Yes or No:"Fully hedged portfolios are not risk free"?

Quote from OddTrader:

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
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1. In case I was unclear, the answer to your question is 'no'. However, the way you have written it a no gives you a double negative... we all know what we are trying to say however.

2. Took a quick peek at the article - I would be careful about generalizing results from multivariate analyses... the country choice was somewhat confusing to me - why nine countries? Why not just the majors? And if you are to include countries such as belgium and canada, why not mexico and spain? Be careful of author's bias in making their numbers work...

3. The real question is this: in a global meltdown, what type of portfolio does best?

You must consider the following risks:
a) Inflation vs. Deflation (most important)
b) Country specific risk vs. External risk
c) Asset risk vs. Credit risk
d) Economic Risk vs. Political Risk

IMHO, the portfolio would look something like this (overly simplified)

1. US and foreign equities
2. Foreign bonds (unhedged)
3. US zero coupon treasuries
4. TIPS
5. US real estate (not securitized)
6. Gold & other PM's, Energies, other commodities and hard assets.
7. Floating rate securities

Of course, the devil is in what percentage allocation to give to these categories.... anyone have any ideas backed by some number crunching?
 
Quote from OddTrader:

"Fully hedged portfolios are not risk free."?
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Q
http://www2.sjsu.edu/faculty/watkins/ltcm.htm

Some firms have found to their chagrin that they lost large amounts of money on fully hedged portfolio that were constructed to protect them against infinitesimal price fluctuations. Fully hedged portfolios are not risk free.

Another chronic problem with LTCM's strategy is that although the traders took a large number of separate positions there was effectively no benefits for risk-reduction through diversification because in effect most of the separate transactions were the same bet on the stabilization of the markets and a return to equilibrium.

UQ
 
First there is no such thing (as a fully hedged portfolio)

Second, there is a physical problem with trying to put on a full hedge.

Third, "Value-At-Risk"

Fourth, Cost

This is where the rubber meets the road. You either partially hedge and live with the uncertainty, or you try to put on a program to dynamically hedge (as much as you can) and hope that you don't have a black swan event on your horizon.

Steve
 
Quote from drsteph:

3. The real question is this: in a global meltdown, what type of portfolio does best?
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Now I believe the above type of issues would be exactly the real question I have had in mind about trading activities particularly regarding managing risks.
 
Quote from GlobalFinancier:

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.
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Hilibrand was the LTCM trader with the largest discretionary book, Haghani was second. Neither Merriwether nor Scholes traded while at LTCM. LTCM was a meritocracy; the larger traders held the lion's share of the bonus pool.
 
How about this one:

Q

Organizations have traded calls and puts on hedge fund returns. UBS sold calls to the partners of LTCM and investd an amount equaling the notional amount in the fund as a hedge.

Because they also reinvested the call premium in the fund, UBS actually invested more than the notional amount in the fund.

When the hedge fund suddenly lost nearly 100% of the NAV of the fund, UBS lost &680 million.

--- How to creat & manage a hedge fund (Stuart A McCrary)

UQ
 
By defenition, a fully hedged portfolio is risk free and also return free as well. (no risk - no reward).

What some of these posts refer to are diversification strategies or even partial hedging.
 
Quote from granville:

By defenition, a fully hedged portfolio is risk free and also return free as well. (no risk - no reward).
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How about insurance premium?
 
Quote from OddTrader:

Yes or No:"Fully hedged portfolios are not risk free."?

If yes, are there any conditions?

If no, why not?

Your comments are welcome.
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A "fully hedged" portfolio cannot be risk-free unless an arbitrage condition exists. (See M. Harrison and D. Kreps. "Martingales and Arbitrage in Multiperiod Security Markets. " Journal of Economic Theory 20: 381--408, 1979). The term "arbitrage" is much-abused as of late, but in theory refers to a very specific condition where the same asset is bought and sold simultaneously to secure an instant profit. Theorists begin to argue when "simultaneous" becomes "sequential", but practitioners draw the line at "executed" and "fungible". One would have a "risk-free fully hedged portfolio" in a genuine arbitrage.

-segv
 
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