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A perfect hedge is an investment that offsets 100% of the risk inherent in another investment. To offset all risk, the correlation, or relative gain or loss in value, between the investments must be exactly opposite. Consequently, a perfect hedge not often found.
All investments are subject to a certain amount of risk. This is the chance that the return will be less than anticipated due to changes in market value; an investment exposed to the full risk of a market is said to be in a naked position. Hedge investments are made to offset, or cover, this position and help ensure a minimally acceptable return. A loss in the value of an investment would be offset by a gain in value for its hedge.
The ideal would be a perfect hedge and removal of all risk, but in reality, only a partial coverage of exposure, or risk, is normally possible. The intent of such an investment strategy is to reduce possible losses, not enhance returns. When hedged, the profits realized from a successful investment will be reduced by the cost of the hedge.
High-risk investments typically offer high returns in order to attract investors, and hedging is often used to make a high-risk investment more secure while sacrificing a portion of the potential profit. To secure a perfect hedge, the cost to the investor might be too high, however. Expected profits may be eliminated or reduced to an unacceptably low level by the cost of the hedge.
Correlation is a measure of the relative change in value between two securities; it is represented as a scale of values ranging from +1 to -1. A value, correlation coefficient, of +1 indicates that the market values of two securities are perfectly aligned and change as one. An inverse relationship is indicated by a coefficient of -1. In this case, market forces causing a change in the value of one security would have exactly the opposite effect on the value of the compared security.
To create a perfect hedge, the correlation coefficient of two securities must be -1. This condition is a very rare occurrence, as the majority of securities pairs have coefficients that cluster around 0, indicating that the relative change in value between the two is random. As the correlation coefficient between two securities approaches -1, the effectiveness of using one security as a hedge against the performance of the other increases.
The quest for a perfect hedge, and hedge investments in general, are advanced investment strategies typically used only by professional funds managers to mitigate short-term risk. Most individual investors do not engage in the practice. Those investing for the long term realize a return as the value of their investment grows with the overall value of the market. Hedging against short-term fluctuations is seen as an unnecessary expense that will limit eventual returns.