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specialized in the technology field, facing market risk and trying to decide whether and which
way to use in order to hedge equity market risk. They choose technology sector because the
partners of PSC felt that they have enough ability to evaluate this sector and specially be
good at picking out-performing stock. Short-selling of NASDAQ and options hedging strategy
are the two major hedging choices for PSC. Either strategy has its own advantages in
different economic periods and conditions. The fund has just through one of the most volatile
periods in NASDAQ's history, and it was trying to decide whether it should continue its risk
management program of short-selling the NASDAQ index or switch to a hedging program
using put options on the index.
The more common hedging strategy they used was a short-sale strategy to eliminate market
risk from the fund. Short-sale strategy can be explained in the following model:
Expected PSC Portfolio Return=α+β*(Market return)
α: The amount of return in excess of that due to market risk
β: The response of PSC’s portfolio to changes in the market
PSC established relationship between the performance between PSC’s portfolio and the
market. PSC adopted the market-neutral strategy because they wanted to eliminate market
risk (beta risk) which was hedged from PSC’s portfolio by shorting the market in proportion to
the beta of the assets in the portfolio while firm-specific risk (alpha risk) remains. And they
believe that it was very specialized in the technology sector and hence be able to evaluate
the field and pick up outperforming stocks accurately. The alpha return that PSC was left with
in their portfolio after hedging market risk could be negative if they picketed the wrong
stocks. But PSC was so confident because their comparative advantage is to select positive
alpha stocks in technology field and do profitable investment.
The number of hedge funds around the world increased greatly in the late 19th century.
Hedge funds are private group investments that offer equity pooling advantages. They are
not publicly owned and less regulated and enjoy additional privileges. So, the attribute of
hedge funds make it more flexible in investment strategies and risk management and it
seems to result in a higher return. Moreover, Hedge funds can use leverage and shorting or
using options to hedge. The advantage of using debt to finance a portion of the assets in a
portfolio is that a higher return on the portfolio’s equity could be got compared with an all-
equity financed portfolio. Hedge funds also have another privileges but the main differences
is the ability for hedge fund to use leverage and to hedge by shorting or using options to limit
the overall risk of their investments. But using leverage increases the risk of an investment
because if leverage is employed and the assets lose value, leverage will go far away from the
investor. Then the loss on equity will be larger compared with an all-equity portfolio. Another
advantage of hedge fund is that it can use options as a hedging tool to limit the overall risk at
a given investment amount. But the question is that the hedge position limits the potential
gains while it also protects the portfolio from the downside of risk.
While at the same time, the QQQ price is 95.62, according to formula (1-1), the number of
shares need to short is
market value of portfolio * portfolio beta / QQQ share price
=34553800*1.67/95.62=603481
Now assume that day is the initial date, we shorted 603481 shares of QQQ, then we verify
the results using real monthly data, till 2001-2-1(the SDLI was acquired in 2001):
Date QQQ price QQQ short selling value 1share PV with hedging PV without hedging PV ratio
with hedging PV ration without hedging
2000-7-26 95.62 95.62 92258664.22 34553811 100.00% 100.00%
2000-8-1 101.62 89.62 96141967.22 42058000 104.21% 121.72%
2000-9-1 88.75 102.49 97993882.69 36143115 106.22% 104.60%
2000-10-2 81.7 109.54 98835008.74 32729700 107.13% 94.72%
2000-11-1 62.98 128.26 101869023.1 24466550 110.42% 70.81%
2000-12-1 58.38 132.86 106431710.7 26253225 115.36% 75.98%
2001-1-2 64.3 126.94 105301308.1 28695430 114.14% 83.05%
2001-2-1 47.45 143.79 100624223 13849690 109.07% 40.08%
the portfolio value with hedging = value of the short selling QQQ stock + portfolio value
without hedging
value of short selling QQQ stock=[initial QQQ price+(initial QQQ price-current price)]*number
of QQQ shares shorted
Portfolio value with hedging can not be directly compared with the PV without hedging ,
since their components are different. But the standard deviation when using hedging (4.75%
of initial value) is much lower than that without hedging (23.29% of initial value).
We can see the monthly value versus initial value ratio is much higher if hedging is used in
market downturns. In the last month of the graph the portfolio lost 60% if without hedging
while the there is even a gain if hedging is used (compared to initial value). But notice that
hedging can also limited the upward potential when price rises, as the second month in the
graph.