Hedging Risk Factors
76 Pages Posted: 24 Mar 2018 Last revised: 3 Jun 2019
Date Written: January 14, 2019
Standard risk factors can be hedged with minimal reduction in average return. This is true for "macro" factors such as industrial production, unemployment, and credit spreads, as well as for "reduced form" asset pricing factors such as value, momentum, or profitability. Low beta versions of the factors perform close to as well as high beta versions, hence a long short portfolio can hedge factor exposure with little reduction in expected return. For the reduced form factors this mismatch between factor exposure and expected return generates large alphas. For the macroeconomic factors, hedging the factors also hedges business cycle risk by significantly lowering exposure to consumption, GDP, and NBER recessions. We study implications both for optimal portfolio formation and for understanding the economic mechanisms for generating equity risk premiums.
Keywords: Risk and Return, Equity Premium, Hedging, Asset Pricing Models, Factor Models
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