Too Much of A Good Thing?

Ms. Havisham, in her mid-50s, is a senior executive of a publicly held company in which she holds a large block of stock that she can not sell for the next several years. While the stock trades on the Nasdaq, no active options market exists. And even if she could use options to hedge her stock directly, she probably wouldn’t do so – it might appear to indicate a lack of confidence in her company.

However, while confident that her company will continue to do well, Ms. Havisham nevertheless realizes she’s assuming significant market risk by having a large portion of her net worth invested in a single holding. Thus, she is seeking a way to protect herself against the risk that her company’s stock may take a tumble.

In conferring with her Contango advisor, Ms. Havisham learned of several strategies that might enable her to reduce those risks without selling her stock. One of the strategies her advisor suggested they explore was putting into place a synthetic hedge – a selection of marketable assets that together mirror the behavior of the designated stock. By selling short the hedge components, this strategy could provide significant protection against downward movements in the price of her stock.

As a first step toward determining whether this might be an effective tool for Ms. Havisham, Contango strategists analyzed the stock’s behavior relative to the relevant industry and market indices as well as to the stock of other companies in the sector.

After concluding that such a hedge could be effective, they, with Ms. Havisham’s approval, designed and implemented a synthetic hedge by:

1. Identifying and collecting comparable publicly traded companies and related index shares.
2. “Screening & cleaning"
                      • Refining criteria;
                      •  Discarding candidates that are thinly traded or difficult to short.
3. Using quantitative techniques to create a proxy “basket” designed to mirror the hedge target’s behavior.
4. Determining how best to balance the strategy to mitigate risk.
5. Selling short or buying puts on the basket in the marketplace.
6. Actively managing the short position.

The result: Ms. Havisham is able to hold on to her stock, but can feel confident that, should it fall dramatically in value, that decline will be offset by the hedge. Of course, it also means that should the stock soar indefinitely, having the hedge in place will cut into her profits. But, as our CEO is fond of saying, “There’s no such thing as a free lunch.”

Synthetic Hedge Results: 4/18/05 - 8/22/05

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This material presented above is based on information, assumptions and market conditions believed by Contango Capital Advisors to be accurate as of the time it was prepared. The example above is hypothetical and for illustrative purposes only, and should not be understood as a recommendation to purchase or sell any particular asset.