One of the fundamental fact about stock markets is risk. But what is risk exactly? Are we able to hedge all risk? How to do so?
There are two types of risk:
- ) Unsystematic risk or “specific risk”
- ) Systematic risk or “market risk”
This risk is specific to given stocks. Let’s consider Apple stocks (AAPL). Of course, there is some fluctuation in the stock price. There are quite complex methods to predict stock prices in the future: machine learning methods, deep learning approaches or time-series analysis. None of them works perfectly. So it seems that investors can not eliminate this risk. But with Modern Portfolio Theory we may come to the conlcusion that it can be achieved. This is called diverzification. If we put several (25-30) stocks within a portfolio: the positive performance of some stocks neutralizes the negative performance of others. Eventually, we can eliminate unsystematic risk with a portfolio containing more assets. This is why Modern Portfolio Theory and Markowitz-model are working quite fine.
So we know that we can eliminate specific risk. But what about systematic risk? According to the Capital Asset Pricing Model (CAPM) the only relevant risk is market risk. Why? Because unlike unsystematic risk, it can not be diverzified away. So we can measure the risk of our investment with a given parameter: beta. This parameter tells us how risky is our investment. So we can eliminate some risk by holding several stocks within a portfolio but we can not eliminate market risk. Or can we?
If we can find assets with positive or negative correlation: we can combine these assets in order to eliminate all risk. Yeah, systematic and unsystematic as well. This is called market-neutral strategy. Black-Scholes model and pairs-trading strategy are like this. There is a positive correlation between a call-option and the underlying asset. Negative correlation for put-option and the underlying. We can construct a special portfolio (long the option, short the underlying) with which we can eliminate all uncertainty. This is what Black-Scholes model is about. Combining risky assets can eliminate risk itself. This was a beautiful scientific discovery in financial engineering in 1973.