Hedging... funny. It sounds important and smart until you realise, in simple words, what it means. I hate those kinds of words because they obscure the simple reality.
When you invest in something you basically say that out of all possible options that were available to you, you predict the one you invest in will most likely (according to your risk assessment) bring profits.
If this was your best choice, WHY IN THE WORLD would you invest in something that is doing the opposite?
And there are other reasons not to play with borrowed money... Common sense says any kind of borrowed money costs.
Hedging is used in short term situations, where you want to insulate yourself from market fluctuations. Say you are Lufthansa and you have tight budget and you don't want your budget ruined by changes in fuel prices. Knowing how much fuel you will need and at what time, you hedge against those changes. It will cost you but you treat this cost like insurance against disruptions of your business.
> If this was your best choice, WHY IN THE WORLD would you invest in something that is doing the opposite?
This is trivially answered via the oldest financial instrument in the world, agriculture futures. A producer trades potential upside in the future to lock in a price now, splitting the risk between themselves and the futures contract holder.
If they couldn’t do that risk split most producers wouldn’t produce at all.
A pension has a similar problem, they need to produce returns in the future, so splitting the risk now allows them to do that.
It doesn’t matter if you are producing corn that takes 5 months to deliver, cattle which takes 2 years, timber that takes 15 or pension returns that take 30. Future production risk needs to be hedged to even engage in the activity.
So there are two types of enterprises that are trading.
Those who invest and are after the price changes -- their entire goal is to buy things that will increase in value.
And there are those who for some reason have to trade but the price changes are nuisance for them. Like agriculture farmers. They know they will have to sell their produce at some point in the future, but they would very much prefer to know the price in advance because that makes it easier for them to plan and make better choices. Do I plant this or that?
When we are talking pensions, this is definitely the first scenario. The large part of the reason to trade is investing (the other is improving supply of money and also helping your businesses have easier time getting funding they need).
The about only reason I can come up with is fund managers sabotaging long term returns just to ensure small, steady, more predictable return every year. So that they can their bonuses every year.
Maybe another reason is people who do not understand trading? Then more steady returns create the illusion their managers are doing good job.
"This is trivially answered via the oldest financial instrument in the world, agriculture futures."
No, I think your parent has an interesting point ...
People don't start farming soybeans because they have a free weekend here and there ... it's a long-term, sometimes generational undertaking that has one locked into these activities and investments.
So, in that case, it makes sense you would use derivatives to hedge the activity you have no choice but to undertake.
On the other hand, if you're just a trader-bro ... you do, indeed, have full autonomy and can buy or sell anything you like. You could just as easily afford equivalent protection by buying less of the underlying asset or buying another asset entirely.
Unless, of course, there is a relative price mismatch between the underlying asset and the derivative - in which case it would make sense to pick up the protection cheaply ...
... but I still think your parent has a point that isn't so easily dismissed ...
I'm not sure how many trader-bros are allowed to make major decisions in pension funds, or why a trader-bro would want to work at a pension fund vs some other type of market participant which could reward their genius^H^H^H^H^H^H crazy risk taking.
One reason why you would opt to use options to hedge rather than sell your position (and be delta neutral) is due to materialising profits and incurring taxes just because you were being prudent about volatility
because people have different risk tolerances? derivatives let you pick a "middle way" instead of having to pick the best of a few options. you can customize your risk/reward tradeoff to whatever you want and that's generally a good thing.
