Economic Hedging Portfolios
Tilburg University Working Paper
31 Pages Posted: 22 May 2003
Date Written: February 28, 2003
In this paper we study portfolios that investors hold to hedge various economic risks. We also consider the risk premiums associated with these economic hedging portfolios for various types of agents. Using a model of state-dependent utility, we show that agents' economic hedging portfolios can be obtained by an intuitively appealing risk aversion-weighted approximate replication of the economic risk variables using the available risky security returns, as opposed to the unweighted hedging demand obtained in a traditional mean-variance framework.
We find that agents across a broad range of levels of risk aversion are willing to pay significant risk premiums for hedges against three sources of economic risk: Inflation risk, real interest-rate risk, and dividend-yield risk. Furthermore, our results show that all economic risk variables we consider require a significant hedging adjustment with respect to one or more securities. Some of these securities prove to be useful hedging instruments across different types of investors, whereas others only serve as hedges for particular levels of risk aversion, which demonstrates the empirical relevance of risk aversion-weighted hedging.
Moreover, we analyze investors' speculative positions and find that hedges against economic risks may potentially explain the anomalies found in stock markets as well as the term and default premiums in bond markets.
Keywords: Economic hedging portfolios, risk aversion-weighted hedging, state-dependent utility, risk premiums
JEL Classification: G10, G11
Suggested Citation: Suggested Citation