Wednesday, April 13, 2011

Shadow Risk Portfolio

by Rick Nason, PhD, CFA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

One of the training tools for investors and investor wanna-bes is the shadow portfolio – or sometimes known as a paper portfolio.  A shadow portfolio is where the investor practices their trading by making trades “on paper” – that is recorded in a notebook, but never having executed the trades for real.  The trader however follows the valuation of their trades just as if they were done with real money, and this way they get investment experience without the “investment tuition”. 

Would it not be a great idea for corporations to also have a shadow risk portfolio – that is a set of strategies that they might be too timid to execute in real life, but they execute on paper – recording their hedging tactics and then tracking the results versus their “do-nothing” strategy.  This would allow corporations to gain valuable experience in hedging that they may not be willing to execute otherwise due to their fear of being wrong, or their lack of understanding of how the products might behave under various scenarios. 

A few years ago, RSD Solutions conducted a back-test for a corporation that wanted to see how a change in their hedging strategy would have worked.  They basically knew that how they were currently hedging was ineffective, but no one in the corporation wanted to be the first to attempt or even suggest a new strategy.  We conducted the study and showed them in clear and easy to understand terms how a different hedging strategy would not only be more cost effective, but would also hedge them in a way that was more consistent with their financial strategy and corporate goals.  The CEO, CFO and Board quickly approved a change in strategy once they saw how much a simple change in hedging tactics would improve the bottom-line and help unit managers with their planning. 

Not implementing a hedging strategy is more often a function of lack of inertia.  Creating a shadow portfolio is one way to get the ball rolling.

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