Risk Management through Derivatives: Strategies for Hedge Investments

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Derivatives are financial instruments that their values are derived from other assets like stocks, bonds, or foreign exchange markets. These contracts are often used for hedging purposes - to protect agnst the potential risk of an adverse movement in asset prices or speculation on future price movements of the underlying instrument. Hedging is a common practice in various sectors; notably within the stock market, where investors can use derivatives to safeguard their portfolios.

Hedging and Derivatives:

Derivatives are financial tools that have values that fluctuate based on another underlying asset. They could be stocks, bonds, commodities, or foreign currencies. Investors often utilize these instruments for hedging strategies, inted to offset potential losses from adverse price movements of the assets they own.

A practical example of derivatives in action is through options contracts. An option grants its holder the right but not the obligation to buy call or sell put underlying assets at a pre-agreed price before or on an expiration date. For instance, if an investor owns Tesla stock and anticipates possible earnings misses that may lower share prices, they could use a 'protective put' strategy.

Protective Put Example:

Assume you hold 1000 shares of Tesla Motors TSLA at $65 per share; your investment totals $239,000 with an unrealized profit of $174,000. The investor might feel worried about potential negative earnings news that could impact the stock price negatively.

In April 2019 when Tesla's stock was trading at $239 per share, representing a total value of $239,000 and an unrealized profit of approximately $174,000, you might want to hedge agnst potential losses.

To do this, one might purchase put options that allow them to sell their Tesla stock at the predetermined price $65 in even if its market value falls below that figure.

Let's break down this strategy using hypothetical figures:

Suppose each put option costs $10 for every $100 of Tesla stock. You would pay a premium equivalent to 110th of the total investment or $23,900 $65 x 10 contracts x $10 per contract.

In this scenario:

• Scenario A: If Tesla's price remns above $65 through expiration, you wouldn't exercise your right to sell at that lower price $65, meaning the premium pd would be lost.

• Scenario B: But if Tesla's stock price falls below $65 by the option expiration date, this protects agnst further loss because you can now sell them at a guaranteed $65.

: The actual gns or losses dep on whether you exercise your right to sell at that lower price $65. And it's important to note that while options offer protection through the contract terms, they also require an initial premium payment which reduces overall profits when exercised.

Derivatives can be a strategic tool for risk management. They allow investors to hedge agnst the possibility of losing money due to market fluctuations by locking in prices or using complex financial instruments like options and futures contracts. Whether used for individual investments, corporate finance decisions, or other economic activities, derivatives play an essential role in managing risk.

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