Hull Ch3 Hedging strategies Using Futures

[verma.rahul]

The reasons for Hedging an Equity portfolio as explained by Hull on pg 70 :
Hedging is justified if the hedger feels that the stocks in the portfolio have been well chosen and will outperform the market.
If the hedger feels that the stocks will outperform the market then why does she feels the need to hedge against performance of market. Please throw some light on this.

Thanks
Rahul

 

[David Harper CFA FRM]

Rahul,

Great point, this is worth a meditation as it invokes Stulz, Hull, Grinold. This is the same idea as "portable alpha" where you want to isolate on the skill or specific bets and neutralize the common factor (e.g., market) exposures. Think of CAPM or APT: the portfolio return is a function of common market (systemic) exposure plus the security-specific return, which gets diversified away. Here we have sort of the opposite of the traditional idea. The traditional idea is diversify away the specific risk and you have only the common factor exposure; this refers to hedge the common factor exposure and isolate on the specific risk. The portfolio manager does not want do go down if the market goes down, so he hedges the market with, say, going short an S&P futures contract; via Hull, he make seek to make the portfolio beta neutral. So he is hedged against market movements but hoping to profit on the "alpha" due his security selection. So, the implication is that hedge is not againt the total portfolio, only against the market (single common factor) exposure, leaving a more focused exposure on the stock selection - David