Question

Using examples, discuss how derivatives allow investors to get involved in hedging and speculation in the foreign exchange market.

Answer 1

It's important to note that hedging is not the same as portfolio diversification. Diversification is a portfolio management strategy that investors use to smooth out specific risk in one investment, while hedging helps to decrease one's losses by taking an offsetting position. If an investor wants to reduce his overall risk, the investor shouldn't put all of his money into one investment. Investors can spread out their money into multiple investments to reduce risk.

For example, suppose an investor has $500,000 to invest. The investor can diversify and put money into multiple stocks in various sectors, real estate, and bonds. This technique helps to diversify unsystematic risk; in other words, it protects the investor from being affected by any individual event in an investment.

When an investor is worried about an adverse price decline in their investment, the investor can hedge their investment with an offsetting position to be protected. For example, suppose an investor is invested in 100 shares of stock in oil company XYZ and feels that the recent drop in oil prices will have an adverse effect on its earnings. The investor does not have enough capital to diversify their position; instead, the investor decides to hedge their position by buying options for protection. The investor can purchase one put option to protect against a drop in the stock price, and pays a small premium for the option. If XYZ misses its earnings estimates and prices fall, the investor will lose money on their long position but will make money on the put option, which limits losses.

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