Derivatives can be used to hedge against risk from "summary" of How Finance Works by Mihir Desai
Derivatives can play a crucial role in managing risk. Companies face various risks in their day-to-day operations, ranging from fluctuations in interest rates to changes in commodity prices. These risks can have a significant impact on a company's bottom line, making risk management an essential part of financial decision-making. One way companies can use derivatives to manage risk is through hedging. Hedging involves using derivatives to offset the potential losses that may arise from adverse movements in prices or rates. For example, a company that is exposed to the risk of rising interest rates may choose to enter into an interest rate swap to protect itself against such a scenario. By using derivatives to hedge against risk, companies can protect themselves from potential losses and stabilize their cash flows. This can be especially important for companies operating in volatile industries or in uncertain economic conditions. Through effective hedging strategies, companies can reduce their exposure to various risks and ensure greater stability in their financial performance. Derivatives can also be used by investors to hedge against risks in their investment portfolios. For instance, an investor who holds a portfolio of stocks may choose to purchase put options on those stocks as a form of protection against potential declines in their value. This allows the investor to limit their downside risk while still maintaining exposure to potential upside gains.- Derivatives provide companies and investors with valuable tools for managing risk. By using derivatives to hedge against various risks, individuals and organizations can protect themselves from adverse market movements and uncertainties. This helps to ensure greater stability and resilience in the face of changing economic conditions and market dynamics.
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