Understanding corporate finance: derivative contracts: investment risk hedging
Hedging investment risk with futures and options
Swaps are not, of course, the only kind of derivative financial instruments that can be used to hedge portfolio risk. Traded stock index futures may also be used to hedge an investment.
Zigvern Ltd is an investment company holding a portfolio of shares which broadly tracks the FTSE 100 index. The company expects the UK stock market to fall in the short term, but recover in the longer term - it does not want to sell the shares and reinvest in, say, bonds. So the company sells FTSE 100 futures. If the FTSE 100 index falls, the company will make a profit on the futures position, off-setting the fall in value of the physical shares. (If the FTSE 100 falls, the futures contracts will be worth less: someone who has sold futures - taken a short position - will realise a profit when they close out the position at a later date by buying an equal number of futures at a cheaper price.)
Options, either over a single share or over an equity index, can also be used to hedge. A company which holds an option (which may be traded on a recognised exchange, or over the counter) over a particular share is guaranteed to be able to buy the share (if it holds a call option) or sell the share (if it holds a put option) at a known price.
Allbutt Ltd believes that shares in a major quoted company are going to increase in value, but it does not want to have to fund the acquisition of the physical stock, or pay transaction costs. It buys a quoted option over the stock in question, paying a premium. If the share price rises above the strike price of the option, the option will increase in value: Allbutt Ltd can sell the option at a profit (thus benefiting from the rise in the price of the share, without having to buy the physical stock). If the price falls, and the option moves out of the money, the company will lose the premium it has paid, but - no matter how low the share price falls - that is the maximum extent of its losses.