Yes or No:"Fully hedged portfolios are not risk free."? If yes, are there any conditions? If no, why not? Your comments are welcome.
I would argue that you can never truly fully hedge without being at zero assets and zero liabilities, which kinda takes the fun out of it all, wouldn't you agree? In any hedge that does not take the opposite position of the underlying, you always run the risk of being over or under hedged. I.E., you are long SPY's but need to hedge your long and can't do so without crushing the market which is relatively illiquid at that point. So you sell futures. You are relatively hedged, but you face issues of underlying implied interest rates and slippage which will impact the hedge. So you can then hedge in the interest rate products, but that gets sorta silly, doesn't it? (unless your position is really huge, and if it is, you sure as hell wouldn't be taking advice from me. Unless you were prepared to pay me. A lot.) Now, if you're really bright, you can do your hedge in options, which opens you up to five more variables to hedge. Congratulations. You have now justified your position on the desk for the next few months. Rinse and repeat, and hope the firm has a good year for your bonus. I'm sure this is overly simplistic, but does it answer the question?
No. In meltdowns, asset prices move the same direction. See Long Term Capital Management for more. However their own wealth was fully hedged as they never lost any of it
Thanks for the input. Perhaps I should wait for more comments coming, if any. PS: Basically I would interpret your answering Yes = Agree, and No = Disagree.
No, because: 1) melt-downs can move all the hedges in the same direction, 2) markets can hit trading limits that prevent a timely exit or stop-loss on one or more of the hedges; 3) counter-parties can fail; 4) governments can capriciously change the rules for traders or markets; 5) currencies can collapse. I'm not saying that trading markets are a house of cards, but they do depend on an extraordinary amount of stability and mutual trust. When things go all pear-shaped, the markets and the trades can go very very wrong. It is true that hedging can help a trader expand the survivable space of economic variations, but there's always some ugly rare situation that results in a substantive loss. I'd also mention that hedging poses an executional challenge of simultaneously entering and exiting the hedge trades that counterbalance the prime trades. Thus there will always be brief moments of unhedged exposure. Finally there is the ugly issue that attempting to remove the risk also removes the profit potential -- that the certain cost of the hedges can outweigh the uncertain chance of loss.
I think I meant that the traders, Merriwether, Scholes etc did not lose money. Maybe I'm wrong about that, skimmed thru the stuff too fast.
Many thanks to all of you for your excellent comments. It seems hedge mechanism can be useful mainly for small impacts. However, hedge would be not effective when facing major shocks. Am I right? Probably that would be why the big players equipped with the best hedge set-up could still suffer significant losses due to major shocks. Are there any potential ways to reduce this kind of losses due to major shocks? Any useful tools? How about PCA: "Generating market risk scenarios using principal components analysis" http://www.bis.org/publ/ecsc07c.pdf
Why hedge funds would go broke? Q http://www.rgemonitor.com/blog/setser/129004 I thought hedge funds were supposed to be hedged ... against market downturns. Brad Setser | May 24, 2006 Wasnât a key selling point of hedge funds that they could make money even when the (US) stock market was falling, unlike mutual funds? Well, hedge funds may be hedged against a fall in the US stock markets, but it sure doesnât seem like hedge funds were (fully) hedged against falls in the stock markets of many emerging economies. Or jitters in commodity prices. I fully realize hedge funds do a whole lot of different things these days, and that in many ways the name "hedge fund" doesn't tell you much about what a fund really does. Hedge funds can do things mutual funds cann't do, but that doesn't mean that they all do the same thing. Or are all fully hedged. Directional macro bets aren't "hedged," and long-short funds are only hedged v. certain risks, not others. Those betting on credit spreads are long credit risk, even if they have hedged their interest risk and so on. But it sure seems like everyone in the 2 and 20 world was piling into to emerging market equities a while ago. It was an easy way to make money. Hedge funds following different strategies all seemed to be taking the same long position. So I am not totally surprised a lot of funds have losses. Hedging a long emerging economies position with a short on the S&P sort of works, but not entirely. Sometimes emerging market fall more than other markets. And I don't think many folks were long say Turkish banks and short the broader Turkish market, or long Brazilian mining companies and short the broader market. Most bets were simply long Turkey or long Brazil. Among my current worries: the temptation to make money (lots of it) by selling insurance against a more volatile world when volatility was falling may have been too great for some folks to resist. Paul McCulley: With policy makers removing sources of volatility risk from markets, actual volatility falls, which like gravity, pulls risk premiums â the market compensation for underwriting volatility â lower. More specifically, P/Es rise, term premiums narrow, credit spreads tighten, and implied volatilities in options fall. As this process unfolds, the forward-looking return on risky assets falls, but their real time actual return is heady, as lower risk premiums are capitalized. This is a perfect prescription for bubbles. Well said. The real time return â not the forward looking compensation for taking risk - may have come to dominate too many (financial) decisions. I am one of thosecurmudgeons who thinks a more unbalanced world will likely prove to be a more volatile world. We will see. Note: I edited a few paragraphs to try to clarify my intent. I did not mean to imply all hedge funds are fully hedged against all risks. I was trying to use a bit of irony. I did mean to imply that a lot of funds following different strategies had lots of directional exposure to emerging market equities. Folks who were long say Brazil were long Brazil and a lot of other emerging markets -- long the local equity market and long the currency. The hedges (offsetting shorts) that didn't cost an arm and a leg were global hedges. If I am way off base there, let me know! UQ