HEDGING FIXED‐RATE PREFERRED STOCK INVESTMENTS

Abstract

Corporations seeking to maximize the return on their cash reserve resources have an incentive to invest in traditional preferred stock because of their right to exclude 70% of the dividends from taxation. Nevertheless, fixed‐rate preferred stock investments may contribute significantly to the return volatility of a cash portfolio and cause unacceptable losses to the corporate investors. As a result, many corporations might consider such higher‐return investments only if they can hedge away a sufficient amount of risk. The research presented in this article seeks to evaluate how much of the return variation of fixed‐rate preferred equity portfolios can be reduced with various hedging strategies.This research shows that it is possible to reduce the risk of preferred stock investments significantly through the use of hedges employing some combination of fixed income futures and/or options. Although some risk remains even with the hedged preferred stock portfolio, the author demonstrates that money market assets can be combined with a hedged preferred stock portfolio to create a position that has no material chance of loss but expected after‐tax returns higher than those on money market investments. In addition, the article also shows the high level of profitability associated with a strategy of increasing the size of liquid reserves in order to allow for losses related to an unhedged preferred stock component of those reserves.