This research examines the use of hedging against exchange rate risk in international portfolios. The use of hedging in the management of equity portfolios is also considered. As the concept of hedging derives from the concept of arbitrage, arbitrage is also discussed.
The term arbitrage refers to purchases in one market, and sales in another market which, together, have the effect of maintaining the prices of comparable items traded in the affected markets within the limits defined by the cost of buying the items in one market and selling them in another (Rees, 1991, 37). Thus, it can be seen, at once, that the use of arbitrage is a method of limiting risk of establishing the boundaries, so to speak, of risk.
Arbitrage transactions, by definition, are either simultaneous, or nearly so; thus, the conduct of arbitrage activities tends to maintain prices in different markets for similar items within a reasonable alignment within the arbitrage limits (Welshans and Melicher, 1990, 402). Although the principal effect of arbitrage transactions is to bring about a relation among prices of similar items according to the cost of converting the items from one to the other (between markets), there need not be certainty about the outcome (Rees, 1991, 38).
The absence of certainty in arbitrage transactions is illustrated in the following example, which involves the use of the principle of arbitrage in equity stock market activity. Assume that a public announcement has been made, to the effect that Firm A and Firm B will merge. Firm A will acquire all of the outstanding equity stock of Firm B at a ratio of two shares of Firm A stock for one share of Firm B stock. If, indeed, the merger occurs, Firm B stock will be worth exactly twice the worth of Firm A stock. Until the merger is certain, however, the value ratio between the two stocks may not be 2:1, because of the risk that the merger will not occur. In such a situation of unc...