A bad argument for hedging Since investors donâ€™t like volatility, one argument that is often offered for hedging at the firm level is simply to reduce firm return volatility. If investors prefer lower volatility, shouldnâ€™t it be a good thing if firms also try to reduce their cashflow volatility? The answer is twofold: One, some firm volatility is diversifiable, and will ultimately not show up in investorsâ€™ portfolio return volatility. Most firm level volatility that firm managers can control is of this nature. However, investors and portfolio managers can diversify idiosyncratic risk better and cheaper than firm managers. Two, except for extremely large firms (like GM in its heyday, perhaps), firms cannot affect economy-level non-diversifiable volatility in any appreciable manner. Firm manager focus should be on the primary activities of the firm, on increasing average returns on assets rather than reducing volatility per se. So if portfolio management can better manage investor return volatility, is there, then, a role for volatility reduction at the firm level?

Average Return and Relevant Volatility 25 ï‚—Consequently, investors will all hold portfolios that contain only market volatility; we can ignore the ei component of a stockâ€™s volatility. ï‚—Each asset contributes to the volatility of the portfolio return in proportion to its own bi and this is the only part of the assetâ€™s volatility that is relevant. ï‚—If we relate the average return on assets and asset classes to their relevant volatility, we find a reasonably good fit. ï‚—For asset classes which are already diversified, the relevant volatility is simply their own return volatility. ï‚—For individual assets, the relevant volatility is that part of their volatility that cannot be diversified, that is their bi times the volatility of the market portfolio. ï‚—An assetâ€™s bi is called its beta (written b) and its average return in a market where assets are properly priced will be proportional to its beta risk. ï‚—If we plot the betas of single assets against their average returns, they should form a straight line ï‚—The model that describes this relationship is called the Capital Asset Pricing Model â€“ the CAPM.

Volatility and Correlations â€¢ We have already seen that we can easily estimate the volatility and correlation using Excel functions STDEV and CORREL. The variance is defined as the square of the volatility (or standard deviation). â€¢ Similar to the case of the returns, it is conventional to express the volatility in an annual basis. â€¢ Annual Volatility = sqrt(12) [Monthly Volatility]. â€¢ Annual Volatility = sqrt(260)[Daily Volatility]. â€¢ For example, a daily volatility of 1% implies an annual volatility of about 16%. â€¢ Recently, we have been observing daily fluctuations of about 1.5% - what does that imply about the annual volatility? 34