I'm studying for the SIE in the United States. I'm learning about the different risks and how to mitigate them. The only way given to minimize systematic risk is to hedge using puts on an index such as the S&P 500. Can't we also just invest less money? What about buying stocks with a lower Beta?
6
-
How about not selling in a down market?– Pete B.Commented May 23 at 10:39
-
1Eliminating risk by not investing, of course, also eliminates gain. Presumably the goal is to balance the two intelligently and as close to optimally as possible. I don't pretend to know how to do that; as long as my long-term returns are reasonable I'm content.– keshlamCommented May 25 at 7:26
-
@keshlam The purchase of a put also eliminates gain– Cotton Headed NinnymugginsCommented Jun 5 at 19:42
-
Not selling in a down market doesn't mitigate risk.– Bob BaerkerCommented Jul 13 at 20:28
-
The purchase of a put does not eliminate gains. It reduces them.– Bob BaerkerCommented Jul 13 at 20:28
|
Show 1 more comment
1 Answer
Puts are one way to hedge long market risk. To eliminate systemic (beta) risk more generally, you need to establish a 0-beta position. The first question is: Which beta? The answer depends on the model you have in mind (e.g., CAPM or multifactor). Let's use the CAPM where the only source of systemic risk is from the market. To form a market neutral portfolio, you want the beta of your portfolio to equal 0, which simply requires a judicious choice of portfolio weights. Consider two assets, A and B, and corresponding portfolio weights, wA and wB, and betas, betaA and betaB. You can always find a market neutral (0-beta position) by choosing the weights so the following expression is true.
betaPortfolio = wA x betaA + wB x betaB = 0
This expression shows that we can either invest in negative beta assets (e.g., put options) or short assets (wB < 0) to neutralize a positive beta position (wA x betaA > 0).
