Question

Using examples, demonstrate your understanding of the concept of ‘risk management’ in financial markets contexts. How can options be used to manage risk?

Answer 1

The risk management with reference to financial market is used to manage the allocation of assets in the portfolio in such a away that the risk of the portfolio, the loss in the portfolio can be minimized and capital is allocated for maximum gain. The risk management is important from the perspective of investors because different investors have different level of risk tolerance and their expectation from the markets are different so in many ways what risk management is about is matching the market risk and return with your own expected return and level of risk tolerance. For example when you are at early age of your life, say in between the age group of 25 – 40, most of the financial advisors would recommend that you invest a major portion of your capital in equity markets where as when the investor is above the age of 50 or 60, it is highly recommended to allocate a major portion of your assets to high quality fixed income asset.

Options are a part of derivative which is used to manage risk exposure to the market. There are call option and put options. Call option gives you the right to but not the obligation similarly put option gives you the right to sell not the obligation. Let’s say you are holding 1000 shares of a stock, now you don’t want to sell but you are concerned that price might fall so you can buy put option. Again, if you think that price might fall little in the short-term but will rise in the long term so you can sell a call option in the short-term to generate income.