January 8th, 2003, 2:27 pm
DCFC - I approve heartily of that one!I thought I was the only one in the world who used the term 'structured hedging' (maybe I really am). By this I mean that you take your P/L, add some reserve accounts, and slice some tranches. A waterfall or other set of rules is used to attribute the risk to the different tranches. Each may be marked on a different basis. The objective is to manage mismatches like liquidity differences between the long and the hedge, correlation problems, and other things that are not well-modelled in a liquid diffusion scenario. This idea may be used qualitatively in practice. The objective in any hedging is to identify and attribute risk factors... when the risk factors have mean-reverting behavior then structured hedging is a smart way to think. You are not losing sleep at night because of basis issues when you have modelled their mean-reversion at the outset.Another concept that lies under my idea of 'structured hedging' is that the trading strategy itself may be part of the structure. That is, the rules you use to adjust hedge positions are stated at the outset. Pricing is contingent upon the trading strategy. So, you don't agonize about complete markets because the strategy is a best-efforts approach, and you price the long deriv in the context of having the business break even or make enough money to pay the gang.