker | operational work, and less netting benefit |
worked example: beta-hedging a hong kong portfolio
Illustrative portfolio, beta and index level.
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the positionHK$80,000,000 of HK stocks, beta 1.2 to the Hang Seng Index
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one futures contractindex 25,000 × HK$50 per point= HK$1,250,000 of exposure
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contracts to sellbeta × portfolio ÷ contract = 1.2 × 80,000,000 ÷ 1,250,000≈ 77 contracts short
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the market falls 5%portfolio (expected) −HK$4,800,000 · futures +HK$4,812,500net ≈ +HK$12,500. What remains is stock-specific: the part you're actually paid to take.
Beta is an estimate from past data and drifts, so the hedge is re-sized as it changes.
hedging the funding rate itself
A one-year synthetic long paying SOFR + spread has a funding bill nobody can predict. To fix it, you can ask the dealer for a fixed-rate funding leg, or keep the floating leg and separately pay fixed on a SOFR swap of the same size and tenor. The floating SOFR you receive offsets the floating SOFR you pay, and you're left paying the swap's fixed rate plus your spread.
The catch: the fixed rate is the market's forecast of SOFR. If the market expects cuts, fixing locks in a rate below today's SOFR. If cuts don't come, you win; if they come faster than expected, you'd have been better off floating.
The currency hedge has its own carry. With SOFR's 90-day average at 3.646% and 3-month HIBOR at 3.020%, a USD investor hedging HKD currently earns about 63bp a year for doing so. That arithmetic is on the gap page.
Basis risk: the hedge and the position don't move exactly together (your basket vs the index). Correlation shifts: in a crisis, betas and correlations jump, just when you need them stable. Liquidity: the hedge you planned to add may be the thing everyone else is buying.
- A hedge trades one risk for another at a price. Name all three.
- Market risk → index futures sized by beta. Rate risk → fixed leg or a pay-fixed SOFR/HIBOR swap.
- Dividend, currency and borrow risk each need their own tool.
- What's left after hedging should be the risk you actually want.