Dynamic vs. Static Hedging Approaches
Dynamic vs. Static Hedging Approaches
Hedging strategies range from static approaches that establish positions and hold to maturity, to dynamic strategies that continuously rebalance as market conditions change. The choice between static and dynamic hedging depends on the nature of the exposure, market conditions, and cost-benefit analysis.
Definition and Key Concepts
Static Hedging
Static hedge: A hedge established at inception and maintained without adjustment until expiration or unwinding.
Characteristics:
- Fixed hedge ratio
- No ongoing rebalancing
- Lower transaction costs
- Higher basis risk over time
- Simple to implement and monitor
Dynamic Hedging
Dynamic hedge: A hedge continuously adjusted to maintain effectiveness as market conditions change.
Characteristics:
- Variable hedge ratio
- Frequent rebalancing
- Higher transaction costs
- Lower basis risk
- Requires active management
Comparison Framework
| Attribute | Static | Dynamic |
|---|---|---|
| Transaction costs | Low (one-time) | High (ongoing) |
| Basis risk | Higher | Lower |
| Operational burden | Low | High |
| Model dependency | Low | High |
| Gamma exposure | Unhedged | Managed |
| Suitable for | Linear exposures | Non-linear exposures |
How It Works in Practice
Static Hedge Example
Situation: Corporate treasurer hedging $50 million Euro receivable due in 6 months.
Static approach: Sell €45 million forward (at EUR/USD 1.10) to lock in USD proceeds.
Implementation:
- Day 1: Execute forward contract
- Months 1-6: No action required
- Maturity: Deliver EUR, receive $49.5 million
Result: Regardless of spot rate at maturity, USD proceeds are fixed at $49.5 million.
Dynamic Hedge Example
Situation: Options dealer with short call position requires delta hedging.
Position: Short 1,000 SPX calls, strike 5,200, 3 months to expiry
Initial delta: -0.40 per option = -400 delta exposure Initial hedge: Buy 40,000 shares of S&P 500 underlying
Dynamic rebalancing:
| Day | SPX Level | Option Delta | Total Delta | Action |
|---|---|---|---|---|
| 1 | 5,000 | -0.40 | -40,000 | Buy 40,000 shares |
| 5 | 5,100 | -0.48 | -48,000 | Buy 8,000 shares |
| 10 | 5,050 | -0.44 | -44,000 | Sell 4,000 shares |
| 15 | 5,150 | -0.52 | -52,000 | Buy 8,000 shares |
| 20 | 5,000 | -0.38 | -38,000 | Sell 14,000 shares |
Daily rebalancing maintains near-zero net delta.
Rebalancing Triggers
| Trigger Type | Description | Example |
|---|---|---|
| Calendar-based | Fixed schedule | Daily, weekly |
| Threshold-based | When drift exceeds limit | Delta drift > 5,000 shares |
| Market-based | After significant moves | S&P moves > 1% |
| Cost-optimal | Balance cost vs. risk | Minimize total cost |
Worked Example
Portfolio:
- Long $100 million S&P 500 ETF
- Long 2,000 SPX 4,500 puts (protective put strategy)
- Current S&P 500 level: 5,000
Greeks:
| Position | Delta | Gamma | Vega |
|---|---|---|---|
| ETF | +100,000 | 0 | 0 |
| Puts | -20,000 | +80 | +$40K |
| Net | +80,000 | +80 | +$40K |
Static Approach
Implementation: Hold positions unchanged for hedge duration.
6-month scenarios:
| Scenario | S&P Level | ETF P/L | Put P/L | Net P/L |
|---|---|---|---|---|
| Crash | 3,500 | -$30M | +$18M | -$12M |
| Down 10% | 4,500 | -$10M | +$5M | -$5M |
| Flat | 5,000 | $0 | -$2M | -$2M |
| Up 15% | 5,750 | +$15M | -$2.5M | +$12.5M |
Characteristics:
- Put premium paid regardless of outcome
- Full crash protection maintained
- No transaction costs during period
Dynamic Approach
Implementation: Adjust delta hedge based on market movements.
Rebalancing rules:
- Rebalance when net delta deviates > 10,000 from target
- Target: 80,000 delta (maintain 80% market exposure)
Simulated rebalancing (volatile period):
| Week | S&P Level | Put Delta | Net Delta | Action | Shares Traded |
|---|---|---|---|---|---|
| 1 | 5,000 | -20,000 | 80,000 | None | 0 |
| 2 | 4,700 | -35,000 | 65,000 | Sell futures | 15,000 |
| 3 | 4,500 | -45,000 | 55,000 | Sell futures | 10,000 |
| 4 | 4,650 | -38,000 | 62,000 | Buy futures | 7,000 |
| 5 | 4,900 | -25,000 | 75,000 | Buy futures | 13,000 |
| 6 | 5,100 | -15,000 | 85,000 | Sell futures | 5,000 |
Total shares traded: 50,000 Transaction cost at 0.05%: $12,500
Dynamic benefits:
- Captured some gains from market swings
- Maintained tighter risk control
- Higher transaction costs
VaR Comparison
Static hedge VaR (95%, 1-month): = $100M × 1.65 × monthly vol (4%) × beta factor (0.8) = $5,280,000
Dynamic hedge VaR: Daily rebalancing keeps delta tighter = $100M × 1.65 × 4% × 0.75 (lower effective beta) = $4,950,000
VaR reduction: 6%
Cost-Benefit Analysis
| Factor | Static | Dynamic |
|---|---|---|
| Put premium | -$2,000,000 | -$2,000,000 |
| Transaction costs | -$50,000 | -$300,000 |
| Gamma capture | $0 | +$150,000 (est.) |
| Basis risk cost | -$100,000 (est.) | -$25,000 (est.) |
| Net cost | -$2,150,000 | -$2,175,000 |
In this example, costs are similar; dynamic hedging appropriate if gamma trading adds value.
Risks, Limitations, and Tradeoffs
Dynamic Hedging Risks
| Risk | Description |
|---|---|
| Execution risk | Market moves between signal and execution |
| Model risk | Delta/gamma calculations may be wrong |
| Liquidity risk | Can't rebalance in stressed markets |
| Whipsaw risk | Repeated rebalancing in choppy markets |
| Gap risk | Overnight moves bypass rebalancing |
Static Hedging Risks
| Risk | Description |
|---|---|
| Basis risk | Hedge drifts from exposure |
| Opportunity cost | Miss beneficial moves |
| Inflexibility | Can't adjust to new information |
| Over/under hedge | Exposure changes, hedge doesn't |
When to Use Each Approach
| Situation | Recommended Approach | Rationale |
|---|---|---|
| Linear exposure (FX, rates) | Static | Low gamma, basis risk manageable |
| Short options | Dynamic | High gamma requires rebalancing |
| Long options | Static | Positive gamma works in your favor |
| High transaction costs | Static | Rebalancing too expensive |
| Illiquid underlying | Static | Can't rebalance efficiently |
| Volatile markets | Dynamic | Basis risk increases |
| Low volatility | Static | Less drift, lower cost |
Common Pitfalls
| Pitfall | Description | Prevention |
|---|---|---|
| Over-trading | Too frequent rebalancing | Set minimum thresholds |
| Under-rebalancing | Ignoring significant drift | Set maximum thresholds |
| Ignoring costs | Rebalancing destroys value | Include costs in decision |
| Wrong model | Delta calculation errors | Validate with market data |
Hybrid Approaches
Threshold-Based Dynamic
Combine static and dynamic elements:
- Hold hedge static within tolerance band
- Rebalance only when drift exceeds threshold
Example: Target delta: 80,000 Tolerance band: ± 15,000 Rebalance triggers: <65,000 or >95,000
Time-Based with Discretion
- Scheduled weekly rebalancing
- Additional rebalancing for large market moves (>2%)
- Reduces transaction costs while maintaining control
Checklist and Next Steps
Approach selection checklist:
- Assess exposure type (linear vs. non-linear)
- Calculate gamma exposure
- Estimate transaction costs
- Evaluate liquidity of hedge instruments
- Consider operational capacity
- Document hedge strategy rationale
Static hedge checklist:
- Execute initial hedge
- Document hedge ratio and rationale
- Set calendar for periodic review
- Define early termination triggers
- Plan for hedge maturity
Dynamic hedge checklist:
- Set up delta/gamma monitoring
- Define rebalancing triggers
- Establish execution protocols
- Configure P/L attribution
- Implement cost tracking
- Review performance regularly
Related articles:
- For institutional overlays, see Overlay Strategies for Institutional Portfolios
- For counterparty terms, see Counterparty Risk Management and CSA Terms