Basis Risk

  

Let's say an investor engages in a hedging strategy (investing in different securities with negative correlations to offset, or "hedge" the risk of price or value fluctuations in one of the securities you've invested in). Their basis risk is the possibility that security "b" (bought to hedge the decrease in value of security "a") will not experience an increase in value if security "a" depreciates.

Related or Semi-related Video

Finance: What is a hedge fund?41 Views

00:00

finance a la shmoop. how does a hedge fund work? so you've probably heard a lot

00:08

about the huge fees that hedge funds charge for the privilege of managing [woman looks shocked as hedge fund is advertised]

00:12

your money. that hedge funds are only investing vehicles for the wealthy and

00:17

how mathy their employees are. but the actual workings of a hedge fund are a

00:23

lot like driving down a road in wartime. there are hills and there are valleys

00:27

your car will Traverse wanting it to speed up and slow down but as long as

00:32

you continue to drive 37 miles an hour the enemy radar can't detect you so you

00:38

drive theoretically, safely down the road. alright so how does this translate to

00:42

financial investments in a hedge fund well essentially every investment made

00:47

on an entity going up in value is usually offset by making a bet on a

00:52

different entity going down in value. that's called hedging got it? the economy

01:02

is coming out of the doldrums and you believe the entire stock market is gonna

01:06

recover but you believe the worst companies which have been down some 90% [chart showing decline]

01:10

in this bad bear market environment will actually do better over the next period

01:16

of time than high quality companies like Coca Cola which didn't decline as much.

01:21

that is yes Coca Cola stock will improve and you think it has Headroom to run

01:26

upwards some 30% in the next year and a half but you believe crap burgers

01:30

dot-com which went from $100 a share at its peak to only $2 today could

01:36

quadruple to 8 bucks in value over that same 18 months. like you get a much

01:41

better percentage return on crap burgers than you do on coke. so as a hedge fund

01:45

manager one quote easy unquote trade that you'll make is too short coca-cola

01:50

betting essentially that it will go down, and then putting the same amount of

01:55

money to being long crap burger com betting essentially that it'll go up. in

02:00

essence the bet that you are making is that crap burger will go up a lot more [Coca-Cola and crap burger stocks in two separate baskets]

02:05

than coca-cola will go up but if the overall market goes down

02:09

well you'll be hedged in that you're short Coca Cola position will cushion

02:13

the blow of crap burgers further demise and it's likely you're looking at crap

02:18

burgers balance sheet and thinking well they have $2 a share in cash and no debt

02:22

how much lower can they go .got it? hedge funds use stock options

02:26

aggressively to manage risk in their portfolios the promise hedge funds make

02:31

to investors is that their performance will be up and/or good whether the

02:37

market goes up down or stay sideways. so another common hedge trade involves the

02:42

use of put options on the market to protect the long trades the fund is

02:47

making. specifically a hedge fund might find 3 S&P 500 stocks it really likes [ put option explained]

02:52

and believes that they will be up significantly over the next two to three

02:55

quarters earnings reports. but it's also nervous about nukes in North Korea in

03:00

order to protect against a bomb going off and the whole market going down and

03:04

ruining its investment performance, and yes there are bigger things to worry

03:08

about then but that doesn't matter to hedge funds not their job. the hedge fund

03:12

goes long the three stocks it likes but it buys put options on the market

03:16

betting with those options that the market itself will go down. it's

03:21

essentially playing both sides of the fiddle so that hopefully it wins in any

03:26

set of circumstances. and yeah it's a lot more complicated than that in practice

03:29

we're just given the idea here. in the case of a put option the market might be

03:32

trading at ten thousand and a put option might have a strike price of nine

03:36

thousand such that if the market declines below nine thousand the put [strike price illustrated]

03:39

option goes quote in the money unquote and pays the investor handsomely for

03:44

making the bet that the market would go from ten thousand and well somewhere

03:47

below nine thousand. if that happened the three long stock bets that the hedge

03:51

fund made would go down but their decline would be hopefully more than

03:55

offset by the gains from the put options the hedge fund bought that were

04:00

portfolio life insurance in the case the market puked. and if that happens well

04:05

all you can really do is offer the market a breath mint and a moist

04:08

towelette and then be sure to collect your fee. [person representing stock market offered towelette]

Up Next

Finance: What is Cost Basis?
10 Views

What is Cost Basis? For accounting purposes, the cost basis is the amount invested at the time of asset purchase. That is subtracted from the sale...

Find other enlightening terms in Shmoop Finance Genius Bar(f)