Table of Contents

Perfect Hedges: What They are and How They are Made

By

澳洲幸运5开奖号码历史查询:James Chen

Updated March 28, 2023

Reviewed by

Thomas J. Catalano

Fact checked by

Suzanne Kvilhaug

What Is a Perfect Hedge?

A perfect hedge is a position that eliminates the risk of an existing position or one that eliminates all market risk from a portfolio. Rarely achieved, a perfect hedge position has a 100% 澳洲幸运5开奖号码历史查询:inverse correlation to the initial position where the profit&𓆏nbsp;and loss from the underlying asset and the hedge position are equal.

Key Takeaways

A perfect hedge is a position by an investor that eliminates the risk of an existing position or one that eliminates all market risk from a portfolio.
Investors commonly attempt to achieve a perfect hedge through options, futures, and other derivatives for defined periods rather than as ongoing protection.
The profit and loss from the underlying asset and the hedge position are equal in a perfect hedge.

Understanding a Perfect Hedge

Investors commonly attempt to achieve a perfect hedge through options, futures, and other derivatives for defined periods r𒁏ather than as ongoi😼ng protection.

An example of a near-perfect hedge is an investor who uses a combination of held stock and opposing options positions to insure against loss in the stock position. The downside of tཧhis strategy is that it often limits the gain of the stock position while trying to protect the underlying asset.

Perfect Hedges in a Practical World

A perfect hedge is based on an investor's 澳洲幸运5开奖号码历史查询:risk tolerance. Removing all risk from the investment impacts the potential for rewards. In attempting a perfect hedge, investꦍors and traders establish a range of probability where both the worst and ꩲbest outcomes are acceptable.

Traders do this by establishing a trading band for the underlying investments they are trading. The band can be fixed or can move up and down. Investors try to create hedges through 澳洲幸运5开奖号码历史查询:diversification. By finding assets with low correlation or inverse correlation, invest🎉ors ensure smoother꧋ portfolio returns.

Investors in traditional securities see the same results. There are many strategies to hedge an investor's stocks through futures, call-and-put options, and convertible bonds, but they all incur a cost.

Popular “Perfect” Hedges

Perfect hedges exist in theory but are rarely worth the cost for any period except in the most volatile markets. Assets considered a perfect hedge in volatile markets include 澳洲幸运5开奖号码历史查询:liquid assets like cash and short-term notes and investments like gold and real estate. These perfect hedges do not experience the volatility of the financial market and illustrate other places in which𝔍 an investor can shelter cash.

What Does It Mean to Hedge Investments?

To hedge is to take an offsetting 🌸position in an asset or investment that reduces the price꧅ risk of an existing position. A hedge can be a trade made to reduce the risk of adverse price movements in another asset.

Why Is Risk Reduced In a Perfect Hedge Position?

Hedging requires taking two equal but opposite positions in the cash and futures markets. In a perfect hedge, gain and loss in one market are offset by loss and gain in the other market, reducing or eliminating risk exposure.

What Is a Hedge Ratio?

The 澳洲幸运5开奖号码历史查询:hedge ratio compares the value of a position protected through a hedge with the size of the entire position. I🥀f you hold $10,000 in foreign equity and enter into a hedge to protect against losses, you may hedge $5,000 with a currency position, creating a hedge ratio of 0.5 ($💎5,000 / $10,000).

The Bottom Line

A perfect hedge is a position that eliminates the risk of an existing position or one that eliminates all market risk from a portfolio. The profit and loss from the underlying assets and the hedge position are equal in a perfect hedge. Investors commonly use options, futures, and other derivatꩵives for defined periods to create a perfect hedge scenario.

Investopedia does not provide tax, investment, or financial services and advice. The information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Investing involves risk, including the possible loss of principal.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Pennsylvania State University. "."

Compare Accounts

The offers that appear in this table are from partnerships from which Investopedia receives compensation. This compensation may impact how and where listings appear. Investopedia does not include all offers available in the marketplace.

澳洲幸运5开奖号码历史查询