Economic Hedging Portfolios

In this paper we study portfolios that investors hold to hedge economic risks.Using a model of state-dependent utility, we show that agents economic hedging portfolios can be obtained by an intuitively appealing, risk aversion-weighted approximate replication of the economic risk variables using the investment opportunity set, as opposed to the unweighted hedging demand obtained in the traditional mean-variance framework.We find that agents across a broad range of levels of risk aversion are willing to pay significant compensations for hedges against inflation risk, real interest-rate risk, and dividend-yield risk.Furthermore, our results show that all economic risk variables we consider require significant, often risk aversion-dependent hedging adjustments with respect to one or more securities.Moreover, we analyze investors speculative positions and find that hedges against economic risks may potentially explain the anomalies found in stock markets as well as the term and default premiums in bond markets.