Derivatives and Hedging Strategies for Managing Investment Risk

Derivatives provide investors with a way to protect against declines in portfolio and single stock investments or to lock in future prices for certain commodities with future contracts, such as through commodity future contracts. Furthermore, derivatives can increase leverage.

Table of Contents

Identifying Risks

Derivatives allow market participants to gain exposure to an underlying asset without purchasing or selling it outright in cash markets. Derivatives can be created based on any asset class ranging from commodities like crude oil or foreign exchange rates all the way through to weather data – options, futures contracts and swaps being among the most frequently utilized derivatives used for hedging purposes.

Usage of regressions to compare new user’s risk exposures in year with their choice of derivatives positions to ascertain which instruments they are employing for hedging purposes. These regressions include both levels and growth proxies for firm incentives to hedge that can vary over time; furthermore they are lagged one year so as to minimize any endogeneity issues caused by simultaneous firm decisions about initiating derivatives programs and their subsequent hedging behavior.

Results indicate that New Users typically are using derivatives to reduce overall levels of risk, in line with theory suggesting hedging as replacing one risk with another.

Hedge Against Portfolio Risks

Derivatives offer you a way to mitigate existing risks when it comes to speculation on the direction of an asset or leverage your position. Hedging stocks for instance can protect you in case of market declines while helping limit their impact on financial bottom lines.

Derivative instruments can be constructed based on virtually any asset imaginable and traded either over-the-counter or via an exchange, often at reasonable prices due to their leveraged nature.

As previously discussed, endogeneity issues may muddy inferences made from changes in New Users’ risk exposures. To control for this bias, I use regression analysis on New Users’ total risk on notional principal and control for incentives to hedge. From this approach I found that 61% of New Users agree with hedging their exposures – similar to what was found when the analysis used net risk exposures instead.

Hedge Against Single Stock Risks

Hedging is an approach used to manage investment risks by purchasing assets with negative correlation to those you wish to hedge against, providing insurance against profits being lost as well as potential losses.

This section’s hedging research is more indirect than in its predecessors because it examines changes to New Users’ risk exposures rather than stock returns as the basis of analysis of hedging strategies. This approach should reduce endogeneity problems that could distort inferences derived from direct tests of hedging.

Analysis of New User sample firm’s hedging strategies involves categorizing them into groups consistent or inconsistent with hedging based on their selection of interest rate and exchange rate derivative instruments, then comparing changes in interest-rate exposure with changes in stock-return volatility to determine if any decrease is caused by using derivative instruments.

Hedge Against Foreign Exchange Risks

Derivatives can be used to hedge portfolio risks or speculate on their movement. Traded on exchanges or over-the-counter markets, derivatives often provide leveraged positions.

Alternatively, if you want to reduce currency risk without engaging in direct transactions such as buying and selling foreign currencies, an effective strategy is entering a forward contract with your financial institution to purchase an amount of said foreign currency in five years’ time at today’s price – known as zero-cost derivative.

Evidence indicates that New User selection of derivative instruments is related to their firm’s risk exposures. Firms more sensitive to interest rate changes increase their use of derivatives with decreasing values when interest rates rise; firms more susceptible to exchange rate fluctuations reduce risk by purchasing derivatives which gain value as exchange rates go up.