Chapter 6

The Decision to Hedge

Stay! though the woods are quiet, and you've heard Night creep along the hedges. Never goWhere tangled foliage shrouds the crying bird, And the remote winds sigh, and waters flow!

Rupert Brooke, Town and Country

6.1. TO HEDGE OR NOT TO HEDGE?

In Chapter 2 we discussed many of the risks to which a portfolio can be exposed. We now turn our attention to the hedging of those risks and consider the elements in the decision about whether those risks should, and can, be hedged.

Until quite recently, when evaluating investment alternatives, finance professionals commonly subscribed to modern portfolio theory (MPT), which came in vogue in the 1960s. In recent years, the theory, which suggests that an efficient portfolio can be constructed that will, through diversification, maximize return for a given level of risk, has come under attack, with several of its assumptions being challenged, perhaps most notably those that market returns are normally distributed and correlations are constant. From a practical viewpoint, many proponents' faith in the theory was shaken when they suffered losses during the recent market turmoil, notwithstanding the vaunted benefits of diversification, and there is now a growing acceptance of alternative theories such as that of behavioral finance. One of the core propositions of MPT, however, that in rational markets investors seek increased returns for assuming incremental levels of risk, is still generally accepted to be true. ...

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