The 2008 crisis has led to a significant evolution of banking regulations and the "Volcker Rule" which aims at limiting speculative investments by banks is probably one of the major new laws.
Indeed, a bank cannot keep a speculative position in proprietary trading and must cover the market risks induced by these positions. This is called hedging.
Hedging consists of holding positions of opposite sensitivity with the aim of offsetting the losses of one position with the gains of another. It is therefore a risk management tool used by investors to protect them against adverse market movements.
Banks use hedging operations to limit their losses that would come from client orders, for example. Since client orders usually generate risk transfers from their position to the bank's position, a hedging strategy allows you to minimize the amount you could lose as a result of these positions.
Hedging is achieved by opening a position that directly offsets your existing position, or by choosing to invest in an asset that is highly anti-correlated with the initial asset and moves in the opposite direction of the assets already held.
Delta Hedging
Banks are usually sellers of options in the markets with their corporate clients
corporate clients who come to buy options to hedge their exposure to market movements. By selling options, they absorb the client's risk and are forced to hedge this directional risk.
Delta hedging is a technique used to reduce or hedge the risk associated with price changes in the underlying market. The delta is the sensitivity of the option to changes in the price of the underlying asset.
Two methods exist:
- either use another option to eliminate this risk. Sell a put, for example, if the initial position was the sale of a call.
- or hedge with the underlying asset for the given delta quantity.
After the bank has covered the delta, the position is said to be delta neutral. But this position is not stable since the delta is dynamic and will change with market movements. These positions therefore usually need permanent readjustments.
