Small wonder then that investors are nervous that some major event may happen, triggering a fall in asset values.
Some experts have suggested that investors buy put options as insurance to control their portfolio risk. But should put options be purchased through the investment horizon to control such risks? Or should insurance be purchased only if event risks fall at the horizon? These are the questions this article attempts to answer.
Event risk: This refers to the risk that the portfolio will decline in value because of a particular event. The Budget is an event risk. This event is certain to happen but the proposals by the finance minister can be perceived as positive or negative by the stock market.
An event risk also refers to the risk of the portfolio declining in value because a certain event happens or does not happen.
Suppose there is a proposal to merge BPCL and HPCL. An investor with BPCL in her portfolio runs an event risk. What if the merger does not materialise?
The question whether investors should hedge event risk assumes importance because insurance is costly. It may be, therefore, sub-optimal to hedge unless an event risk falls close to the investment horizon.
Event risk at horizon: Consider this hypothetical scenario. An investor has large exposure in the SBI. She wishes to cash her investments by June 2006.
The RBI is likely to change banking regulations during May-June 2006, which could adversely impact the post-tax earnings of banks.
There is a risk that the horizon objectives may not be met because the investor is overweight on the SBI. It is, therefore, necessary for the investor to buy SBI puts to hedge this risk.
Now, consider another scenario. India is attempting to settle a certain dispute with ASEAN. The settlement is likely to happen in May 2006. If the settlement favours ASEAN, companies in India stand to lose. This event risk, hence, relates to the entire stock market.
Since this risk is close to the investment horizon, the investor would buy Nifty puts as insurance. If the market goes down, gains from Nifty puts could control the losses on the portfolio.
Note that selling futures may not be optimal because the symmetrical payoff could hurt the horizon objectives if the market goes up instead.
Hedging longer horizon objectives: A portfolio will be exposed to several event risks through the investment horizon. Should the investor continually insure against these risks even if they do not fall at the horizon?
The problem is that non-institutional investors can insure with only short-maturity exchange-traded derivatives. So, investors have to buy several contracts even if the event risks are just a few months apart.
And continually buying insurance could lead to the hedged portfolio falling short of the horizon objectives because of high insurance costs.
Of course, an event risk that happens even a year earlier could have a severe impact on the horizon objectives. Suppose the macro event risk mentioned above happens in 2005 and the market loses 30 per cent in one month. It is moot whether the market will recover well enough for the investor to achieve her horizon objectives.
The problem, however, is that it is very difficult to gauge ex ante if an event risk will impact the market so much as to affect the horizon objectives far into the future. It may be instead better to reduce market exposure during times when the investor believes that event risk is likely to hurt her horizon objectives.
Of course, such tactical asset allocation strategy needs market timing which every retail investor may not be competent to do. But buying insurance to hedge event risks through the investment horizon is surely a costly substitute.
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