The Financials That Failed The Stress Tests: A Look At Hedging Them

 |  Includes: BBT, C, IYF, MET, STI
by: David Pinsen

Of the 19 U.S. financials that were subjected to Federal Reserve stress tests, four failed, as the Financial Times reported on Wednesday. The stress test results were important not just for what they suggested about the companies' financial strength but because the ones that passed the test were given license to return more cash to shareholders, via dividends and share buybacks. JPMorgan Chase (NYSE:JPM), for example, which passed the stress tests, subsequently announced it would buy back as much as $15 billion in shares and would raise its dividend.

Of the four financials that failed the stress tests, one of them, Ally Financial, is no longer publicly traded. The table below shows the costs, as of Wednesday's close, of hedging the three publicly traded companies that failed the stress tests against greater-than-20% declines over the next several months, using optimal puts.


For comparison purposes, I've also added one of the financial stocks that passed the stress test to the table - BB&T Corporation (NYSE:BBT). As another comparison, I've added the iShares Dow Jones U.S. Financials Index ETF (NYSEARCA:IYF). First, a reminder about what optimal puts are, and a note about decline thresholds. Then, a screen capture showing the optimal put option contract to hedge the comparison ETF, IYF.

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" is the maximum decline you are willing to risk. 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% decline thresholds for each of the names below.

The Optimal Puts For IYF

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of the iShares Dow Jones U.S. Financial Index ETF (IYF) against a greater-than-20% drop between now and August 17th. 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 slightly lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).

Hedging Costs As Of Wednesday's Close

The hedging costs below are as of Wednesday's close and are presented as percentages of position value. If you own these financials as part of a diversified portfolio, and are content to let that diversification ameliorate your stock-specific risk - but are still concerned about market and industry risk - you might consider hedging your market and industry risk by buying optimal puts on an index-tracking ETF such as IYF.



Hedging Cost

Failed Stress Test
MET Metlife, Inc. 4.31%**
STI SunTrust Banks Inc. 6.78%***
C Citigroup, Inc. 4.60%**
Passed Stress Test
BBT BB&T Corporation 3.22%**
Comparison ETF
IYF iShares DJ US Finance 1.74%*
Click to enlarge

*Based on optimal puts expiring in August

**Based on optimal puts expiring in September

***Based on optimal puts expiring in October

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