In recent times, the concept of hedging has come out to quite popular, this is because of the fact that it assists the investors to protect against the portfolio’s future value. An investor could take out a hedge to protect the future price of sale of the portfolio (the portfolio contains bonds, cash and shares) by selling an equal amount of futures contract (Haushalter 2000). It is by means of future or options contracts that risk could be hedged. One has to take a positon in financial futures in order to hedge through future contracts which would result in a gain that would offset the loss in the present investment portfolio.
However, one has to take a short position so as to hedge a huge stock of portfolio and the short position has to be of a value which is equal to the size of the complete stock portfolio. Under the options contract, the party is not obligated but has the right to sell or buy on an agreed future date at a set price (Chava 2007). Future Contracts involve the cost of eliminating opportunity but they are a means of avoiding risk. A trader in order to take advantage of an unexpected upswing would prefer to hedge risk by means of options. Hedgers would not be able to take advantage of the upswing in case they sell future contracts of the equity portfolio against their position so as to guard their portfolio and instead of stock market going down (as thought) it goes up. Thus, when the investor is certain of the outcome of the future it is advisable to use future contracts as the contract fixates a value of an asset. But, hedging by means of options is regarded as expensive. This is because of the fact that it has no obligation to purchase asset at a fixed price and at the same time it protects downside loss while leaving the upswing probability open (Guay 1999). The firms could protect themselves against the interest rate movements and security price movements by using derivatives. Bank and treasury managers actively use the interest rate derivative and they are heavily traded by them.