Hedging is a zero-sum game

[MSharky]

Hi

I am going through the theoretical arguments as to why hedging does not add value to a firm and I am having trouble understanding the argument that hedging using financial derivatives simply moves cashflows/earnings from one time period to another and that the pricing of financial derivatives takes into account all its risk characteristics. What does this mean? Who is performing the hedging? The investor or the firm? Can someone provide an example?

Thanks,

 

[nh53019]

Anyone can perform hedging as long as the "so called investor" already has an exposure. Since he has an exposure, the movement in the price is not in his control and hence it would be safe to hedge his investment to mitigate risk. Hedging reduces the amount of profit he can make from his investment but also limits risk exposure. Typically, retail investor may not be too keen of hedging as 99% of the times retail investors are speculators who would like to make maximum profit on an investment. But, if you talk about banks or other financial institutions, hedge funds, they would hedge their exposure as their investments are several % greater than that of retailers and leveraged position could cause heavy loss if the market moves in an opposite direction. This is why the firms get into hedging and if they are long on their stocks portfolio, they may think of hedging that exposure by selling futures of the corresponding index. This need to be evaluated as what is the best possible security that you can hedge for your investment. If say, his stocks portfolio is consisting of stocks from S&P 500 index, then he could sell s&P500 futures to hedge his risk. Always remember, hedging is to limit risk and not to completely eliminate risk. So, if the market moves in an opposite direction, you can still lose money but you will lose very little to what you have lost if you hadn't applied a hedge. There are people who try to come up with a perfect hedge but remember that the transaction cost and commission could well be your loss in those scenarios.

 

[MSharky]

That sums up hedging quite nicely, hedging decisions are based on the risk appetite of the firm and how much risk they can tolerate. However, my issue is trying to understand the arguments against hedging. For example, in the book one of the arguments against a firm hedging is that both the investor and the firm can perform the same financial transaction at the same cost, (assuming perfect competitive markets, no transaction costs or taxes). Hence with these assumptions, hedging will not be beneficial to the firm because it will not add value. So if a firm is long a stock portfolio and decides to sell futures on the corresponding index to hedge their risk, this hedge will not work (in theory)? Why?

Another argument is that hedging is a zero-sum game, which I also do not understand...

 

[nh53019]

The point is in this example of mine, firms normally hedge their portfolio of stocks when they suspect that market may move against them to vipe out the % of profit which the portfolio has already made. So the hedge is temporary and it will remain until the firm analyst think that the time is safe to close the hedge. I think you termed it zero hedge for examples when you buy set of stocks and sell futures contract as the same time. This is possible too but the advantage I see from this is when you are long on your portfolio and when stock price drops you will realise profit on your hedge and keep holding onto your stocks.

 

[MSharky]

So how does the Modigliani-Miller (M&M) theorem work in this case? (If shareholders can perform the same hedge as the firm then that hedge will not add value to the firm)

 

[David Harper CFA FRM]

@JackSmith you gave no context/information about your problem. @Nicole Seaman this is strange (weird type of spam)