Hedging risk exposure and arbitrage Term Paper Example | Topics and Well Written Essays - 1500 words

Hedging risk exposure and arbitrage - Term Paper Example Some of the methods include hedging or diversification of risks (Madura, 2014). The investors should choose the best option cautiously not only to eliminate the risk but also to maximize revenue. This document evaluates put option as a hedging strategy in a simulation scenario. Hedging is concurrent acquisition and sale of two equivalent securities having different maturity period with the expectation of gaining from the consequent movements the price of those securities (Bouzoubaa & Osseiran, 2010, p. 78). The investors hold stocks with the expectation that at one point they will be able to sell the stock at a higher price to cover the transaction cost and other cost of holding the stock such as inflation cost (Bingham & Kiesel, 2004). The stocks are sold at a premium, but the sales may have to be delayed. The unit value of stock after price appreciation is equivalent to the marginal cost of holding that security. Anticipation of price increase in the stock value will result to an increase in the current price of the stock (Madura, 2014, p. 342). By hedging the stock investors commit to taking a minimum value of the stock and avoid making loss in case, the value of the underlying security goes below the future value of the contract. However, the hedger risk losing profit in case the value of the stocks exceeds the future contract value. It is imperative to note that the individual’s decision to hedge security does not affect the market condition because the investor transfers the risk to a willing speculator who buys a security. Also, when an investor purchases a security with anticipation that their prices will raise in the future that result in the transfer of risk from the seller to the buyer of the stocks (Madura, 2014, p. 242). However, investors accept risk premium in order to hedge their securities. The implication of risk premium is the fact that the investor has to sell