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Hedging Single concentrated stock postion

In the section 4.3.1.1 in reading 11 Concentrated Single Asset position the CFA book says that “For instance, assume an investor owns 1 million shares of ABC Corp. stock and ABC Corp. shares are currently trading at $100 per share, so the investor is long $100 million of ABC Corp. shares. To establish an exactly offsetting short position in ABC Corp. shares, the investor could use any of the four techniques mentioned above and described below

In all four methods the investor who is long on ABC stock establish a short position. One of the goal of hedging as given in CFA book is that investor should not lead to “transferring the legal and beneficial ownership of ABC Corp stocks”.

I presume since it is a short position so investor has to ultimately settle the short position later on. Say in one of the technique where investor has borrowed 1 million shares of ABC Corp from broker and collected a proceed of $100 million by selling these borrowed stock, the broker will ultimately ask investor for returning his 1 million stocks.

At that point if the value of each unit of ABC Corp is say $150 then investor will have two options i.e. either return 1 million ABC Corp from his holding in which case he end up transferring the ownership of all his holding OR other option is to liquidate the diversified portfolio and then whatever shortfall remain cover it by giving some stocks from his long position in which case he end up transferring the ownership of some of his holding.

If each of unit is less than $100 say $80 then story is different and definatly investor’s holding of 1 million ABC Corp shares is protected.

So what is confusing me is that investor is not very much protected if stock price rises. So is this strategy good to hedge the concentrated position in single stock?

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I have not read the chapter, but these are my thoughts:

1. If I hold a concentrated position in a stock, I would only hedge if I expect the price to go down.

2. The way to cover the loss would be in two ways: A. Buy the stock in the equity market at $150 by paying cash. And then transfer this stock. B. Give the seller some of your holdings. I would go with option A if I don’t want to give my ownership away.

However note that in this strategy my net worth does not change if the price of the stock goes up or down. Just causes issues in liquidity. 

If investor holds one million shares of ABC Corp. stock and ABC Corp. shares are currently trading at $100 per share, why would investor hedge against upward move in stock price in case his net wealth would increase? I don’t understand your doubt. Investor only hedge  downward price movement and likely loss in his net wealth. If this scenario will not happen, he only has a cost of hedge.

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Although I agree that no one would like to hedge the price rise if someone is long but as far as what is written in book, the problem is “Concentration within asset classes poses problems that need to be managed”. I guess the problem is not restricted to managing the downside potential in a stock holding. The focus of chapter is in managing a concentration in single stock. In this respect the book suggested 1) Equity monetization, 2) Hedging and 3) Yield enhancement as three option.

What I posted originally was covered under Equity monetization where the idea is not to lose the holding in stock as it may cause A) taxable event and/or B) sale of stock is not permitted and be able to make money.

So definitely no one can time the market and hence predict that stock is going to rise and hence let not indulge in Equity Monetization I guess my point is that if a consultant has advised investor to go for Equity Monetization to manage the concentration in single stock where one of primary goal is not to lose holding in long position then if stock price increases then there are very good chances that investor will have to loose the holding which is very much against the goal with which we started with i.e. without loosing out our holding we were looking to monetize the equity.

Hope I am able to explain what is my doubt.

OK, you have to dilute risk to single stock position without sale and losing the beneficial ownership so sale is not the solution. Also sale will cause immediate taxation.

So, you should find the best solution to monetize this holding with following goals:

  • avoid immediate taxation
  • retain the ownership
  • protect downside move in stock price
  • avoid high cost of hedging

There are few solutions and it’s depending on particular case and other client’s requirements. The ultimate goal with monetization is creating additional portfolio cash inflows and decrease overall portfolio exposure to single stock in the manner that after monetization total portfolio assets are properly recruited among 3 risk buckets, personal, market and aspirational.

Eg. before monetization client had 10 % of asset in personal, 20 % in market risk bucket and 70 % in aspirational which was risky. The goal is rebalancing portfolio risk and return characteristics between buckets without selling a concentrated position.

Gone fishing...

+1 

seems you still got it..

Flashback wrote:

OK, you have to dilute risk to single stock position without sale and losing the beneficial ownership so sale is not the solution. Also sale will cause immediate taxation.

So, you should find the best solution to monetize this holding with following goals:

  • avoid immediate taxation
  • retain the ownership
  • protect downside move in stock price
  • avoid high cost of hedging

There are few solutions and it’s depending on particular case and other client’s requirements. The ultimate goal with monetization is creating additional portfolio cash inflows and decrease overall portfolio exposure to single stock in the manner that after monetization total portfolio assets are properly recruited among 3 risk buckets, personal, market and aspirational.

Eg. before monetization client had 10 % of asset in personal, 20 % in market risk bucket and 70 % in aspirational which was risky. The goal is rebalancing portfolio risk and return characteristics between buckets without selling a concentrated position.

Ishwar, forgive me if I misunderstand your confusion, but I believe that you are thinking too far ahead. Your point that a rise may force a sale later on is correct. However, it is beyond the scope of the question to speculate on specifics of what may or may not happen to the holding after a move in price. The goal is to monetize and diversify without relinquishing ownership within that transaction. Hope this helps.

Mikewinner wrote:

+1 

seems you still got it..

It’s good to recall this to stay in the mood.:)

Gone fishing...

idreesz wrote:
I have not read the chapter … .

Before responding, you really should.

The point of the chapter is to diversify the risk of the concentrated position.

Hedging, by the way, is a technique for reducing risk, not (merely) limiting loss.  You can limit your loss easily: sell the asset.  No hedging necessary.

Simplify the complicated side; don't complify the simplicated side.

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Im currently on this reading too, and gosh is it taking forever going through the CFAI curriculum but such is to be expected.

So, maybe this is outside the scope of this (and tell me if it is). so let’s say i have a concentrated position in ABC. I think it will go up but it may go down. So, will I still hedge it is what you’re saying with whatever technique it is protect against downside risk? So basically just buy puts would work here. Because if it goes up, then great, I lose premium, if it goes down, then i’m kind of safe because the put is like my insurance contract.

We’re not talking about monetization (which is in fact, just a word for getting cash and still holding onto your stock….kinda like having your cake and still eatting it at the same time) or a sale (which in this case would trigger your taxable event). 

Level 3 is kinda like going to a buffet and getting more food than you can finish. Quitting and throwing it away hurts more than if you just sit down and finish it. - VWJETTY

If the costs of rolling puts are higher than the usefulness (potential gains) of certain asset, this is not profitable. There might be other hedging solutions available but mainly with simply rule, less cost = less protection.

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