The Perfect Hedge: JP Morgan Case Study

Deutsch: Irrgarten hinter Traquair House in Sc...

Deutsch: Irrgarten hinter Traquair House in Schottland English: Hedge maze in rear garden, Traquair House in Scotland (Photo credit: Wikipedia)

At its simplest, to hedge is to offset risk. While the term is most often associated with investments, we all hedge all the time. We buy health insurance to hedge against the costs associated with an accident or illness. Farmers settle on a price for their crops before the planting season to hedge against big fluctuations in supply or demand. Airlines lock in future fuel costs to hedge against volatility in the price of oil. I will be wearing a helmet when I go mountain biking this weekend to hedge against serious injury. You get the point. On Wall Street, a hedge can take all sorts of complicated forms and firms are always on the lookout for the perfect hedge - one that reduces risk to zero.

For JP Morgan, the quest for the perfect hedge cost the firm $2 billion. If hedging is meant to offset risk, then how could that happen?

Reports indicate that JP Morgan was betting on changes in the creditworthiness of US investment grade corporations (basically, betting on the US economy). To offset their risk, the firm bought credit default swaps. These financial instruments are a form of insurance against exposure in the fixed income market.  Similar to health insurance, when you buy a swap, you make premium payments to the seller in exchange for protection, in this case protection against a default on the US corporate loans. That sounds like a good hedge, right? It usually is.

Where things got complicated is that JP Morgan also began selling related credit default swaps. By selling, the bet changes from likely default to likely payment. The seller collects a premium (he acts as the insurance company this time) for each swap making a tidy profit in the process. JP Morgan’s “London Whale” got his nickname because he sold so many of these swaps that he basically drove down the cost of premiums for buyers.

So now JP Morgan owned the underlying bonds, owned insurance on some of those bonds and sold insurance on a lot more. When the sovereign debt fears flared up again in April, the firm was caught with positions that were losing value on both sides. To make matters worse, when they started to unwind the worst of them (the swaps the London Whale had sold), other investors caught wind of it and used that knowledge to make it very difficult for them, thus multiplying JP Morgan’s losses.

On the conference call, CEO Jamie Dimon said, “The portfolio has proven to be riskier, more volatile and less effective an economic hedge than we thought.” Not the perfect hedge after all.

NYSE Euronext experts often write about hedging and other trading approaches, a recent example can be found on our blog. Also, for a helpful breakdown of JP Morgan’s otherwise very complicated trade, check out this Reuters article and this blog at WSJ.com.  

 

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