Investment and Portfolio Managment - Essay Example

Investors must take account of the interplay between asset returns when evaluating the risk of portfolio at a most basic level; for example, an insurance contract serves to reduce risk by providing a large payoff when another part of the portfolio is faring poorly. A fire insurance policy pays off when another asset in the portfolio-a house or factory, for example-suffers a big loss in value. The offsetting pattern of returns on these two assets (the house and the insurance policy) stabilizes the risk of the overall portfolio.

Investing in an asset with a payoff pattern that offsets exposure to a particular source of risk is called hedging. Anther means to control portfolio risk is diversification, whereby investments are made in a wide variety of assets so that exposure to the risk of any particular security is limited. By placing one's eggs in many baskets, overall portfolio risk actually may be less than the risk of any component security considered in isolation. So, using portfolio is very much important in investment decision-making Prof Stein should protect the value of his shares before the company issues an IPO by using derivative products such as options, forwards and futures.

Derivative products help to avoid risk of price fluctuations and others. In hedging, Derivatives are tools for changing the firm's risk exposure. A derivative is a financial instrument whose payoffs and values is derived from, or depends on, something else. For example, an option is a derivative. The value of a call option depends on the value of the underlying stock on which it is written. Actually; call options are quite complicated examples of derivatives. The vast majority of derivatives are simpler than call options.

Most derivatives are forward or futures agreements or what are called swaps.An unlimited variety of payoff patterns can be achieved by combining puts and calls with various exercise prices. Some strategies are discussed below:Protective Put:Under this one would like to invest in a stick, but one is willing to bear potential losses beyond some given level of investing in the stock alone seems risky to one because in principle one could lose all the money one invest. One might