What Is a Perfect Hedge?
A perfect hedge is a position that eliminates the risk of an existing position or one that eliminates all market riskfrom a portfolio. Rarely achieved, a perfect hedge position has a 100% inverse correlation to the initial position where theprofitandlossfrom theunderlying assetand thehedgepositionare equal.
Key Takeaways
- A perfect hedge is a position by an investor that eliminates the risk of an existing position or one that eliminates all market riskfrom a portfolio.
- Investors commonly attempt to achieve a perfect hedge through options, futures, and other derivatives for defined periods rather than as ongoing protection.
- Theprofitandlossfrom theunderlying assetand thehedgepositionare equal in a perfect hedge.
Understanding a Perfect Hedge
Investors commonly attempt to achieve a perfect hedge through options, futures, and other derivatives for defined periods rather than as ongoing protection.
An example of a near-perfect hedge is an investor who uses a combination of held stock and opposing options positions to insure against loss in the stock position. The downside of this strategy is that it often limits the gain of the stock position while trying to protect the underlying asset.
Perfect Hedges in a Practical World
A perfect hedge is based on an investor's risk tolerance. Removing all risk from the investment impacts the potential for rewards. In attempting a perfect hedge, investors and traders establish a range of probability where both the worst and best outcomes are acceptable.
Traders do this by establishing a trading band for the underlying investments they are trading. The band can be fixed or can move up and down. Investors try to create hedges through diversification. By finding assets with low correlation or inverse correlation, investors ensure smoother portfolio returns.
Investors in traditional securities see the same results. There are many strategies to hedge an investor's stocks through futures, call-and-put options, and convertible bonds, but they all incur a cost.
Popular “Perfect” Hedges
Perfect hedges exist in theory but are rarely worth the cost for any period except in the most volatile markets. Assets considered a perfect hedge in volatile markets include liquid assets like cash and short-term notes and investments like gold and real estate. These perfect hedges do not experience the volatility of the financial market and illustrate other places in which an investor can shelter cash.
What Does It Mean to Hedge Investments?
To hedge is to take an offsetting position in an asset or investment that reduces the price risk of an existing position. A hedge can be a trade made to reduce the risk of adverse price movements in another asset.
Why Is Risk Reduced In a Perfect Hedge Position?
Hedging requires taking two equal but opposite positions in the cash and futures markets. In a perfect hedge, gain and loss in one market are offset by loss and gain in the other market, reducing or eliminating risk exposure.
What Is a Hedge Ratio?
The hedge ratio compares the value of a position protected through ahedgewith the size of the entire position. If you hold $10,000 in foreign equity and enter into a hedge to protect against losses, you may hedge $5,000 with a currency position, creating a hedge ratio of 0.5 ($5,000 / $10,000).
The Bottom Line
A perfect hedge is a position that eliminates the risk of an existing position or one that eliminates all market riskfrom a portfolio. Theprofitandlossfrom theunderlying assetsand thehedgepositionare equal in a perfect hedge. Investors commonly use options, futures, and other derivatives for defined periods to create a perfect hedge scenario.
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