Question

What is the definition of a hedge? If Asset X is to be a hedge against a bad outcome Y (such as inflation), then the correlation between return on asset X and the bad outcome Y

a. Should be as high as possible (ideally 1)

b. Should be as low as possible (ideally -1)

c. Should be zero

d. Does not matter

You are considering an investment in a mutual fund that has historically outperformed the rate of inflation by, on average, 5.2 % per year. Does this investment provide a good protection against inflation over yearly horizons?

a. yes

b. no

c. not information provided

You bought a 5-year U.S. Treasury bond one year ago. The bond has a coupon rate of 0.0154 and it was issued at par/face value. The face value of the bond is $1,000. The yield-to-maturity today is 0.0237. If you sell your bond right now, what is the return on your investment (or equivalently, what is your realized return)?

Answer 1

Part A:

Generally hedge means protecting himself from financial loss by eliminating the risk from current position. It is always inversely related to the initial position.

In case of -1, it is called as ideal hedge or peerfect hedge as in this investor is completely protected.

Option b is correct

Part B

Generally if a mutual fund has hostorically outperformed inflation by 5.2% then it implies it is good protection in normal scenarios against inflation over yearly horizons.

However in stress scenario, we can't predict about these investments.

Option a is correct

Part C

FV = 1,000

Coupon payment = 1.54% * 1,000 = 15.4

N = 4

YTM = 2.37%

Using Financial Calculator:

PV = 968.68

Realized return = (968.68 + 15.4 - 1,000)/1000

Realized return = -1.59%

A perfect hedge is a position undertaken by an investor that would eliminate the risk of an existing position, or a position that eliminates all market risk from a portfolio. In order to be a perfect hedge, a position would need to have a 100% inverse correlation to the initial position. As such, the perfect hedge is rarely found