The Art of Hedging ees Stephen Antczak, CFA Rebecca Cheong, CFA Willie Williams Head of US Credit Strategy Head of US Advisory FX Derivatives Sales 212-278-7803, 212-278-5302 212-276-4417 stephen antezak@sqelb.com rebecca. cheong@sgeib.com wile williams @sgcio.com SOCIETE GENERALE Corporate & Investment Banking Please see important disclaimer on p. 28Five Main Portfolio Risks Idiosyncratic Risk - > Risk associated with an asset that cannot be explained by common factor risks > This is generally considered as “alpha” m Market Risk — > Common factor risk specitic to a particular asset class, such as sector risk > This is gonerally referred to as “beta” = Correlation Risk - > Gross-Asset risk associated with another asset class, such as equities vs. bond correlation > This is particularly important in a multi-assot portfolio where overall risk is based on cortain correlation assumption ™ Macro Risk - > Extraneous risk not specific to any asset class but has a broad implication, such as global recession > This risk can change significant over time even for the same portfolio = Tail Risk - > Tail Risk refers to an unexpected extreme scenario that causes 4 multi-standard deviation down move within a short period of time > This risk usually has a low probability, but an unusually large impact to a portiolio -> FAT TAIL! SOCIETE GENERALEPortfolio Hedge Comparison Overview o a jobs Ressten Tio Too Coety 2 “Maker Siow Large _Sectar Caneurraton Fk No~Too Cost Maybe = ue-Based 3 Covaiaion Mocerato Modersto Egutes vz. Gord tie Gach Time 4 “Wfaco”—Mecorts— Mederste Bazi Foregn fom Tax rie ach Tine 5 Tal Shap Smal Lohman Crt Yee 4) Macto Risk 1) Idiosyncratic Risk _32) Market Risk x Vv \ ui ‘Comihodites "Beta, Alpha = —~ _-~~ 3) Correlation Risk yO a ~_\ Private Eq Atpne Beta A A Beta Alpha (Be \ — $5) Tail Risk ————_____uee, EB SOcIETE ceneRALE Sipe neste brTaiogrnore Marist Ta Hedging Instruments Overview ™ One-Delta— > Instruments — Portfolios, Futures, ETFs & Swaps > Payoff - Symmetric > Strategy — Tactical, Shorter Term = Vanilla Derivatives — > Instruments — Listed Options > Payoff — Asymmetric Strategy ~ 1) Long Options require Upfront Premium but has Limited Downside Risk 2) Short Options may collect or cost premiums; downside Risk may not be Limited 3) Maturity: Longer Maturity is Cheaper / Day but subject to Spot drift away from Strike. = OTC Single-Instrument Products - > Instruments — Innovative solutions to tailor investors’ view. €.g. CDS, Digital & Barrier Options > Payoff - Typically more Leveraged than Vanilla Derivatives. ™ Correlation Products — > Instruments Examples — “Worst-Of", Dual Digitals, Correlation Swaps, Dispersion > Payoff - Typically need all the Undertiers in the Basket to move in the expected direction Volatility Products — > Instruments Examples — VIX, Vol Swaps, Variance Swaps & Forward Variance Swaps SOCIETE GENERALE Capote dine ongIdiosyncratic Risk Hedge — Very Limited Choices Instead of hedging idlosyneratic risk, mi would be prudent Investors choose to retain it o8 However, F cancervaton rek bacores to bg, hedging lm The most common and direct way of hedging idiosyncratic risk is via the asset Itself or option on the asset However, certain circumstances disallow such a practice such as — > Regulation: During IPO lock-in period > Liquidity: Holding size is large relative to trading volume = Potential Solutions > Short a basket of assets with the most similar risks (referred to as “the basket") > Buy put or put spread or collar on the basket to limit downside risk SOCIETE GENERALE Sipoaeamasinem eenMarket Risk Hedge | - Underlyer Selection Warkat Risk typically dominates Common Facior Risk. This is particularly Important when dispersion fs high (oomerisis period). Wain Hedgng Trsde-of is Lquty/Tedng Cost (sta Index) vs. rack Ema (Custom Bssket to talrrik excosues) = mBoat “| | meee a ee | S lyagllTl]f tty LE year poe tle = yall li Mth ay I | tN] = AO% | Best Mirus Worst Anmual Petr Ae Sees =| Be) tm aa SESH EEE EES “SOPHIE OOE 28: LLL, = Example 1 - SPX Best Worst Sector dispersed by 47% per annum between 1990 & 2009. An income portfolio consists of Telco & Utilities sectors only lost 1% in 1996, but would have lost 21% if hedged with S&P 500 which rose 20% that year. = Example 2 - For the 12M ending June 08, all but one sector fell; Bovespa Index rose 20% due to its heavy weight in Petrobras & Vale. Non-Materials investor hedge with Bovespa would have lost in his own portfolio & market hedge SOCIETE GENERALEMarket Risk Hedge Il - Timing Selection. "A"Blind” Systematic Approach le TOO COSTLY. That's why Hedging lean ART! ‘SPX Cumulative Rot Uahedged vs edged with 2 10090 Pu pre —srx 8PiHedye 565 PS) SP edged cao F5) SPxHodget 98 wo Skaggs) \ bai Systema Hedge va SPPRER EEE RRS 13 Options eet oe DNL bvees 1599 a 209 m Suggested Alternatives > Investors could hedge Tactically based on market views or market parameters > vgstor could use mat signal such as VX oad or neroase hedge (Example fn Market Fisk ige SOCIETE GENERALE. Scpaate a nore tng> Mlogyneratt ET Corretation > Macro > Tall > Market Risk Hedge IIl - Sample Rule-Based Strategy ‘ASimple Rule-Based Example shows the potential improvement over “blind” systematic hedging strategy ‘SPX Hedge Rete Px ‘SPX Hoagod ub Seana 100100 PS) 1 ‘SPxHoagod (10990 PS) zoo | ioe | Pe om gn lim | me gon | 26m | ise atm y au | oe | ote ¥ 20 | om | ire 18% y zon | a | mm te gow | ax | ae am Towrage ts] Os ‘don | ae | oN a ) a A Simple Rule improved average return by 5% per annum vs, a “blind” hedge "Pidaitaiitviri = Example — Two Hedging Criteria > Hedge when fear rises > Spread of VIX - 1M SPX Realized Volatility > 1M Avg Spread » Not Hedge when fear is overpriced (too extreme) -> Spread of VIX— 1M SPX Realized Volatility <10 SOCIETE GENERALECorrelation Risk — Not A Stable Relationship ‘Corelation Risk stypeally hedged via hybrid products, coraation swaps or dispersion strategy. = Correlation Risk exists both Intra- and Inter- asset classes. = Correlation Risk is critical in a multi-asset portfolio. If realized correlation deviates from assumption, overall portfolio risk can change substantially. Example: Pension Fund Diversification assumption will break if correlation rises among asset classes. =| Even for a single asset class portfolio, leveraging a cross-asset view via a hybrid product may reduce hedging cost due to correlation effect. =i 2 : — Ci i = PAN i (ald consid herd creo, scent ” BO Dun iss pore, domes or ah gol and USD re cenoraly ‘Comte woe SSRRRREERRRRERS SOCIETE GENERALE seacsewovowe S0SteunstnentotegMacro Risk | — Different Each Time Waco Hedge I iypiclly view based, Goal eto Idely the "Firat Degree of Impact fo manimiza Payout. Hance, an open skalegy § normally Prefered ums rs and leverage upside potent Macro Risk Is an exogenous factor not dependent on specific asset classes, such as, political and economic risks. Macro Risk may introduce new scenarios in an asset selection process, which is typically hard to quantify the exact impact. Historical Examples: » Recession: Jul 81 — Nov 82, Jul 90 — Mar 91, Mar — Nov 01, Dec 07 - Dec 09 » Oil Crisis: Oct 73 — Mar 74 (OPEC oil embargo against US), 1979 — 80 (Iraqi invasion of Iran) » FX Crisis: Brazilian Real (BRL) devaluated from 1:1 vs. USD to 2:1 in 1999 and eventually 4:1 in 2002, 1997 Asian Financial Crisis & 1998 Russian Financial Crisis were driven by foreign FX devaluation that led to LTCM collapse » Stagflation: High inflation + Economic stagnation in 1973 — 75 > European Sovereign Crisis: Greece Sovereign in 2010 SOCIETE GENERALESears Mat = Macro Risk II - Recent Trends from the 360 Monitor SOCIETE GENERALELatam Currency Crisis - USDBRL Asian Currency Crisis - USDKRW Greek Sovereign Crisis - EURUSD SOCIETE GENERALE ersten myFX and FX Vol may be used as a cheaper proxy to hedge for certain scenarios USDJPY vs S&P 500 correlation EURUPY vs S&P 500 correlation ‘Then: Equity skew low due to "Risk On". FX skew High due to currency hedging from Japanese ‘exporters and deeply discounted forwards due to higher G3 rates Now: Equity skew high due to lack of supply because of new regulatory contraints, “Risk Off, dooply discounted forwards duo to low G3 rates. FX skew low duo to lack of forward discount, and intervention from CB to prevent further JPY strength SOCIETE CENERALETail Risk | - No one likes to hedge this low probability event but needs to! FATTAIL LOW PROBABILITY LARGE DOWN MOVE sociere GENERALETail Risk Il - WOW! How Did We Get Here? Monthy I-A mortgage supply, 207-07 Tveraged oon unre, 00 2 = ae : = a enc nan Se sae et, cD Parca ct oan sane eo eharoeldr Mendy purposes Morgage td rose as underwingstandards dened a Department of Justice SOCIETE GENERALETail Risk Ill - WOW! How Did We Get Here? ‘One Key reason for “bubbles” is that many have a tendency to move incrementally. Fis, tke a pool of morigages wih sinfant underying to ths pol through securtizaton. Why dont wo ad abit ore leverago va an ABS structure, is that mare leverage thugh another sacutzation shoulbe OK Aer lite A coltral tow a Es) ‘ert BBR rior 8 ser 0 SOCIETE GENERALE, Expented reste be eiTail Risk lV - Was Lehman Crisis Unique? - Not Really Different Drivers, Same Underlying Problems & Same Results. Diferent Dives - Each Aset Class has caused atleast ONE markt ach over the les tho dacades, Same Underhng Problems ~ Too Much Leverage, Too Lt Liquy. Same Resuls- Rtn Fall, Vly Rose & Conlon R Equities Recession/Tech Bubble Feb 01-Apr01 ‘WorkiCom Accounting Scandal ‘Mar 02— Jul 02 Commodities Asian Crisis Retum ‘Gui War Jul 97 - 1998 Fell Jul 90 - Oct 80 Rates Credit Russian Default, LTCM Volatility Rose Lohman Crisis Jul 98 - Oct $8 Rose Aug 08 - Nov 08 Real Assets Home Price Colapse 0503-0804 SOCIETE GENERALETail Risk V - Drawdowns are more common & Hedge Moves are more “predictable” than you think! Equity Market had 21 drawdown periods °20% decline) ove had tre most conaetant and exclosve movas dung cis, Spot itedge rte "Feafedge SOCIETE GENERALE snr snm one emo 5 Ge SCOSTESENGROY Safety HedgeSiac Marist > Corres > Maco S357 Tail Risk VI - Recent Hedging Payoffs (4/23 - 5/20/201 ‘WC & COX Siraegies were the best hedges. Othe than ese Fear Hedges, among Index Vanlla Opin, OTM opons prowde he best pays! ratios eo et Payout Donnelae as Te a Roideateae Tparery | Rite Swe Gor Trade ume Long aM ATHE90 PS 14 UpfontPromtim SM testamenocs | os Usietsroniee Long aM @6 Put 40° Upfront Prom “ aor Long 3M 05.85 PS. 23 fro Prom Long aN 105 Gal G2 Ubtont Prenim Fame ono — Loam atin Par 32 thotPemim = Leng 9105-19503 | 0§ __Uptont Perum, torgauam ea [82 trovkl” — GEYTUSO) Leng swan cal = Dotort Partum lengeu nea {oto Lengswarmnriocs | oe Uprent>emium Peay ay Lang sk 105 ca 24 Uport ori ‘WeCTEAFE Line sMATW Pur —2¢—Uponrontin Long sat 105-1'568 | 15 _uptnt Prana Longamaneooes | 12. Upronteromim — JBYUBD ‘tng SWATH Cal 08 Upon rerio tong ase 25 Upronprentin Lengswarentocs | G1 UprentPenim Long 385.8525 22 Upon renkin Leng 4105 Cal 14 Upfront Perum TSC ERG Lona ATP Tt —Gprentrontm —-ToVoar Treasury Long sMATM cal 27 Ustort rari Tingawaneaves | 17 Upfonprentin engsarenriocs | 5 Uprentemim tong ates Pa 43, UptonPrentin ings tos $4 Upronteroriam Lang 2.05 PS 28 __UpromPrenkin Longsatie5-s¢s_| 33 Upon Prana FISEARGS CWAsLong AAT 1 tpetvonn mio [= Tongawareages | 11 Uptoabentin TapATAAGST a bong aes Pa 24 UbtontPrenbin ena 24120-GetaCat | 310. UptrePat Lemaweseses | 17 Upton remtam, Ueng2\16 staat _| 164 Upfront Pram eee ‘ing 2414020 Deta CS] 23 —Uprent Pramaure Ling 220" setac] 53 pnt Pena tang gu AmeD0 PS Shor av 02 70 baa] 381 Stke tare tong hss {3 Upton Pom. Shela a a] 8 Sine e {Upto Premt\ aa geaeg SM Oat _21 Ske nacre, Leng S987 £ fs DOXTG Spread tong S¥ Cred Petectol 197 HVSpresd Leng ¥ Ged Pret) SOCIETE GENERALE Expected rected botong see aco tesences Marist = Corr Credit Hedge | - Simple is Not Necessarily Bad For reference, we provide @ mat hat presents the P&L freight hedgrg vehicles given varous decines nthe SPX ndex, assuring thatthe chance of SPX flings 25%, This matrix asus that ho SPX hovers in +2% to 2% othe, PL for various dectnes ofthe SPX index with 2% chance a aecurrance thousands) ‘Hosouy HY indo CDXIG—«COXHY 70 Tranche 00-100 Tenens SPKPUt Kal ems 89 4s ot @7 a0 22 18 ome es os 110 0 40 ta ems 100 es 2 12 ue 10 105 Ese oe 6 18 as tar 109 oe 18 ' Pow ae 45 uae as 130 x0 wa 18 Bosom ane aa sa 107 m2 ua 161 130 sm aa 12 a7 ue ma 02 ma ms sem ar 108 07 m2 no m5 mo me SOCIETE GENERALECredit Hedge II(a) - How to Fund a Hedge? ato of eevance for sharhalder-rendly acties ve. refsancing setae Rani “Amountof cash and equivalents for atypical company Fro cath ow ve evisend or atypical company i PRESERE Ih atull S3SSFE SENERRTE marae ae S2mete Snboy Ye A tm Ld Eapsats eee beneSener Marke Cre aT Credit Hedge II(b) - How to Fund a Hedge? ‘As re of hub, we favour selectWvely using short-matunty high-yield risk to fund longermeturty shorts inthe high-grade space. Shorter ‘enor high-yield postions tad fo be ctven more by fundamentals nd less by headines than lngetaror cc postion, and we are rat parculaly concered about near-term default isk {LONG 3:yoar COXA Serle 10 nd SHORT Soar CDKIG Series 4 Soe Couey nse Pra of th crvtiocon sytem nce 2004, Decl CORY Sere 10 yarn, cathern CORE yea pane SOCIETE GENERALE Spent d instant engMake > Concation Svar Se Credit Hedge Ill(a) - Targeting Your Tail Hedge “The chance ta atleast one of hese soverlgns wll expertence a erst events now north of 60% erento 08 ‘SemnoeIA21 hang ‘ear ‘ned Pretty ‘Saat Paaey Pry once a ne Ire vole 4ok om doe tea actos wee ome eee tt Soin “ 108 pee 8% a ty eae ome 8am ot Pry oat etme ww aw pate tee SOCIETE GENERALEa Credit Hedge Ill(b) - Targeting Your Tail Hedge ‘Wile select sovereign sprsads are not all hal ar fon thai wides, 2 shorten so-deaul structure can bing the east of ying pretation down ‘mearirgfly for those who can withstand tad Iqudy. Vie belave tha! fureing an FTD wih shorted protacton cn elect coportes can reaut an afiot ustin-case’hadge Fst o-dotult package trade —long exposueto sleet names wth He near-srm deat sk canbe used o fund an "opton” on ramos that may bo euscoptbl toa sovorign credit event LONG EXPOSURE ‘SHORT EXPOSURE (Single Name CDS) (First-to-Default Package) Se a TeerTeonaegy 370“ —~ Heaton a ee ) axa ” - JO Penny 6 BOem S020 VS. Roc oo - fo Dror a) onh a Wye +8 form Were oF tone sm som santo cme sm som san SOCIETE GENERALE Expres ese bang_>- Curvettion > Credit Hedge IV - Dislocations Across C Capital Structures ‘Wren voaliy ses shapy, ollentines valuatone h aWerert matkel segments reflect difring Iavels of “iek” As a teil, Fvaslos can enablsh Postons that provide aynmetic payoff profes, Given extreme movements st ely that all markets can price in the same evel of ak? ‘Selng cutcfmoneyequty put optlons + buying BP CDS resuhed nan stymmete payot pote Peston eve exe 26 2010 PAoe 0842019 Pow ew CebkengEast) Jan teeaiee 70 ertace seat soo siz SebtenaEast) Sen", 20aite sO carta see sear ore SebtenaEast) Jan ATSate GO certace fae soos ses uy Sort cet mo 608 stonm 10 aw sense romaine ‘gumooo ore er 608 s09e10 "i ge nage SOCIETE GENERALE Epo vere BogKey Parameters Consideration Vikvs. Credit Tota corsan, bul lands tobe Warslent aver Ue. One indeator of vaua ls when the VIX | CDXIG ralloexomeds ive standard eviatons In rent years and in pereant change tarms (VIX ané COX IG soread, respectively this signal accurately highlighted the most efclnt hhecige 89% ofthe time, and outperformance averaged more than 4%, Rati of CDXIG Spreed over Vi vs. Ztandard deviations above Canthe ra of CDKIG over VIX work as an efective signal? and below ho average &-month oling) Ton Poe ee A a . Wh Steet [bee SOCIETE GENERALE,Key Parameters Consideration II: Daily Move vs. Spot Drift Daily Move > Volatility = Anasset can have a high volatility with little spot drift, and vice versa. ™ In choosing option hedges, one needs to compare SpotDrit expected returns vs. current cost (implied vol & skew) among choices. In this case, whether implied vol is cheap vs. realized is less critical unless expected returns are similar. Mey Retr TM ATM imp Vol] Imp Premum to Hist, EB Ea Eos Se ee ee) a Set ee ae 5% es taO | am tee & mm | es ata | me om ee ee eSB 18 172 | 5 —— y J CComparile Spot ‘Treasury Implied Vol Lower in both Moves YTD Absolute & Relaive Terms SOCIETE GENERALE Gopowtedistnen Boming Hee at Sue ergCross Asset Basic Tail Risk Hedging Costs At a Glance Cor Po eee Pree a in EO. SPX Long 803. Pu a ti eR Unsrort Premium EQ Spx Long 85% Put OM 20% 119% Upsrot Premium EO vik Long Dec! 4250 (20 Det) Call mM 44% 66% = $1 MPA Vege Netoral Vergy a EQ vik ‘Short Doet0 1x2 26/42 Call Sor zr oa aim SNM eg Naenall Varies ty Rol os Fates 75-Yoar Treas Long Bond 105% Cal a aa Tio Premn x USD, Tong 35% EURLSD Put (USD Apprales) —stA_—0.9%___-S 7% Upfront Premium FX FURJPY Long 9594 EURIPY Put SM tase BE Upirent Prem: Fx Jey Long 95% USDJPY Pul(Yon Aperecats) SM 0.8% S206 Uptort Prem, CON Copper Long Copper 95% Put aM aie tase Upirort Premium OM Gal Long Galo 105% Call aM 20% gis Upton Premium . Pr so Ustront Premium + GRE CDXIG Long 5Y Prolecien sv 1t% 1% vero oremum f Heasine vl n Neor-‘orm Detaut GRE CDXHY vs 1G Short HY 88 SY and Long 10815 5Y OM sve Cary ae el ‘rto-Delaut Short Sov and Loog Con 7 sve Cam Lausty + Notional GRE Fistio-Delash Short Sov and Long Comp v Cary are can +214, Rol Moatnty SOCIETE GENERALE, pete neste brDisclaimer {MPORTHNT LAER: Ts care as en paso y 86 was Shis, LD (SAT) nea po Sed Gees sh epatet nt sat be a 2s 3 ‘icra pt. 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Ta rine mance Pro) tle GUD ae ¥ Jp eh he na ean ‘pec opr rae ©All’ Sh ln asta Bee (2070256 8) a atl pale canals a EES. 1m 2985 ed rere Capes A901 (0H fe) Th sn tren taro won eta ocr kts ok fy arm da cha mcd Be vance Cay Ta Si lad ap 210A gt ma he eos sa abe aan 9 «omen ya eal ay xy ebro 2 pce ay ons omy ret wg bf sete ene ‘Bec a suo reser oye pry at sents Page Sead oy aoe be Son pecs oasis stl nthe nfl a load o/b Pt er soa fas ax) mon ato maxon hori Sa Ay pawn in ba Uta Sue wenger erry cous exe cro iene ney rou 20 0 Wh of a SES. SOCIETE GENERALE Groote d nestnet boning