Why Hedging Reduces Risk and Expected Return

# How can you possibly profit from hedging, in view of Algorithmic Trading?


# How can you possibly profit from hedging, in view of Algorithmic Trading?












To wit, doesn't hedging necessarily break even or lose money? I assume the semi-strong form of the EMH, defined in Zvi Bodie, Alex Kane, Alan J. Marcus. Investments (2018 11 edn). p 338.

> The semistrong-form hypothesis states that all publicly available information regarding the prospects of a firm must be reflected already in the stock price. Such information includes, in addition to past prices, fundamental data on the firm’s product line, quality of management, balance sheet composition, patents held, earnings forecasts, and accounting practices. Again, if investors have access to such information from publicly available sources, one would expect it to be reflected in stock prices.

Reddit

> You have an asset X that moves based on factors a and b and another Y that moves based on a. You want to bet on b but not a. So you buy X and hedge out the a by shorting Y.

defines 'hedging' better than p G-6

> hedging Investing in an asset or derivative security to offset a specific source of risk.

### Examples

- Wikipedia's example of hedging a stock price nets you only 'a profit of $25 during a dramatic market collapse', but it overlooks trading commissions and transaction fees. You can argue that humans are better at deciding subjective questions like if Company B is a "weaker competitor" to Company A, but I'd speculate that an algorithm can do this by reviewing accounting figures.

- Unlike example 1, now presume the absence of any complement. How can this example possibly profit you? If it can, wouldn't algorithmic trading have arbitraged away any profit?

> "Say there's 20 minutes to the close of trading," he continues. "If I'm long the call and it's at 95 1/2 I can do two things: I can exercise those calls and buy the stock. Or I can try to sell those calls at a discount in the trading crowd, and in the meantime, just to protect myself, sell the stock short at 95 1/2 myself."

## Answer by Stéphane (score 2)

https://quant.stackexchange.com/a/53395

To understand the issue here, pick a simple example.

In their original article, Fisher Black and Myron Scholes derived a famous partial differential equation from which they obtained their celebrated formula. Recall the argument they made. In the continuous trading limit, delta hedging can eliminate all the risk faced by the underwriter of a European option. By absence of arbitrage, what should be the return on that portfolio? The continuously compounded risk-free rate of return.

From the point of view of financial economics, what is going on here is that expected returns include a compensation for bearing risk. If you reduce your exposure, you reduce your expected returns. Said differently, hedging is like buying insurance.

The reason you will find firms that do believe arbitrage exists still hedge certain sources of risk is that they are trying to narrow down the type of risk to which they wish to be exposed. It's all fine to expose yourself to default risk on the sovereign debt of emerging economies if you're aware that this is what you're doing. It's a whole lot less fine if it bites you in the back when you didn't expect it.