Risk mitigation in financial markets utilizes two basic strategies: hedging and diversification. The two strategies take contrary approaches to mitigating risk. Hedging mitigates risk by matching one investment with another that has an opposing risk. Hedging strategies aim to make money regardless of whether the market is considered to be up or down. Numerous asset classes and methods are used in hedging strategies. Diversification aims to remove unnecessary risk through investments in multiple assets instead of investment in a single asset. These two risk mitigation strategies may be used independently of each other or to complement each other.
At A Glance
- To minimize risk and achieve higher returns, some investors use hedging strategies which can be short- or long-term in nature.
- Generally, hedge funds are pooled funds from multiple large investors to generate revenue from beta movement.
- Many forms of hedging, such as equity hedge, market neutral strategy, distressed debt hedge, global macro hedge, and merger arbitrage, use put options and sell a stock short with cover.
- A diversified portfolio is one way to minimize risk associated with beta movement.
Portfolio diversification presents a variety of advantages, such as less risk, and disadvantages, such as reduced potential gains.
- If carrying risk is too high, some securities holders will use derivatives to minimize risk.
- There are multiple types of derivatives, such as futures contracts, forward contracts, swaps, options, and collateralized debt obligations, each with its own benefits.
- Certain alternative investments, such as futures and forward contracts, swaps, and options, can be used to lower risk while increasing return.