Leland Model More Accurately Evaluates Efficacy of Portfolio Hedging Strategies

Leggio, Karyl B.; Lien, Donald
January 2008
Journal of Financial Planning;Jan2008, Vol. 21 Issue 1, p40
Academic Journal
• The debate continues between investment advisors who recommend hedging strategies to their customers and academics who question the claims that protective puts and covered calls increase returns while reducing risk. In this study, we examine the debate from the perspective that traditional measures of risk-adjusted performance are misleading. • Protective puts work well in volatile markets because they ensure limited downside risk and unlimited profit potential for the life of the option. Covered calls work well for bullish or neutral markets expected to experience little movement for the underlying stock. • Puts and calls do not produce symmetrical return distributions, however and thus standard risk-measurements such as the Sharpe ratio inaccurately suggest that an index portfolio is always preferable to puts or calls. • This study introduces the use of Leland's beta to correctly measure risk-adjusted performance. The measurement captures the mean, variance, skewness, and kurtosis in stock returns. • The study examines a variety of put and call options. The results from the Leland model demonstrate the value of both a protective put and a covered call strategy in reducing portfolio risk, without significantly affecting return, though transaction costs will reduce this benefit.


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