Posted on March 21, 2013 @ 10:17:00 AM by Paul Meagher
The purpose of this article is to clarify the investment concept of hedging by using a real world example and some simple math.
The real world example comes from a book I'm currently reading:
The Signal and the Noise: Why So Many Predictions Fail — but Some Don't (2012) by Nate Silver. Penguin Books.
The example involves sports bettor Haralabos "Bob" Voulgaris who was born in Winnipeg, Manitoba but who moved to Los Angeles after cashing in on a large bet.
The bet involved picking the Los Angeles Lakers to win the 1999-2000 season NBA championship early in the season when the odds makers were skeptical that they would win and offered 6.5 to 1 odds on them winning the championship. He bet $80,000 - the money he had earned by the time he was a college senior at University of Manitoba through work and investments. So, if the Lakers did in fact win the NBA championship, he would get 6.5 * $80,000 = $520,000 or approximately a half a million.
In the Lakers' semi-final match against Portland Trail Blazers, in game 7, Portland was a 3-to-2 underdog to win that game. At that point, if Bob had the money, he could have "hedged" his bet and put $200,000 on Portland to win. If Portland won that match, then he would get 1.5 * $200,000 = $300,000. Subtract the $80,000 he would have lost from his Lakers bet, and he still would be ahead by $220,000 in the event of a Lakers loss.
Conversely, if the Lakers won, he would lose his $200,000 hedge bet, but he would still end up making $320,000 ($520,000 - $200,000). The Lakers were heavily favored to win the finals against the Indiana Pacers, but Bob could have hedged his bet again to mitigate that risk. In the end, the Lakers won against Portland and then went on to win the NBA championship for that year.
So the investment concept of "hedging" involves an initial bet on some outcome and then subsequent bets on other outcomes to mitigate risk and/or ensure a positive outcome.