Originally Posted by sunandaC
Broadly, if a funds manager holds an equity portfolio and expects the market to decline, he can sell the index futures at the current price for future delivery. if the market did decline, his equity portfolio value will come down, but his futures contract will show corresponding profit, since he had sold it at the higher past price.
this is called “hedging” portfolio risk. in this case, the fund manager would not have any loss due to market decline. however, contrary to the expectations, if the market prices actually rose, our fund manager will not gain. the rise in his equity portfolio value will be neutralized by the loss on his futures position, since he had sold futures at lower price relative to the current market levels.
Options, too, can be used to hedge an investment portfolio – by buying put options (or options to sell underlying asset) at a price (the premium). The funds manager can exercise the option only if the prices fall, since he has the right to sell at a higher price. he can forgo the premium and not exercise the option, if the prices actually rise. This way he can still let his portfolio NAV, while protecting the downside risk.
Please check attachment for Notes on Risk Management - Profiling and Hedging, so please download and check it.