Derivatives can be used for hedging and risk management from "summary" of Institutional Investment Management by Frank J. Fabozzi
Derivatives play a crucial role in institutional investment management by allowing investors to hedge against various risks. Hedging refers to the practice of using financial instruments to offset potential losses that may arise from adverse movements in the market. By using derivatives, institutional investors can protect their portfolios from volatility and unforeseen events. One common way derivatives are used for hedging is through the use of options contracts. Options give investors the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specific timeframe. By purchasing put options, investors can protect their portfolios from downside risk, as the option will increase in value if the underlying asset depreciates. Conversely, investors can use call options to hedge against upside risk by locking in a maximum purchase price for an asset. Another popular hedging strategy involves the use of futures contracts. Futures are agreements to buy or sell an asset at a specified price on a future date. These contracts can be used to hedge against fluctuations in interest rates, currencies, commodities, and other market variables. For instance, a pension fund manager may use interest rate futures to protect against changes in interest rates, which can affect the fund's liabilities. In addition to hedging, derivatives can also be used for risk management. Risk management involves identifying, assessing, and mitigating potential risks that could impact an investment portfolio. By incorporating derivatives into their investment strategies, institutional investors can better manage risks associated with market volatility, interest rate changes, currency fluctuations, and other factors.- Derivatives offer institutional investors a powerful tool for hedging against risks and managing their investment portfolios effectively. By understanding how to use derivatives strategically, investors can protect their assets and optimize their returns in an ever-changing market environment.
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