About this time very year, as the clocks go back, I ask my students: How do I hedge risk?
Eventually we stumble on the answer which involves buying an asset whose prices changes, or returns in financial language, are negatively correlated with those of my current portfolio.
Thus I give up a little of the returns from my current portfolio and add an asset whose returns will be high (low) when those of my current portfolio will be low (high).
And so I ensure, through the purchase (giving up of some of returns) of a hedge, that my returns or income stream is better stabilised.
The price that people are willing to pay for hedges can give us very useful information on the market’s perception of risk.
Let us, for example, consider credit default swaps on sovereign debt.
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Jagjit Chadha is Professor of Economics at the University of Kent. He is the co author of the recently published The Euro in Danger