Investment strategies often include hedging to protect against currency fluctuations and derivatives as a form of insurance against loan failures. Hedge funds and mutual funds have different approaches to managing and compensating investments, with hedge funds using high water marks and mutual funds offering liquidity and professional management.
Hedging and Derivatives in Portfolio Investment Decisions
In the context of investment and finance, companies often engage in hedging to protect themselves against currency risk. A U.S. firm exporting to France, for example, may have a contract to deliver goods for 1 million euros, the value of which in U.S. dollars could fluctuate due to changes in the exchange rate. By entering into a hedging contract, the firm can lock in a specific exchange rate for a future date, thereby mitigating the risk of a declining euro. Although this comes at a cost, it ensures financial predictability.
Furthermore, the complex derivatives that played a part in the financial crisis derived their value from the occurrence of certain events, such as mortgage failures. These were meant to be a form of investment insurance, reducing risk by compensating banks if the loans defaulted. The management of these financial contracts is often handled by financial institutions or brokerage companies, which may earn revenue through fees or by creating a spread in the exchange rate.
Hedge funds often use high water marks to ensure that they are compensated for genuine performance, avoiding rewards for volatile trading, market manipulation, or undiversified asset portfolios. Meanwhile, mutual funds provide an accessible investment opportunity due to their liquidity and professional management, despite potential high costs for diversified portfolios.