Newspaper article The Evening Standard (London, England)

Why Hedging Makes Stocks More Volatile

Newspaper article The Evening Standard (London, England)

Why Hedging Makes Stocks More Volatile

Article excerpt


STOCK markets are bouncing around like yo-yos. Not just dropping like a stone.

Up one day a few per cent, down the next day a few per cent.

Volatility in the past month has been about three times its normal level.

Developed country stock markets are behaving like Brazil or Russia.

There are two main reasons why this is happening.

One is that there is just a lot of uncertainty out there. Is the world going to tip into a double-dip recession? How much can you trust company accounts?

That uncertainty is the main reason for the sharp increase in volatility.

But there is another. The hedging strategies used by investors to protect themselves against plunging stock markets are, in themselves, accentuating the volatility.

Think of an insurance company that cannot afford another downward lurch in markets. It may buy a put option on the FTSE 100 index at, say, 4000 from an investment bank.

However,the bank needs to hedge itself too. So it goes out and sells futures on the FTSE. That, in the jargon, is known as delta hedging. But this is not all. Whenever the FTSE dives, the bank has to sell even more futures to hedge itself. And, assuming lots of banks are doing the same thing, that will probably push the market down further.

By contrast, whenever the FTSE rebounds, the bank has to buy more futures - and that helps push the market up.

This process, in the jargon, is known as negative gamma. It magnifies the roller-coaster ride investors are having to endure. It's not much fun - unless you are a masochist.

CONSIDER the dilemma facing Cookson shareholders. They have to decide this month whether to back a rights issue the industrial group is making to repair its balance sheet. It is not underwritten so if they don't, the shares will probably fall below the 25p issue price. If they do, the shares may rocket.

Moreover, Cookson has added a further twist. It wants to raise pound sterling277 million, but will take whatever it gets. …

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