What's the point of risk-neutrality and/or delta-hedge

[Khoa Tran]

Someone complained that there's nothing called QF going on here recently. What can I do? I have nothing to entertain you so let me ask you a crappy question.

We quants care so much about BS, which says that the risk-free rate is NOT important. Stock move neutrality seems to be a principle for quants. Please correct me if I'm wrong.

In hedge funds, you bet on things that you can predict (e.g. volatility) and hedge on every other factor (e.g. the stock move). That's how you make profit. But there's nothing that you can be certain. Now if you stick yourself to the risk-neutrality BS framework, you essentially need to hedge on those that you can predict as well. You don't want to do this cuz you want to make profit.

So, if you're a quant trader, would you try to make predictions on the risk-free rate?

[neomikeo]

What do you define risk-free rate? The real risk-free rate is unobservable. What we do observe is the realized nominal rate estimated from a stream of fixed rate government coupon bonds or constant maturity swap contracts. The realized rate is rather volatile. So if you have a skill to forecast the short rate (say term structure model), you could make money.

Depending on your specialized skill set, the rest, however, should not forecast short rate or general market movement (SP500), i.e. market timing. Say a model like CAPM, E(Rt-Rf)=beta*M(t)+error(t). The conditional expectation of the error term for an asset (like stock) is zero, i.e. excess return is captured by factor loading. Thus, if you are a specialist, you have positive forecast for error of stock A, you should buy A and sell beta*Sp500 to earn positive realized return.

In brief, the answer is yes. However, in general people try to focus more on the error term.