Funds Investing

In the common stock investment techniques, the most obvious hedging strategy might be to be long the stocks that are relatively discounted and sell short those that appear most overpriced. However, the process is not so simple.

Because of the composition of the Master List, the stocks as a group tend to do significantly better than the market as a whole. Consequently, although the long positions have significantly outperformed the broadly based market, the short positions, if sold, will likely provide lesser returns than the overall market.

It is because of the Master List’s positive bias that in hedging accounts Drach utilizes writing index call options as a substitute for the short side. This substitution both eliminates the effect of the Master List’s upside bias that would be experienced in attempting to short Master List stocks and provides added profitability for the short side because of premium capture. As discussed in Chap. 9, the method of going long the selected Master List issues and proportionately shorting (selling) index call options is a lethargic process, which has so far produced a constant annualized return of about 15 percent irrespective of overall market conditions. Read the rest of this entry »

Earlier we provided two interpretations of a swap: (1) a package of futures/forward contracts, and (2) a package of cash market instruments. The swap spread is determined by the same factors that influence the spread over Treasuries on financial instruments (futures/forward contracts or cash) that produce a similar return or funding profile. As we explain subsequently, the key determinant of the swap spread for swaps with maturities of five years or less is the cost of hedging in the Eurodollar CD futures market. For longer maturity swaps, the key determinant of the swap spread is the credit spreads in the corporate bond market. Read the rest of this entry »

One issue that has elicited different responses is the role of currency risk in overall risk and return. Currency risk has been accounted for in all of the evidence presented. So the existence of currency risk will not reduce the benefits of investing in foreign markets. Rather, the question is whether managing currency risk will improve the gains from international investing.

While the reduction of any kind of risk is good, there are two issues that must be considered with regard to currency risk. First, the correlation between currency risk and stock market risk is close to zero. That means that currency changes and stock returns are independent of one another. Though both currency risk and stock market risk contribute to the total risk of a portfolio of foreign stocks, the contribution of currency risk to the total risk is not very large because of the zero correlation. On average, currency risk contributes less than 20 percent of the total risk. Read the rest of this entry »