by A perfect hedge is a position undertaken by an investor that would eliminate the risk of an existing position, or a position that eliminates all market risk from a portfolio. In order to be a perfect hedge, a position would need to have a 100% inverse correlation to the initial position. As such, the perfect hedge is rarely found.
A common example of a near-perfect hedge would be an investor using a combination of held stock and opposing options positions to self-insure against any loss in the stock position. The downside of this strategy is that it also limits the upside potential of the stock position. Moreover, there is a cost to maintaining a hedge that grows over time. So even when a perfect hedge can be constructed using options, futures and other derivatives, investors use them for defined periods of time rather than as ongoing protection.
When the term perfect hedge is thrown about in the world of finance, it usually means an ideal hedge as judged by the speaker’s own risk tolerance. There is really no reason to completely remove all the risk out of an investment, as neutering risk has a similar impact on rewards. Instead, investors and traders look to establish a range of probability where the worst and best outcomes are both acceptable.
Traders do this by establishing a trading band for the underlying they are trading. The band can be fixed or can move up and down with the underlying. However, the more complex the hedging strategy, the more likely it is that hedging costs themselves can impact overall profit.
The same is true of investors in traditional securities. There are many strategies to hedge owned stocks involving futures, call and put options, convertible bonds and so on, but they all incur some cost to implement. Investors also try to create “perfect” hedges through diversification. By finding assets with low correlation or inverse correlation, investors can ensure smoother overall portfolio returns. Here again, the cost of hedging comes into play in that an investor ties up capital and pays transaction fees throughout the process of diversification.
Perfect hedges do exist in theory, but they are rarely worth the costs for any period of time except in the most volatile markets. There are several types of assets, however, that are often referred to as the perfect hedge. In this context, the perfect hedge is referring to a safe haven for capital in volatile markets. This list includes liquid assets like cash and short-term notes and less liquid investments like gold and real estate. It takes very little research to find issues with all of these perfect hedges, but the idea is that they are less correlated with financial markets than other places you can park your money.
Imperfect Hedge
The hedger’s gain and loss in the spot and futures market are not fully offset and the hedger will end up with some gain or loss. This is called imperfect hedge. Note that the gain or loss of hedging will be much less than not utilizing hedge.
Seller’s hedge or short hedge
Following the example from the previous page, assume the price has gone down between the time of selling the futures contract and November 1st and the basis has changed a bit (imperfect hedge). Let’s explore two cases:
- On November 1st, the spot market prices are $59.5/bbl and the December futures contract would be $60.60/bbl.
- On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.
Buyer’s hedge or long hedge
Following the example from the previous page, assume prices have gone down from the time the refinery buys the future contracts until November 1st. Let’s consider the above cases:
- On November 1st, the spot market prices are $59.50/bbl and the December futures contract would be $60.60/bbl.
- On November 1st, the spot market prices are $59.60/bbl and the December futures contract would be $60.40/bbl.
