RiskMetrics - Three strategies for managing risk
Three strategies for managing risk
Understand the three basic strategies for managing financial risk: hedging, diversification, and insurance
There are three fundamental techniques for managing financial risk:
- Diversification Reduce risk by investing in a large number of independent assets. Example: Most investors diversify by holding a variety of stocks and mutual funds.
- Insurance Purchasing insurance involves paying a premium to protect against unfavorable events. Example: GE stock investors can buy a put option to protect against the stock falling.
- Hedging Eliminates exposure by entering into an offsetting position. Example: You can hedge S&P 500 exposure by shorting S&P Depositary Receipts (SPY).
Let's illustrate these three risk reduction techniques with a simple case study. Tired of paying exhorbitant NY rents, Jane G. decides to buy her first apartment. To ensure she can make the downpayment, she would like to reduce the risk of her highly speculative portfolio (below).
Given her shorter investment horizon and greater need for capital preservation, she now targets a RiskGrade of 80.
First, she diversifies her assets by re-allocating half of the portfolio to cash and bonds. Her risk falls by more than half: the new portfolio RiskGrade drops to 135 and XLoss declines to $3,111.
Next, she reduces her exposure to Cisco, her largest investment. Instead of selling the stock, however, she buys a put option to insure against Cisco falling below $60 without sacrificing upside potential. Her RiskGrade is now down to 88 and XLoss is $1,967.
Still above her target RiskGrade level of 80, Jane hedges her S&P 500 exposure by selling S&P Depositary Receipts (SPY). Her risk level is finally at an acceptable level, with a RiskGrade of 78 and XLoss of $1,728.