What it means
A micro hedge protects one item, such as a single loan or invoice. A macro hedge looks at the combined exposure and protects the total.
It is useful when a portfolio contains many positions that would all suffer in the same event, such as a recession. The tools vary with the risk.
A fund worried about a falling stock market might sell index futures, which gain when the market falls. A company with revenue in many currencies might buy a basket of currency options, and a bank concerned about rising rates across its whole balance sheet might use interest rate swaps.
The key calculation is how much hedge you need. This depends on the size of the portfolio and on its beta, which measures how strongly it moves with the market.
A portfolio with a beta of 1.2 tends to move 20% more than the market, so it needs a larger hedge than one with a beta of 1. Macro hedges are cheaper and simpler than hedging every position, but they are imperfect.
The hedge and the portfolio do not move in exactly the same way, so there is a leftover risk known as basis risk. A fund could lose on its stocks and see the hedge fall short of covering the loss.
There is also a cost. Futures need margin, which is cash set aside as security, and options cost a premium.
If the feared event does not happen, the hedge loses money and drags on returns. In accounting, macro hedging also refers to strategies that hedge groups of items in a bank's books, such as an overall interest rate exposure.
These raise special rules about how gains and losses are reported, and specialist advice is needed.
In practice
Real-world examples.
Example
A pension fund holds a diverse equity portfolio and fears a downturn before it pays out a large sum. It sells index futures to protect the portfolio for six months, accepting that it will give up some gains if the market rises.
Example
A manufacturer exports to ten countries and receives payment in several currencies. Rather than hedging each invoice, the treasurer buys currency options on the three main currencies, which protect the group's overall profit if the dollar strengthens sharply.
Example
A regional bank worries that rising interest rates will squeeze its margins across thousands of loans and deposits. It enters interest rate swaps for a portion of its balance sheet instead of adjusting every contract individually.
Formula
Calculation
Number of futures contracts = (Portfolio value x Portfolio beta) / Value of one futures contract
A fund holds a $10,000,000 equity portfolio with a beta of 1.2 and wants to hedge fully against a market fall. One index futures contract has a notional value of $250,000. Number of contracts = (10,000,000 x 1.2) / 250,000 = 12,000,000 / 250,000 = 48 contracts sold. If the market falls 10%, the portfolio is expected to fall by 12%, or $1,200,000, while the 48 contracts should gain about 48 x 250,000 x 0.10 = $1,200,000.Case study
Seen in the real world.
Harrowgate Capital is an illustrative, fictional investment fund with $80,000,000 invested across forty shares. After a long rally, its chief investment officer feared a sharp correction but did not want to sell the holdings and trigger tax and trading costs. She chose a macro hedge using index futures.
The fund sold futures covering about 60% of its portfolio value. When markets fell by 15% over the next two months, the portfolio lost around $12,000,000 on the stocks, but the hedge gained about $7,200,000. The fictional fund ended with a smaller net loss and kept its positions for the recovery.
Later the market recovered and the hedge cost the fund some of the upside. The illustrative lesson was that a macro hedge works like insurance: you pay for protection by accepting lower returns when nothing goes wrong.
Watch out
Common mistakes.
- Hedging the portfolio value without adjusting for beta, which leaves the fund under-hedged or over-hedged.
- Expecting the hedge to remove all risk, when basis risk means it will not match the portfolio exactly.
- Forgetting the cost of carrying the hedge, which includes margin calls, premiums and lost upside.
Questions
People also ask.
What is the difference between a macro hedge and a micro hedge?
A micro hedge protects a single asset or transaction, while a macro hedge protects the overall portfolio or balance sheet against a broad risk.
Which instruments are used?
Index futures, index options, currency forwards and options, and interest rate swaps are common, depending on the risk being covered.
When should a hedge be removed?
When the risk it was meant to cover has passed or when the cost of carrying it outweighs the protection, the position should be reviewed and closed.
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