Hedging vs. asymmetric hedging

 

Due to the large viewership of the blog post titled A short explanation on J.P. Morgan’s Derivatives Loss, I have decided to delve a little deeper and explain the difference between hedging and a strange phrase dubbed asymmetric hedging.

Jamie Dimon, CEO of J.P. Morgan Chase Corp., has attributed the recent massive losses due to asymmetric hedges the firm took. These losses were revealed in advance and ahead of the Q1 earnings report. What is interesting is the manner that the CEO described the loss, calling it a hedge gone wrong.

Now, to reiterate, to hedge means, to offset. An example would be to go long in an interest rate swap contract, in which J.P. Morgan pays a fixed rate of 500 basis points + spread between a AAA corporate bond and the 10 year Treasury security and receives 500 basis points + LIBOR. The transaction is settled quarterly and netted. This means that if at the settlement date, LIBOR is higher than the 10-year spread, J.P. Morgan, receives the interest difference between the two. This discrepancy is usually based on historical returns and current market fluctuations. In this case, the cash flows usually cancel each other out.

Now, in an asymmetric hedge, an example would be as follows: J.P Morgan would agree on a swap that includes paying 500 basis points + LIBOR and receives 500 basis points + the return on a thinly traded security or index. Now, in this case, the probability of small netted returns and cash flow netting is smaller, than in the previous example.

If for example, the thinly traded index fell 40% at the settlement date, J.P. Morgan would not only pay its cash flow, but the difference in the index between the two dates as well. It would have to book a massive loss for doing so.

That is an “asymmetric” hedge. Using leverage compounds the loss, and offsetting the position can also be very costly if the ongoing fundamentals for the swap is negative for J.P. Morgan.

The example doesn’t even resemble a classic hedge, but rather a speculative position. Even if J.P. claims that is making a market and offsets the position with its client through the hedge, seeking asymmetry is more something a hedge funds would do.