Hedging Risk Factors

34 Pages Posted: 24 Mar 2018 Last revised: 17 Apr 2018

See all articles by Bernard Herskovic

Bernard Herskovic

University of California, Los Angeles (UCLA) - Anderson School of Management

Alan Moreira

University of Rochester - Simon Business School

Tyler Muir

University of California, Los Angeles (UCLA) - Anderson School of Management; National Bureau of Economic Research (NBER)

Date Written: March 24, 2018

Abstract

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

Suggested Citation

Herskovic, Bernard and Moreira, Alan and Muir, Tyler, Hedging Risk Factors (March 24, 2018). Available at SSRN: https://ssrn.com/abstract=3148693 or http://dx.doi.org/10.2139/ssrn.3148693

Bernard Herskovic

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

Los Angeles, CA 90095-1481
United States

HOME PAGE: http://bernardherskovic.com

Alan Moreira

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

Tyler Muir (Contact Author)

University of California, Los Angeles (UCLA) - Anderson School of Management ( email )

110 Westwood Plaza
Los Angeles, CA 90095-1481
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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