Static hedge

A static hedge is one that does not need to be re-balanced as the price of other characteristics (such as volatility) of the securities it hedges change. This contrasts with a dynamic hedge that requires constant re-balancing.

A simple example of a static hedge is a future that is used to hedge a position in a foreign currency. Once the future is in place the foreign exchange risk is entirely eliminated. Leaving aside counter-party risk and similar problems, the portfolio (the foreign exchange position plus the future) is entirely risk free.

Static hedges need to be perfect, but, without the risks attached to re-balancing, they can be.

A static hedge is likely not to last indefinitely. Most hedged portfolios contains securities that will expire or mature. At that point a the hedge will need to be adjusted or re-constructed. Unlike a dynamic hedge, this happens occasionally at comparatively long intervals.

Static hedges can be much more complex than the simple example above: for example, when statically hedging a barrier option with vanilla options a number of vanilla options may be required to hedge one barrier option.

A dynamic hedge is sometimes required: for example to hedge an option with its underlying (as opposed to other options on the same underlying) requires dynamic hedging — delta hedging at the very least.

Like a dynamic hedge, a static hedge may be reversed to replicate the cash flows of a security. By the law of one price, this also implies the value of the security in question, just as the value of a dynamic hedge can be used to derive the Black-Scholes model.

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