Derivatives can be used in risk management to hedge a position in protecting against the risk of unfavourable move in an asset. The process of using it to manage risk should be integrated into the individual’s investment strategy. Nowadays there have been a lot of changes in the investing environment which require a more strategic focus on risk management. And a derivative can use to make future risk management strategy.
It is a financial security whose value is affected by the performance of the underlying contract. Most common underlying instruments include currencies, commodities, stocks, interest rates, and market indexes among others. So, basically, it is a contractual agreement between two parties where one is obligated and other has the right to buy or sell the underlying security. And hedging is often considered an investment strategy, in fact, quite an advanced one!
But, most people do know about this. Even if you aren’t aware you are still hedged somewhere. For example, a life insurance policy which you have to support your family in case of your death is a hedge. It helps us in mitigating against opposite price movements.
To best illustrate this let’s take an example:
Assume an investor bought 1000 shares of XYZ Company on 5 Sep 2015, for Rs. 65 a share. He was able to keep his investment for 2 long years but now afraid that XYZ Company will need to be able to meet its earnings per share (EPS) and revenue expectations.
The XYZ Company’s stock price opens at a price of Rs. 243.93 on 11 Sep 2018. The investor is looking to lock on the profits of at least R.s 165 per share on his investment. So, to hedge himself against the opposite price movements, the investor buys the 10 PUT Option contracts on XYZ Company with a strike price of Rs. 230 and an expiration date on 5 Dec 2018.
These PUT Option contracts are a type of derivative which gives individual full rights to sell the shares of XYZ Company at Rs 230 a share. If one stock option contract leverages 100 shares then the investor can sell all his 1000 shares with 10 PUT Options.
The XYZ Company is expected to report it’s earning on 3 Dec 2018. If the company misses its earnings expectations and its stock price fall below Rs. 230 then the investor has PUT Option locked on the selling price of Rs. 230. So, he could sell all his 1000 shares.
Final Thoughts: –
Managing financial risk should be the top priority of any firm or individual investor who is invested in the stock market or any financial market. It’s not easy to bear the financial loss. So, in order to protect you against the financial risks use derivatives as a tool this can be implemented as a risk management strategy.
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Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.