In the second of the series on trading strategies, Jim Hanly and John Cotter* ask, how effective are hedging strategies?
The terms risk management and hedging are often used
together. Hedging is a component of risk management as it is
one of the methods available to control risk, and there are
many hedging tools and strategies that may be used to try and
engineer an efficient hedging outcome. Hedging1 whereby the
underlying spot asset is hedged by the corresponding futures
contract is an important tool in the management of risk.
This article examines the hedging effectiveness of different
hedging strategies in risk management. It details and compares
a number of risk measures that can be used to measure the
effectiveness of different hedging strategies. A key issue is
the extent to which hedging reduces the volatility of investors
positions. Since hedging can be interpreted as a form of
insurance, it is worth considering how effective that insurance
is in terms of risk reduction, and it is this issue we
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