How do hybrid mutual funds use derivatives for hedging?

Hybrid mutual funds may use derivatives for hedging purposes to reduce risk and protect the value of the fund’s portfolio. Here’s how they typically use derivatives in their investment strategy:

Hedging against Equity Market Volatility

Hybrid mutual funds that include a mix of equities and debt may use derivatives like futures and options to hedge against market downturns. For instance, they might sell equity index futures to protect against a potential decline in the stock market. This helps minimize losses when the equity portion of the portfolio faces volatility.

Protecting Against Interest Rate Changes

Since hybrid funds often invest in both stocks and fixed-income securities (such as bonds), they might use interest rate futures or swaps to hedge against interest rate movements that could negatively impact the debt portion of the portfolio. For example, if interest rates rise, the value of bonds generally decreases, and derivatives can be used to offset those potential losses.

Currency Risk Hedging

If the hybrid fund holds foreign securities, it may face currency risk. To manage this risk, the fund could use currency forwards or options. These derivatives allow the fund to lock in exchange rates and avoid losses due to unfavorable currency movements.

Reducing Credit Risk

Hybrid mutual funds may invest in corporate bonds or debt instruments with varying credit quality. To manage the risk of a credit downgrade or default, the fund could use credit default swaps (CDS). These derivatives act as insurance, paying the fund in case of a default by a bond issuer.

Managing Market Liquidity Risks

In some cases, the fund may use derivatives like futures contracts or options to quickly adjust its exposure to certain asset classes without needing to sell underlying securities. This can help the fund manage liquidity risks, especially during periods of market stress.

By using derivatives, hybrid mutual funds aim to reduce downside risk and smooth out returns, especially in unpredictable market environments. However, it's important for investors to understand the risks associated with derivatives before investing in hybrid funds.