Page 128 - DCOM507_STOCK_MARKET_OPERATIONS

Unit 6: Trading Strategies

Notes

Caselet The Perfect Hedge: JP Morgan

t its simplest, to hedge is to offset risk. While the term is most often associated
with investments, we all hedge all the time. We buy health insurance to hedge
Aagainst the costs associated with an accident or illness. Farmers settle on a price
for their crops before the planting season to hedge against big fluctuations in supply or
demand. Airlines lock in future fuel costs to hedge against volatility in the price of oil. I
will be wearing a helmet when I go mountain biking this weekend to hedge against
serious injury. You get the point. On Wall Street, a hedge can take all sorts of complicated
forms and firms are always on the lookout for the perfect hedge – one that reduces risk to
zero.
For JP Morgan, the quest for the perfect hedge cost the firm $2 billion. If hedging is meant
to offset risk, then how could that happen?

Reports indicate that JP Morgan was betting on changes in the creditworthiness of US
investment grade corporations (basically, betting on the US economy). To offset their risk,
the firm bought credit default swaps. These financial instruments are a form of insurance
against exposure in the fixed income market. Similar to health insurance, when you buy a
swap, you make premium payments to the seller in exchange for protection, in this case
protection against a default on the US corporate loans. That sounds like a good hedge,
right? It usually is.
Where things got complicated is that JP Morgan also began selling related credit default
swaps. By selling, the bet changes from likely default to likely payment. The seller collects
a premium (he acts as the insurance company this time) for each swap making a tidy profit
in the process. JP Morgan’s “London Whale” got his nickname because he sold so many of
these swaps that he basically drove down the cost of premiums for buyers.
So now JP Morgan owned the underlying bonds, owned insurance on some of those bonds
and sold insurance on a lot more. When the sovereign debt fears flared up again in April,
the firm was caught with positions that were losing value on both sides. To make matters
worse, when they started to unwind the worst of them (the swaps the London Whale had
sold), other investors caught wind of it and used that knowledge to make it very difficult
for them, thus multiplying JP Morgan’s losses.
On the conference call, CEO Jamie Dimon said, “The portfolio has proven to be riskier,
more volatile and less effective an economic hedge than we thought.” Not the perfect
hedge after all.

Source: http://exchanges.nyx.com/allison-orourke/perfect-hedge-jp-morgan-case-study
6.4 Hedge Fund Strategies

The predictability of future results shows a strong correlation with the volatility of each strategy.
Future performance of strategies with high volatility is far less predictable than future
performance from strategies experiencing low or moderate volatility.
Aggressive Growth: Hedge fund investors invest in equities expected to experience
acceleration in growth of earnings per share. These are generally high P/E ratios, low or
no dividends; often smaller and micro cap stocks, which are expected to experience rapid
growth. These include sector specialist funds such as technology, banking, or biotechnology.
Hedges by shorting equities where earnings disappointment is expected or by shorting
stock indexes tend to be “long-biased.” Expected Volatility: High.

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