The only problem is what they got it hedged against---it assumes things will move in tandem and not on a tangent. It also assumes the house can't go broke and we have seen some houses go broke as of late. This is probably why Lucky Luciano said after visiting the NYSE, " I joined the wrong mob."
Sincerely, Tom
James Devine wrote:
> In reference to my assertion that the problem with the LTCM "hedge fund"
> was not hedging but leveraging, a lboster asked me off-ist:
>
> >What is a brief definition of "leveraged" ?
> >and "hedge" ?
>
> I thought maybe my answer would be of more general interest (and I've added
> a little):
>
> 1. "leveraged" means that you buy an asset, like a stock or whatever, using
> borrowed money.
>
> This helps give you a big return:
>
> zero leveraging: if you buy a stock at $100 of your own money and it goes
> up to $110 in a year, you get a return of 10%. (rate of return = (sale
> price of asset - amount you have to pay)/amount invested
> = (110-100)/100 in this case.)
>
> some leveraging: if you borrow $50 at 5% interest and use $50 of your own
> to buy the asset, then you still get the $110. After you subtract the
> principle and interest on the loan ($50 + 0.05*$50 = $52.5) and the amount
> you invested ($50), your profit is $110 - $102.5 = $7.5. So your rate of
> return = $7.5/$50 = 15%.
>
> even more leveraging: if you borrow $90, the rate of return is ($110 - ($90
> + 0.05*$90 + $10))/$10 = 55%.
>
> The more the leveraging, the more the risk, however. If the price turns out
> to be $100 (instead of $110), then your return is 0% in the first case, -5%
> in the second, and -45% in the third. The second -- and especially the
> third -- means that you may not be able to live up to your debt obligation,
> which leads to bankruptcy.
>
> 2. "Hedging" refers to diversification in order to minimize risk in the
> future. (It's also a poker term, with pretty much the same meaning.) A
> farmer sometimes "hedges" by signing a contract with someone to pay a fixed
> price for some of his product in the future. This "locks in" the price, so
> that the farmer doesn't suffer in a big way from price declines. Locking in
> the price of half of her crop at $10 per bushel, if the market price falls
> to $5, the average price is $7.50. On the other hand, hedging means you
> don't take advantage of price rises: if the market price rises to $15, the
> average price would be $12.50. Hedging is like buying insurance: you don't
> suffer as much from price fluctuations, but you suffer a cost. (Options
> make this more complicated, so let's ignore them.)
>
> Hedging is often seen as the opposite of speculation, which involves
> _seeking_ risk in order to get a high return.
>
> btw, how 'bout those Cubs?!? I expect to see pigs flying soon.
>
> one of those hated academics,
>
> Jim Devine jdevine at popmail.lmu.edu &
> http://clawww.lmu.edu/Departments/ECON/jdevine.html