This lesson examines how derivatives are used to protect the value of an investment portfolio.

7.1 Core Principles of Hedging

The distinction between hedging and speculation is a critical principle in treasury management. Hedging is the use of financial instruments to reduce or eliminate an existing financial risk, while speculation is the use of these instruments to take on risk in the hope of making a profit . Treasury functions should be focused on hedging, not speculating.

7.2 Key Derivative Instruments for Investment Hedging

Derivatives are financial contracts whose value is derived from an underlying asset or reference rate . Key instruments include:

• Forwards and Futures: Contracts to buy or sell an asset at a fixed price on a future date, used to lock in a price or rate .

• Options: Contracts that give the holder the right, but not the obligation, to buy (call) or sell (put) an asset at a specified price .

• Swaps: Agreements to exchange one stream of cash flows for another .

7.3 Hedging Strategies for Investment Portfolios

A treasurer can use a variety of strategies to manage the risks of an investment portfolio. These include using derivative instruments to hedge against interest rate and currency movements . Interest rate swaps and foreign exchange forwards are common tools . The selection of the appropriate hedging strategy depends on the nature of the exposure and the organisation’s risk appetite.