Lesson Objective: To apply derivatives to hedge investment risk and to formulate portfolio management strategies to modify the risk-return attributes of the portfolio.

In-Depth Notes:

1. The Role of Derivatives in Risk Management:
Derivatives are powerful tools for managing financial risk. They allow investors and corporations to transfer, hedge, or speculate on specific risks, such as price risk, interest rate risk, and currency risk. By using derivatives, investors can modify the risk-return profile of their portfolios, protect against adverse market movements, and enhance returns.

2. Hedging with Futures:

  • Short Hedge: Used to protect against a decline in the price of an asset. For example, a farmer can sell corn futures to lock in the price of their corn crop.

  • Long Hedge: Used to protect against a rise in the price of an asset. For example, an airline can buy oil futures to lock in the price of fuel.

  • Hedge Ratio: The number of futures contracts needed to hedge a specific exposure. The optimal hedge ratio is based on the correlation between the spot price and the futures price.

3. Hedging with Options:

  • Protective Put: Buying a put option to protect a long position. This provides downside protection while allowing for upside participation.

  • Covered Call: Selling a call option against a long position. This generates income but caps upside potential.

  • Collar: Buying a put option and selling a call option at the same time. This provides a limited risk and a limited reward.

4. Delta Hedging:
Delta hedging involves taking an offsetting position in the underlying asset to neutralize the delta of an option position. A delta-neutral portfolio is insensitive to small changes in the price of the underlying asset. Dynamic hedging involves adjusting the hedge as the delta changes.

5. Hedging with Swaps:

  • Interest Rate Swap Hedge: A company with a floating-rate loan can enter into an interest rate swap to convert it to a fixed-rate loan.

  • Currency Swap Hedge: A company with foreign currency exposure can use a currency swap to hedge its FX risk.

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