Chapter 18
Hedging Portfolio Risk
Better to light a candle than to curse the darkness.
—Chinese proverb
We studied two examples of hedging in Chapter 2. These dealt with basic interest rate risk, specifically, the risk posed by having assets whose durations do not necessarily match the durations of liabilities. The first immunized the duration risk on a bond portfolio intended to defease a 10-year liability while the second example solved a more complicated problem that searched for a portfolio of bonds whose cash flows matched the cash flows on a set of pension liabilities. In general, hedges are strategies that insulate portfolios from adverse market movements. Hedges, properly constructed, perform the functions that firewalls do for computer operating systems—they act as barriers that block the impact of exposures to specified risks. The material in this chapter is not intended to serve as a comprehensive treatment of hedging instruments and strategies. Nevertheless, because hedging is so critical to understanding risk management, it is important that we develop this topic on both an intuitive and applied level. I therefore introduce to you in this chapter a few hedging applications that are useful in managing portfolio risk.
