By Mike Duncan | April 2026
Cost, Budgeting, and When It Fails
The gap between institutions that have hedges and those that have a convexity programme
Most institutional portfolios have hedges. Very few have a convexity budget. The difference is not semantic.
A hedge is a position designed to offset a specific risk. A convexity budget is a structural portfolio decision: how much of the portfolio’s return should be allocated to shaping the distribution of outcomes, not just maximising expected return. One is reactive. The other is deliberate. And in practice, they produce completely different outcomes.
The institution that hedges reactively buys protection after it becomes frightened, pays elevated volatility for the privilege, and cuts the programme when it underperforms for two consecutive quarters. The institution with a convexity budget deploys protection systematically when it is cheap, sizes it to a portfolio objective, and measures it against that objective rather than against the cost of premium in a quiet period.
The harder truth is this: most programmes do not fail because the instruments were wrong. They fail because when the hedge worked, no one converted it into cash.
What this paper argues
A hedge that moves deeply into the money during a stress event has created value. But that value is unrealised. It sits on the portfolio as a mark-to-market gain that will decay as rapidly as markets stabilise, policy intervenes, or implied volatility mean-reverts. The window between the peak convexity value and the start of that decay is often measured in days, sometimes hours. Marks do not fund margin calls, redemptions, or operating expenses. Only cash does.
The failure is not technical. It is structural. Governance processes that require committee approval cannot act at the speed markets require. The decision to monetise a convexity gain cannot wait for the next scheduled meeting. Without a pre-committed monetisation doctrine and delegated authority, even a well-designed programme will consistently fail at the moment it matters most.
What it covers
- Why convexity is a legitimate portfolio allocation, not a cost to be minimised, and what that reframing changes about governance and measurement
- How to size a convexity budget starting from a specific portfolio objective, not a generic rule of thumb
- The 2 to 5 % premium range: what each level achieves and what it costs in calm markets
- Why premium budgeting outperforms notional budgeting across the volatility cycle
- Instrument selection across equity puts, put spreads, variance swaps, payer swaptions, credit CDS, and cross-asset overlays, matched to specific tail scenarios
- Strike selection, maturity choice, and roll mechanics
- The governance framework: the three principles that determine whether a programme survives long enough to do its job
- The speed problem: why monthly investment committees cannot respond to events that develop in 48 hours
- Pre-committed monetisation triggers and delegated authority structures
- The monetisation doctrine: when to act, how much, in what order, and what to do with the proceeds
- Performance metrics that measure the programme against its objective rather than its option P&L
- A case study showing the same instruments, the same market, the same stress event, with and without a monetisation doctrine. The difference in outcomes was $ 40 million on a $1 billion portfolio. The capture rate was 30% without a doctrine and 97% with one.
The central argument
Most institutional portfolios have hedges. Very few are prepared to convert them into something useful when it matters. That preparation happens before the crisis, not during it.
Read the practitioner paper
Convexity in Portfolios – Cost, Budgeting, and When It Fails
