Cost-Effective Portfolio Hedging: A Dividend-funded Derivative Approach

Abstract

This paper examines the effectiveness of using dividend yield to fund hedging protection for an S&P500 equity portfolio. We construct a hedged portfolio that consists of the S&P500 index but uses the dividend yield to purchase put option protection for hedging risk. We then compare the risk and return of the hedged S&P500 portfolio to that of an unhedged S&P500 portfolio. The trade-off reduced returns compared to the overall risk reduction are also measured. Results indicate that this risk-management strategy could be appealing to a large contingency of investors seeking down-side protection at a modest cost that is self-funded from dividends.