Naive Hedge

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Could someone tell me what a naive hedge is? I see it mentioned in the material but I can’t find a definition. Thanks.
 
What Level are you on? There are several places in the CFAI material talks about naive hedge. I can think of using strictly treasury bonds to hedge MBS is one of the example, or using only notional amount to hedge foreign currency transcation is another example.
 
Whoops, I meant to post this on the Level 3 forum. Thanks though, ws.
 
Google, it”s your friend.
Quote:
FIs can use derivatives to manage interest rate, credit and FX risk. Also, derivatives generate fee income and profits ($4B QI 2001) for FIs, see “In the News 24-1” on p. 621.
Spot Market: Cash transactions for immediate delivery (1-3 days) of commodities, securities (bonds, stocks), FX.
Forward Market: Agree on P and Q, for future delivery (1 week to 10 years), often customized, nonstandardized contracts for FX, commodities, securities. Actual exchange of commodity, FX, securities takes place, on expiration (settlement) date. Secondary markets for forward contracts are usually thin or nonexistent. Some possibility for default.
Futures Markets: Exchange-traded standardized securities (size and settlement date), organized exchanges, active secondary market, daily settlement to eliminate default risk, cash settlement, daily price limits. $3T market for FIs.
Hedging with Forward Contracts
Naive Hedge - Full (100%) “perfect” hedge of a cash asset with a forward or futures contract. Example: Portfolio managers holds $1m face value 20-year T-Bonds, current price is 97%, or $970,000. Interest rates are 8%, but the FI forecasts that interest rates will rise to 10% over the next 3 months, causing a large capital loss for FI. D = 9 years. To calculate the possible capital loss:
Ä% PV Bond = - D * ÄR / (1 + R)
%P = - 9 * ( .02 / 1.08) = -16.6667%
$970,000 - 16.6667% = $808,333 (or a loss $161,667)
$97 - 16.6667% = $80.8333
Manager can make an off-balance-sheet hedge with a forward contract. Manager is worried about interest rates rising and bond prices falling, so would want to take a short position and sell T-Bonds forward 3 months, and find a buyer to go long at 97 for $1m face value of T-Bonds in 3 months. The buyer could be someone who is worried about interest rates going down in the next three months, i.e., a life insurance company planning to invest $1m in three months. Assume that the life insurance does not have the same forecast about interest rates rising. Payoff Diagram:
Suppose that interest rates do rise and the FI has a capital loss of 16.67%, or $161,667, because the P went from 97 to 80.333. However, they can now buy $1m of face value 20-year bonds in spot mkt at $80.833 (80.333% of face), or $808,333, and can sell to the forward contract buyer at 97, or $970,000, for a gain of $161,667 (off-balance-sheet) to exactly offset the capital loss (on balance sheet). Any other change in interest rates would result in an off-balance-sheet gain (loss) to exactly offest the loss (gain) on-balance-sheet.
Result: Naive hedge that immunizes the FI against interest rate risk by using a forward contract perfectly matched to the asset or transaction being hedged.
Click to expand...
http://www.flint.umich.edu/~mjperry/468-24.htm
 
haha. the above is incredibly incorrect if you’re wondering what a naive hedge according to the L3 text is..
a naive hedge is when someone who owns a self-directed DC plan invests their dough as (1/n) where n = the number of funds provided by the company. its naive b/c if all the funds are in foreign equity, than its not a hedge. but because most average people are idiots, they think its diversified/hedged b/c they’ve invested in all the funds.
 
Matt -
I came across naive hedges somewhere in the currency hedging section, so I’m inclined to think that in this case they were referring to Jonathan’s response. You are referring to “1/n diversification,” found in the behavioral finance section.
 
hmm. don’t remember coming across it in any other section. i’ll get to it this weekend. we shall see. the best thing about finance is multiple definitions for the same word or phrase. always great!
 
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