Hedging yourself 'Microsoft' style...

All right, say you're an active investor in the equity or commodity markets. Your investment portfolio includes several growth and value stocks. You are contemplating an investment in a risky start-up and have no way of telling what your future returns will be like.

One way to reduce (hedge) your risk against drastic capital losses would be to purchase a PUT option on your stock. This would allow you to sell your stock at a pre-decided strike price upto a period of time, hence limiting any potential damage. Options are a form of derivatives. As the name suggests, Derivatives are financial instruments that derive their value from the underlying asset (stock, gold, oil, etc). Options, futures, swaps, forwards, etc are all types of derivatives and judicious use of these is an intricate field of its own.

Coming back to our investor, sounds like a great deal for him, n'est ce-pas? He gets to reap the benefits, without baring proportionate risk. Just a minute though. Who sells these options? And how does the game benefit them?

Indeed, corporations regularly put out options on their stock. During the 1990s, Microsoft regularly sold PUT options on its stock to investors. This meant that MS had an obligation to buy back its own stock at the pre-decided strike price, when its stock price fell below the strike price. This represented a loss to MS, again only if its stock fell below the strike price. Needless to say, its stock NEVER fell below the decided strike price.

What did happen though, is that for four years in the mid-1990s, MS earned $2 Billion just by selling Put options on its stock. Think about that! USD 2 BILLION in 4 years, and its not even their core business. MS earns revenue by selling software, for Pete's sake. Investors kept buying the options and MS kept outperforming market expectations.

Other than earning this capital, this move also paid huge returns to MS's shareholders. When a company sells Put options on its stock in huge volumes, it is a strong signal to the world that damn-it, our stock will NOT drop! It is a signal that our stock is currently under-valued. Capital gains inevitably follow and this stock appreciation is great news for all stakeholders.

All of this got me thinking. I wonder whether INSEAD will allow me to purchase a Put on my education. If, in 7 months time, I am jobless, they would have to 'buy' pack my tuition! Sound strange? Trust me, its only a matter of time...