Downside Risk

A Primer on Inflation-Linked Bonds. He became a member of the Society of Professional Journalists in This measure is a variation of standard deviation in that it measures the deviation of only bad volatility. The writers of stock put options takes on the downside risk the chance the underlying stock may rise in price in exchange for the premiums they charge. In general, many investments that have a greater potential for downside risk also have an increased potential for positive rewards. Imagine that you wanted to take advantage of technology stocks and their upside, but you also wanted to limit any losses. In the first case, where the CEO had an options-heavy package, cash flow volatility did not change and was similar for firms that had no exposure to the chemicals.

A short position in a stock, however, as accomplished through a short sale entails unlimited downside risk, since the price of the security could continue rising indefinitely. Similarly being a long an option - either a call or a put - has a downside limited to the price of the option's premium, while a short options position has unlimited potential downside.

Buying Puts

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The Advantage of Tax-Advantaged Funds. For example, when you take out insurance to minimize the risk that an injury will erase your income or you buy life insurance to support your family in the case of your death, this is a hedge.

You pay money in monthly sums for the coverage provided by an insurance company. Although the textbook definition of hedging is an investment taken out to limit the risk of another investment, insurance is an example of a real-world hedge.

Hedging by the Book Hedging, in the Wall Street sense of the word, is best illustrated by example. Imagine that you want to invest in the budding industry of bungee cord manufacturing. You know of a company called Plummet that is revolutionizing the materials and designs to make cords that are twice as good as its nearest competitor, Drop, so you think that Plummet's share value will rise over the next month. Unfortunately, the bungee cord manufacturing industry is always susceptible to sudden changes in regulations and safety standards, meaning it is quite volatile.

This is called industry risk. Despite this, you believe in this company - you just want to find a way to reduce the industry risk. In this case, you are going to hedge by going long on Plummet while shorting its competitor, Drop. If the industry as a whole goes up, you make a profit on Plummet, but lose on Drop — hopefully for a modest overall gain.

If the industry takes a hit, for example if someone dies bungee jumping, you lose money on Plummet but make money on Drop. Basically, your overall profit the profit from going long on Plummet is minimized in favor of less industry risk. This is sometimes called a pairs trade and it helps investors gain a foothold in volatile industries or find companies in sectors that have some kind of systematic risk.

Expansion Hedging has grown to encompass all areas of finance and business. For example, a corporation may choose to build a factory in another country that it exports its product to in order to hedge against currency risk. An investor can hedge his or her long position with put options or a short seller can hedge a position though call options.

Futures contracts and other derivatives can be hedged with synthetic instruments. Basically, every investment has some form of a hedge. While not all instances of substances being labeled carcinogens make front page news, they clearly pose a real risk to the companies involved.

Trichloroethylene was labeled a possible cancer causing agent in , for example. The group studied the impact of a newly labeled carcinogen, like trichloroethylene, a number of ways. First, they looked at companies in industries where employees had been exposed to a chemical recently tagged as potentially cancer causing versus firms in industries that did not have exposure.

The question was whether firms with a potential exposure would try to cut their risk by stabilizing their cash flow. A further analysis of mergers and acquisitions activity during the period revealed that the key mechanism for slashing cash flow volatility was diversifying into new businesses.

Given that the typical response to a major new headache was to eliminate nasty swings in cash flow, the researchers then asked whether options-based compensation changed that equation. They cut the group of companies where workers were exposed to a potential carcinogen into two segments: Those where the CEO received a lot of options, and those for which CEO compensation had a below-average use of options.

In the first case, where the CEO had an options-heavy package, cash flow volatility did not change and was similar for firms that had no exposure to the chemicals. Those CEOs did not try to cut risk in response to the new potential liability. But firms where CEOs had relatively few options did, in fact, cut their cash flow volatility — a clear signal they were taking risk-reducing steps.

Upon digging deeper, the co-authors found that firms where executives had options that were in the money — or options more akin to straight equity — took steps to cut risk more than those whose executives had options that were out of the money. If options tend to increase risk taking, the next question is whether that is better for shareholders. The answer is unclear, Gormley says. And morale was very low. Even without [firms] going into bankruptcy, those financial problems can destroy a lot of value.

In that kind of situation, diversifying into other businesses may offset some of that. But in other cases, when those additional pressures are not present, diversifying may mean moving into businesses where you have little expertise — something that can hurt shareholders.

Gormley points to the case of defense contractor General Dynamics as an example of risk paying off. When the defense industry was in decline in the s, General Dynamics bucked the trend of diversifying into new businesses.

How it works (Example):

Aug 23,  · If the market rises above the option strike price, it expires worthless, but the investor is protected from the downside risk of the underlying assets. "Anyone who has bought put options because they believed the market had hit highs and would drop has mostly lost," Glassman Andrew Osterland. In fact, options have even greater downside risk than stock. Consider two executives in the same company. One is granted a million dollars worth of stock, and the other is granted a million dollars worth of at-the-money options—options whose exercise price matches the stock price at the time of the grant. The writers of stock put options takes on the downside risk (the chance the underlying stock may rise in price) in exchange for the premiums they charge. If a stock stays above the strike price, the option won’t be exercised and the writer keeps the premium.