How to Use Derivatives to Hedge Risks?

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A hedge is a type of financial transaction which eliminates or reduces associated risks with another transaction. Similarly, derivatives are used in financial risk management by hedging a position to avert the risk of an adverse move in an asset. Derivatives are a financial instrument which is valued depending on the price of its underlying asset. Derivatives also constitute a contractual agreement between two parties that specifies which party has the right to sell or buy an underlying asset. Derivative contracts are generally categorized as swaps, futures & options. Financial derivatives are widely used to deal with multiple risks such as market, credit and operational risks. They are becoming increasingly important as options trading is used to hedge against price movements.

Hedging is done by taking an offset position for a related security, which in turn mitigates the adverse price movements. Derivatives have been used as a tool for risk management by most of the financial institutions as it is capable of breaking down the risks into smaller elements. Subsequently, these elements can be bought or sold according to one’s risk management objectives. Hence the original purpose of derivatives is to hedge and spread risks. In other words, hedging risks allows an investor to attain the desired risk profile.

For instance, an investor holding stock of a certain company may be concerned about the fall in its prices. However, he may still hold on to the shares for three more months due to tax issues. In case the investor decides to sell these shares at exactly the same price after three months, he can fully eliminate the risk associated with holding the shares. Therefore, he mitigated the risks by hedging the shares to his friend. On the other hand, hedging may not always be a good idea as the investor also ends up eliminating the risk of potential profit. If the investor’s shares would have appreciated significantly over the next three months, locking in the current price may turn out to be a bad decision.

Derivative trading has revolutionized risk management in the realm of finance. It allows investors to sell off unwanted risks which leads to effective risk management. In case of financial derivatives, specific risks can be dealt with and targeted and used for hedging against unwanted risks. As a result, market efficiency improves because the risks are sold off to other parties who are willing to accept them. However, derivative trading should be used with caution or they may turn out to be a financial threat.

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