Hedging, Part 1

Oct 31, 2016 | by Franck Cushner, CFP®

Over the past 16 presidential elections (1952 to 2012), the market has indicated whether or not the incumbent political party would maintain executive office 13 times (81.25%). If from August 1st to October 31st the S&P 500 is down, a new party will be elected, however, if up over the same period, the incumbent remains. If this holds, Donald Trump will take the election on November 8th (as the market is down roughly 2% from August 1st to Friday’s close). When facing a catalyst event (election, news release, earnings call, etc.), one should always attempt to be aware of how it may impact their portfolio, and highly correlated assets.

How would I do this?

First, try and consider what has a fundamental connection to the value of your investments. From here, you can assess the strength of that relationship by observing how much your asset has increased or decreased in market value based upon changes in the related asset or event in the past.  Consider the Mexican Peso (MXN) and Trump’s proposal of a building a wall and subsequent trade negotiations between our two nations.  As Trump’s campaign has an increased probability of winning, the MXN depreciates against the Dollar; however, when his loss likelihood increases, the MXN appreciates.  Using fivethirtyeight.com’s “Polls-plus forecast” as a measure of likelihood, on a daily basis one observes a correlation of -0.45 and an R-Squared of 20.3%.  Meaning, the price of MXN decreases as the probability of victory increases with 20.3% of the variance in MXN explained by variance in Trump’s likelihood for victory. Rather, the noise around ‘fundamental value’ is 20% connected to Donald Trump.

So, how would I respond?   

Well, although the indicator’s success rate isn’t ideal, we may say that 81.25% of the time over the past 50 years it has been a ‘good’ indicator.  Based upon that you have an 81.25% chance that MXN will see a decrease in value, 20.3% explained by Trump (though, this percentage is likely to increase in the short-term as the results of victory are no longer speculative). To hedge, you find an asset with a negative correlation to the Peso (and ideally positive correlation to the event), so that if your long MXN position does lose value, you expect to positive return in the hedge.  Let’s say you hedge using the S&P 500 via an ETF.  Over the same time period as the study between MXN and Trump’s likelihood of victory (June 8th to October 26th), the S&P has a correlation of -0.524 to MXN (and an almost 0% R-Squared to Trump’s victory).  Further, it historically returns a median of 0.95% from November 1st to Inauguration Day after a new party is elected. These characteristics suggest a decent, though not ideal hedge.  One positive aspect, in the event of an incumbent victory, where we expect the Peso to either recover value or change very little, the S&P returns a median of 3.34%.  Theoretically, in a trade like this, you are mitigating losses in the MXN position in the event of a Trump victory, while increasing your reward if Clinton wins.  This is unlike a perfect hedge where you would be indifferent to outcome, but still helps alleviate some risk (unless, of course, the S&P and Peso both lose value). 

How does this play out? Am I good?

Don’t get your hopes up. There isn't enough data to say that the S&P will go either way nor that the correlation will hold or isn't already priced into the current value of MXN.  Further, the amount of expected return if Trump were to win, may not be enough to offset an unpredictable expected loss in MXN (especially with how volatile currencies have been). To be blunt, this is not a model one would trade or invest on, rather an example of where research begins. It is a thought-process. Mitigating your exposure to risk is a constant refinement – not a set it and forget it.  

**This is not a recommendation for a trade nor investment. Rather a real world example for a naive hedge.

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