Short-term and Long-term Strategies for Dealing with Financial Risk Exposures

Abstract

With a risk-return perspective, this work presents an original framework enfolding several profit & loss diagrams for a variety of option strategies to be employed in the short-term, either for hedging or for speculative purposes. This work also discusses performance evaluation of several diversified portfolios subjected to different rebalancing procedures during a three-year period, using data for securities traded at the Brazilian exchange B3, so as to assess the effectiveness of long-term investment strategies. Besides comparing annualized returns, data for risk-adjusted returns given by the information ratio is useful to provide insights on the effects of rebalancing and also on the ‘mean reversion’ principle.

Furthermore, resorting to risk budgeting knowledge and equations, this work detects that the “1/N Rule” for portfolio diversification is more than just an empirical rule-of-thumb, and there is sound theoretical evidence sustaining this wide-spread practical procedure.

Last but not least, a holistic framework to compare and select asset classes when employing either long-term or short-term diversification strategies is suggested in the last section of this work, taking into account total return (i.e., capital gain or losses, and income) and volatility altogether. Therefore, new tools were developed for investors with financial risk management awareness.

Keywords: Option Strategies, Derivatives, Diversification, Asset Allocation, Financial Portfolio Rebalancing, Portfolio Management, Risk Return Financial Analysis, Risk Management

JEL Classification: G11, G13, G10, G12, G15, G20, G23, G30, G00, A20, B26, B40, B41, D14, E37, F17, O16