Monday, 20 February 2012

Hedging: It is not always smart to hedge.


Market or systematic risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging.

An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.

  • A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures.  This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations.  If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole.
  • A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.  
  • A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling gold futures.
  • A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets.  

It is not always smart to hedge.
  • When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged.  
  • Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment.  
  • When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky.  
In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits.

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