Hedging Theory

How does one invest?

This elementary act keeps the stock market active. A person with liquidity, puts his money to work. The Dow has a value of $16,376.27 at 12:18 PM ET today. I remember when $6,000 used to be a high valuation many years ago, now it is almost three times that much.

Undoubtedly the Dow goes up as time passes, if that was all, I wouldn't need to think about Hedge.

Before going into the answer to the question, I consider one recent advance in Mathematical Physics. UCLA math professor, Terry Tao, proposes to solve  turbulent motion  equations, with the concept of a fluid computer, i.e., he proposes that a fluid, can be a universal computer. In simple terms, this means that fluid motion is more complex than previously thought. Mechanistic interpretations of mathematics, are not enough. We need complexity ideas, which always were part of fluid motion, but up until now, were not understood.

If even turbulent fluid motion needs to consider deterministic chaos, which is a result of non-linear mathematics, hedging needs it even more. In this note I start to consider Hedging Theory.

In a stochastic stock market, the price goes up and down, without apparent order. It seems as likely to go up as to go down, like the toss of a coin. If this is true, there is no need for Hedging Theory. As stated above the general trend seems to be up, even after discounting the effect of inflation. This has to be explained. A fair coin model does not give an increase of the total value as time goes on. There is more to this though. A simple demographic argument would be enough to explain the general trend up. More people putting their money in the stock, would produce a total higher valuation.

Another aspect that makes it necessary to consider the stock market anew, is the use of Information Engines. Now the investor can change his position at the nanosecond level, definitely entering into the realm of Physics, or more appropriately Econophysics.

The elementary act of buying a share with a hedging strategy has to be revisited.