Financial Theory: Lecture 20 Transcript
November 10, 2009
Professor John Geanakoplos:
The subject of today's lecture is hedging. So this is what hedge funds do. It's
what almost everyone on Wall Street does nowadays, at least to some extent, say half the people on Wall
It was hardly done at all in the past. So first of all, just to mention what a hedge fund is, a hedge fund is a
firm that manages money. And why is it different from any other firm that manages money? Well, the
definition of hedge fund basically has three parts.
One is that hedge funds hedge. Now I'll say what that is in a second. Secondly, hedge funds use borrowed
money in addition to their investors' money to buy assets. So they do what's called leveraging, which is going
to be an important subject for the last few lectures of the course. And thirdly, they charge their investors very
That's basically the definition of a hedge fund, because they're supposed to be so good at what they do, they
can charge high fees and still get the investors. So what is hedging? Hedging is the idea that you want to
cancel out some of your risks. So for instance, you might know that a company's not going to default,
whereas the rest of the market thinks it is going to default. So you know the company's worth more than the
rest of the market thinks, so you might be tempted to buy the company.
But if the interest rate were to change, say go way up and the company's paying, has constant cash payments,
if the interest rate goes way up and the company has constant cash payments, you could end up losing money
anyway, because the present value's going to go down, just because the interest rate has gone up.
So what a hedger would do is, the hedger would say, "Look, I'm relying on my expertise as an evaluator to
realize there's no default risk. I want to bet that there's no default risk in this company. It's not going to
default. I donâ€™t want to bet on which way interest rates are going to go, because I don't know which way
interest rates are going to go, so I want to hedge myself against that." So to take-- sorry, I'm just starting here.
Hello. Sorry, hard to talk when everyone else is talking. So what does hedging a risk means?
It means no matter which way the risk factor goes, you're going to still end up with the same amount of
money. So the first person to do this and call himself a hedge fund was somebody named Jones in the 1940s
and he was a stock picker who would try to find the best possible stock to buy. So before him, people would
say, "Okay, Ford is a great auto company. We're going to buy Ford."
The trouble is that Ford may in fact turn out to be the best auto company, but because the whole economy
collapsed, it may be that Ford collapsed with the rest of the economy, even though it did better than all the
other auto companies. So what Jones said is, "I'm not going to just buy Ford. What I'm going to do is, I'm
going to buy Ford and I'm going to sell General Motors, so that way I'm going to be betting not on whether
Ford is better than General Motors, and in addition, whether the whole economy's going to go up. I only want