What is a Perfect Hedge?

A perfect hedge refers to a position which an investor undertakes to eliminate the risk of an existing position, or a position which eliminates every market risk from a portfolio. In a bid to be a perfect hedge, a position must have a 100% inverse correlation to the first position. Thus, the perfect is rare to find.

How Does a Perfect Hedge Work?

A common instance of a near-perfect hedge will be an investor making use of a combination of opposing options and held stock positions to self-insure against losses in the stock position. The disadvantage of this strategy is its limitation to the upside stock position potential. Moreover, hedge maintenance has a cost that grows eventually. So even when a perfect hedge can be built utilizing futures, options, and other derivatives, investors utilize them for specific periods of time as against ongoing protection.

Perfect Hedges in a Practical World

When perfect hedge, as a terminology, is thrown about in finance, it always means a normal hedge as judged by the risk tolerance of the speakers. There's no reason to totally eliminate every risk out of an investment, as neutering risk has a synonymous effect on rewards. Instead, traders and investors seek to establish a probability range where the best and worst outcomes are both acceptable. Traders do this by creating a trading band for the underlying asset they're trading. The band can either be fixed or can move down or up with the underlying. However, the more complicated the hedging strategy, the more possible it is that hedging costs can affect overall profit m This also applies to investors in traditional securities. Various strategies exist for hedging owned stocks comprising futures, put and call options, convertible bonds, and much more, but they all incur some implementation cost investors also try creating perfect hedges via diversification. By getting assets with inverse correlation or low correlation, investors can ensure better overall portfolio returns. Again, the cost of hedging materializes in that an investor ties up capital and also pays transaction fees all through the diversification process.

Popular Perfect Hedges

Perfect hedges exist in theory, but in most cases, the hedges are not worth the amounts for any period of time except in markets with the most volatility. There are several asset types, however, they are usually called perfect hedge. In this context, the perfect hedge refers to a safe place for capital in volatile markets. This list comprises liquid assets such as short-term notes and cash, and less liquid investments such as real estate and gold. Finding pro forma with every perfect hedge requires very little research, but the idea is that they're less linked to financial markets than other places where you can pack your money.