Using event contracts to hedge idiosyncratic risk

Abstract

A method for hedging in which the hedging party holds an underlying investment subject to idiosyncratic risk, identifies events giving rise to idiosyncratic risk affecting the investment, and takes a position in an event contract providing for a payout to the hedging party if the event giving rise to the idiosyncratic risk occurs. An investor may choose to determine whether the market has mispriced the risk as a factor in deciding whether to employ this hedging methodology. An investor may choose to determine whether employing the hedge will result in less variability in possible outcomes or a smaller possible maximum loss as factors in deciding whether to employ this strategy. This method may be used with various forms of event contracts or combinations of event contracts, including but not limited to vanilla event option contracts, digital event option contracts, event forward contracts, event futures contracts and event swap contracts. The investment being hedged can be illiquid, a short position or even an operational investment. Operational investments that can be hedged using this method include issued insurance contracts. The hedge can be implemented by taking either a long or a short position in event contracts.

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