Hedging Strategies Using Derivatives

We have already discussed the factors determining the price of a derivative, including the role of models like Black-Scholes in determining fair values. Now, let's see how these derivatives could be used effectively in hedging risks in the market.

There is so much risk involved in investment, and hence market fluctuations cannot be managed. Due to sudden changes in the market, an investor might incur severe losses when they are not expecting it. These are usually uncontrollable. Thus, nothing is considered wiser for an investor than to take ample risk management measures. And at this stage hedging comes in handy, a popular strategy devised to protect one's downside without compromising the potential benefits accruable from market opportunities. Volatility in financial assets is influenced by both domestic and international factors. Derivatives assist investors in protecting such risks through various hedging strategies.

What are Derivatives?

Derivatives are financial instruments deriving their value from an underlying asset, whether it be stocks, commodities, or currencies. Options, futures, swaps, and forwards are the most common derivative types. While these instruments may be used for speculation, they are also a powerful hedging tool, enabling investors to protect against adverse price movements.

Why hedge?

Hedging, explained in simple terms, is risk management. Suppose you have some investment in stocks, you would be running a risk due to market volatility, economic changes, or political instability. You can go and take positions in derivatives that will offset some losses in your core investments through these positions, thereby netting overall risk while keeping your exposures intact.

Popular Hedging Strategies

1.Stock Futures for Hedging Equity Positions

Stock futures are the most common hedging tools of India. You may have some shares of a particular company, and you believe that for some time, its price is going to decline. In that case, you sell its stock future. This will lock in the future selling price for you. In case that stock goes down, its loss will be offset in your actual stock by the profit that was accrued through the future. It saves from losses arising out of temporary fluctuations.

2.Protection with Options

Options are one of the other popular derivatives that are used in hedging. A put option gives the investor the right to sell a stock at a specified price, which protects if the price falls. You might own a stock and become concerned that its price would drop. Buying a put option offers you protection. If the stock's price falls below the strike price on the put, you can exercise the option to sell at the higher strike price, limiting potential loss.

Alternatively, you can use a call option if you are concerned that upside potential might be lost should the stock go up. You purchase a call option and, through this, you have the right to buy the stock at a predefined price without the risk of missing out on an upward movement, yet your initial investment remains low.

3.Currency Hedging for Exporters and Importers

Currency future and forward contracts are among the broadly used hedging instruments for business entities. These are essentially contracts to buy or sell something at a future date, with the price or rate being decided today. This helps companies avoid the impact of adverse exchange rate movement, especially in transactions involving exporters and importers, where the difference may amount to huge profits.

Conclusion

Hedging with stock futures, options, or currency would allow an investor to cushion their portfolio from adverse movements of prices. The hedging tools would help to minimize potential losses and make the ride smoother for those not comfortable with uncertainties.

Hedging instruments are huge in the field of handling risk, but it is equally important to understand the financial commitment or risk involved. We shall now discuss the various types of margins required in the trading of derivatives, which become necessary in managing risk and at the same time smoothly executing hedging strategy.