Ahead Of The Euro Summit: Hedging 3 Pairs Of EU And U.S. Stocks

 |  Includes: C, DB, FXE, GE, ORCL, SAP, SIEGY, UUP
by: David Pinsen

Days until the a much-anticipated European Summit

In his Financial Times column last week ("The Eurozone has only days to avoid collapse"), Wolfgang Münchau argued that if participants in this Friday's upcoming European summit didn't agree to an ambitious three part plan to save the Euro (an ECB backstop, plus a timetable for a Eurobond, plus an agreement on a fiscal union) the Eurozone risked collapse.

I am hearing that there are exploratory talks about a compromise package comprising those three elements. If the European summit could reach a deal on December 9, its next scheduled meeting, the eurozone will survive. If not, it risks a violent collapse. Even then, there is still a risk of a long recession, possibly a depression.

Whether Friday's summit results in one of such dichotomously definitive outcomes, or instead leads to short term measures that kick the can down the road, remains to be seen. I was curious to see, though, whether the hedging costs of a handful of leading European companies suggested an elevated level of risk compared to their American counterparts.

Comparing hedging costs of a few US and EU companies

With that in mind, I put together the table below, which compares the costs of hedging three pairs of companies in three different industry groups against greater-than-23% drops over the next several months, using optimal puts. For two of these pairs -- the industrial conglomerates and the money center banks -- the comparisons aren't exact since the optimal puts have expiry dates one month apart. Nevertheless, the differences in hedging costs are striking.

Currency ETF comparison

The table below also shows the current costs of hedging the PowerShares DB US Dollar ETF (UUP) and the CurrencyShares Euro Trust (FXE) against the same 23% decline using optimal puts. First, though, a reminder about what optimal puts are, and a note about why I'm using a 23% decline threshold here, then a screen shot showing the optimal puts to hedge the European money center bank, Deutsche Bank AG (DB).

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position). I have used 20% thresholds for each of the securities below because that was the smallest decline against which it was possible to hedge Deutsche Bank AG -- i.e., the cost of hedging Deutsche Bank against a greater-than-22% drop was itself greater than 22% of position, so Portfolio Armor indicated no optimal contracts were found for it at that threshold.

The Optimal Puts for DB

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of DB against a greater-than-23% drop between now and July 20th, 2012. A note about these optimal put options and their cost: to be conservative, Portfolio Armor calculated the cost based on the ask price of the optimal puts. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask.

Click to enlarge

Hedging Costs as of Tuesday's Close

The data below is as of Tuesday's close, and is presented as percentages of position value. That GE and ORCL have the exact same hedging cost is a coincidence, not a typo.



Hedging Cost

Industrial Conglomerates
GE General Electric Company 4.13%*
SI Siemens AG 9.83%**
Enterprise Software
ORCL Oracle Corporation 4.13%*
SAP SAP, AG 5.61%*
Money Center Banks
C Citigroup, Inc. 12.4%*
DB Deutsche Bank AG 22.5%**
Currency ETFs
UUP PowerShares DB US Dollar 0.45%*


CurrencyShares Euro Trust


Click to enlarge

*Based on optimal puts expiring in June 2012

**Based on optimal puts expiring in July 2012

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.