Investors Prefer Benchmark Securities for Hedging Their Risks
Introducing liquid benchmark securities into financial markets leads to more pricing information and greater liquidity for all individual securities.
ANN ARBOR, Mich. Benchmark securities, such as the Standard & Poor's 500-stock index futures and exchange-traded funds (ETFs) on major indexes, have gained popularity since their introduction into financial markets, but opinions differ about the reasons for their strong appeal to investors.
Some observers have theorized that benchmark securities are favored by uninformed liquidity investors because these securities have a lower downside risk. However, Kathy Yuan, an assistant professor of finance at the University of Michigan Business School, offers an alternative explanation for the securities' popularity.
In her research findings, Yuan argues that informed investors are the traders who actually prefer benchmark securities because they are better hedging instruments than individual stocks. She further demonstrates that the introduction of liquid benchmark securities helps to generate more information about stock pricing among traders and leads to greater liquidity for all individual securities.
Informed investors, who possess security-specific or systematic-factor information, are able to realize higher expected returns by trading benchmark securities in several ways.
"Benchmark securities are the perfect hedging instruments for investors who are informed about security-specific risks (but uninformed about systematic risks), because they are able to hedge out the systematic-factor risk and concentrate trading on the risk they know bestsecurity-specific risk," Yuan says. "On the other hand, benchmark securities are the preferred trading vehicles for systematic-factor informed investors, because these securities have the best alignment with the investors' signals."
Better hedging and signal alignment produce increases in the anticipated revenue from trading, and these higher returns encourage more investors to acquire both security-specific and systematic information. This leads to more informative prices, less information asymmetry and higher liquidity for all securities in the market.
Today, benchmark securities play an important role in stabilizing markets and the loss of these securities can create havoc, according to Yuan.
"When the U.S. Treasury announced the suspension of all sales of new 30-year T-bonds in October 2001, traders lamented that this loss might make the pricing of bonds more difficult, thereby creating more volatility and damping the appetite for risk," she says. "Subsequently, agency debt securities, high-grade corporate debt securities and interest-rate swaps are being used to replace treasuries as reference and hedging benchmarks among market participants."
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