Understanding corporate finance: derivative contracts: investment risk
Managing investment risk
It is well known that the value of an investment in shares can go down as well as up. Any company (such as an insurance company) which holds substantial numbers of quoted shares as an investment will naturally want to protect the value of its investment so far as is possible.
One way it can do this is by active management of the portfolio: keeping a close watch on the market, and buying and selling in line with market intelligence. Another way is by diversification: a company with a varied portfolio is less exposed to the poor performance of any one particular share, or one particular sector. A company which fears downward movements in the stock market as a whole will probably want to hold interest-bearing investments such as gilts and bonds, as well as shares.
But holding a diverse portfolio of investments and frequent buying and selling are not without cost. As well as having the staff and systems in place to do this, the company must pay transaction costs, and Stamp Duty Reserve Tax (SDRT) is payable on share transfers.
Equity derivatives can give a company a ‘synthetic’ exposure to the stock market, or to a particular share or bundle of shares, without it having to incur so much in the way of costs. There is an example at CFM13460 of a company using an equity swap to gain exposure to the FTSE 100 index.