Consumption hedging property
A security’s consumption hedging property is an important theoretical concept. The theory argues that it is not the return on a security by itself that matters, but rather when the security pays off the most.
On this page, we discuss the consumption hedging property of equities and the relationship between consumption hedging and the equity risk premium.
Consumption hedging property definition
Before we discuss the relationship the equity risk premium and stocks’ consumption hedging properties, let’s first look at the theory first. In simple terms, an asset’s hedging property is higher when it pays off more during economic downturns. Such securities are generally in high demand, because they help investors smooth consumption. When there’s a recession, most securities go down in value. At the same time, this is also a period in time when people are more likely to lose their job.
Thus, if you can buy an asset that pays off more during such bad times, it provides you a great hedge against bad times.
Examples of securities that pay off a lot during bad times are government bonds and inflation-linked bonds. These securities go up in value (= pay off) when there is a recession.
Relationship with equity risk premium
Taking a look at stocks, we know that stocks generally go down when a recession is expected. Thus, stocks clearly don’t pay off during bad economic times. This is a clear risk for which investors want to be compensated. Investors require a premium to hold equities because they drop considerably in value during bad times.
This is simply the Equity Risk Premium (ERP), a compensation for the fact that equities lose a lot during bad times.
Summary
We argued that the equity risk premium is a positive risk premium that compensates equity holders for the fact that equities drop considerably in value during recessions. These are exactly the periods when most assets drop in value. Thus, investors want to be compensated for taking on such risk.