Basis Risk
Let's say an investor engages in a hedging strategy (investing in different securities with negative correlations to offset, or "hedge" the risk of price or value fluctuations in one of the securities you've invested in). Their basis risk is the possibility that security "b" (bought to hedge the decrease in value of security "a") will not experience an increase in value if security "a" depreciates.
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Finance: What is a hedge fund?41 Views
finance a la shmoop. how does a hedge fund work? so you've probably heard a lot
about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]
your money. that hedge funds are only investing vehicles for the wealthy and
how mathy their employees are. but the actual workings of a hedge fund are a
lot like driving down a road in wartime. there are hills and there are valleys
your car will Traverse wanting it to speed up and slow down but as long as
you continue to drive 37 miles an hour the enemy radar can't detect you so you
drive theoretically, safely down the road. alright so how does this translate to
financial investments in a hedge fund well essentially every investment made
on an entity going up in value is usually offset by making a bet on a
different entity going down in value. that's called hedging got it? the economy
is coming out of the doldrums and you believe the entire stock market is gonna
recover but you believe the worst companies which have been down some 90% [chart showing decline]
in this bad bear market environment will actually do better over the next period
of time than high quality companies like Coca Cola which didn't decline as much.
that is yes Coca Cola stock will improve and you think it has Headroom to run
upwards some 30% in the next year and a half but you believe crap burgers
dot-com which went from $100 a share at its peak to only $2 today could
quadruple to 8 bucks in value over that same 18 months. like you get a much
better percentage return on crap burgers than you do on coke. so as a hedge fund
manager one quote easy unquote trade that you'll make is too short coca-cola
betting essentially that it will go down, and then putting the same amount of
money to being long crap burger com betting essentially that it'll go up. in
essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]
than coca-cola will go up but if the overall market goes down
well you'll be hedged in that you're short Coca Cola position will cushion
the blow of crap burgers further demise and it's likely you're looking at crap
burgers balance sheet and thinking well they have $2 a share in cash and no debt
how much lower can they go .got it? hedge funds use stock options
aggressively to manage risk in their portfolios the promise hedge funds make
to investors is that their performance will be up and/or good whether the
market goes up down or stay sideways. so another common hedge trade involves the
use of put options on the market to protect the long trades the fund is
making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]
and believes that they will be up significantly over the next two to three
quarters earnings reports. but it's also nervous about nukes in North Korea in
order to protect against a bomb going off and the whole market going down and
ruining its investment performance, and yes there are bigger things to worry
about then but that doesn't matter to hedge funds not their job. the hedge fund
goes long the three stocks it likes but it buys put options on the market
betting with those options that the market itself will go down. it's
essentially playing both sides of the fiddle so that hopefully it wins in any
set of circumstances. and yeah it's a lot more complicated than that in practice
we're just given the idea here. in the case of a put option the market might be
trading at ten thousand and a put option might have a strike price of nine
thousand such that if the market declines below nine thousand the put [strike price illustrated]
option goes quote in the money unquote and pays the investor handsomely for
making the bet that the market would go from ten thousand and well somewhere
below nine thousand. if that happened the three long stock bets that the hedge
fund made would go down but their decline would be hopefully more than
offset by the gains from the put options the hedge fund bought that were
portfolio life insurance in the case the market puked. and if that happens well
all you can really do is offer the market a breath mint and a moist
towelette and then be sure to collect your fee. [person representing stock market offered towelette]
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