This is a real challenge. On the one hand you want the short basket to be similar enough to remove market/industry risk factors. On the other hand, the short basket must be dissimilar enough that it doesn't have the same trading set-ups as the long-basket. If the hedge is too similar it moves in exactly the opposite direction as the trade and deftly removes all the profit. This is a bit easier, assuming the trading setups aren't dependent on profiting from currency fluctuations.
Of course not, but if you want to get into details, it would depend on the definition of "fully hedged". If you're long $500K and short $500K of different stocks, then for risk charge (haircut purposes) you are "fully hedged" - but you are certainly not "risk free". If you hold a conversion, a "virtually" risk free position where you are long stock, short calls, and long puts, you have risk especially if the stock closes at expiration time at or near the strike price of the options. Since you are long the puts, and you don't know if the owner of the calls is going to exercise their right to the stock, you don't know if you should exercise your right to "put" the stock. You could end up long, short, or flat, depending on what others do. Hope this helps, Don
A risk free porfolio is like an honest politician... everybody wants one but there aint one... The closest you can get to beign risk free, is having a beta neutral portfolio, and optimizing your performance against your risk... so you get the best payout for the risk you´re taking... but there´s always going to be a risk.
This first one is not a challenge at all. He's an example (of something I don't have time to trade): There are 60-70 REITS that trade on the NYSE. After appplying ** sophisticated quantitative analysis **... One would always be long 20 REITS and short 20 REITS. And trade in and out ** extremely actively ** to take advantage of spread and pricing reversions to mean. Such a portfolio would be HIGHLY market neutral... And highly profitable... but ONLY in the hands of an experienced, professional quant... With highly customized, proprietary software. It would take several years of experience to learn to avoid the pitfalls indigenous to REITS... And 6 figures to devlop the trading systems over time. In such hands... (Do not try this at home)... The portfolio described above would generate a Sharp Ratio > 3.0 And have maximum drawdowns in the 5-10% range. There are countless such universes with a full spectrum of risk profiles. I'm sure the Brights are doing a lot of this sort of thing. The second part is actually the harder part. When you hedge against anything external or dissimilar... You are, by definition, making a ** directional bet **... In return for, hopefully, lower long term portfolio volatility.