Buying / Selling Protection - What it would mean?
Hi - I'm interested in the idea of buying and selling protection and in particular what this means. I also posted this on the trading forum (not sure if it's forum etiquette to double up)
I understand what buying protection would mean (and correct me if I'm wrong) and this would be depending on what you're looking to hedge, buying way out of the money options. If you're looking to protection against bond or equity market crashes you'd buy way out of the money put options and if you're looking to hedge against inflation you may buy way out of the money call options on commodities or put options on bonds. I could be wrong on this so if anyone can help me on this I'd appreciate it.
However, what would selling protection mean and how does an investor do this? How would, and I'm thinking specifically about an institutional investor such as a pension fund be a seller of protection? Would they do this by selling at the money options? Would they do this through investing into a hedge fund that sells protection, if so, what is the strategy of such a hedge fund? And can anyone give me an examples?
Okay, If I'm buying protection it means I am hedging myself against some risk that i've exposed myself to. For example, I could go out and buy a bunch of Bonds and then buy a credit default swap against it therefore buying 'protection' from default. By contrast, whoever is selling me that swap is said to be selling protection in theory. The whole reason I would sell protection is that I believe that I won't ever have to make good on that swap thereby collecting the premium that the buyer paid up front and never having to pay out.
Now why would someone sell protection? Simple, they think that at the end of the day whatever event they are insuring won't happen and they won't have to pay out. There are a million ways to sell protection, and CDS's are just one form of it but it is my favorite way to explain this at the moment. When you sell someone a CDS your basically saying, " Pay me X per year for N years, and i'll insure you against whatever it is you want defaulting" Pretty simple. So say I go out and buy $100 million dollars worth of CAT bonds. For some reason I'm nervous that they could default at some point in the near future, so i'll go out and buy swaps on them. Since the probability of default is very low, you only have to pay 100,000 a year to insure them. Whoever is selling that is now making 100,000 a year simply for assuming the risk of those defaulting. As long as nothing goes wrong, all is well and you pocket 100,000 for nothing in theory. This is an oversimplification in many ways but It shows you why someone would sell protection.
As you said, you can do the same thing with options. Someone buys a put you can conversely sell a put to someone thereby giving them the right to put that stock to you at a given time. Thus you collect the premium, and as long as they don't execute the option you simply collect the premium and don't have to shell out money to take delivery of the stock.
Thanks - I'd be interested to know how an entity like a pension fund can claim that they are a "seller of protection" if they invest through external managers, generally in bond funds such as PIMCO or Wellington? I'm assuming that to be a buyer of protection through external managers you'd invest in some sort of tail risk manager.
Selling protection in the markets works the same way insurance companies work for autos, homes, etc.
So I'm assuming that investing in Insurance Linked Securities would be an example of selling protection?
Not too familiar with those to be honest....but the wiki page about them is great:
http://en.wikipedia.org/wiki/Insurance-Linked_Securities_(ILS)
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