With the portfolio insurance approach, a portion of the potential return from an uninsured portfolio is surrendered in order to guarantee a minimum portfolio value. This leads to a measure of the effectiveness of the hedge. A way of measuring how well the hedge operates is to compare the basis risk that is assumed by hedging with the price risk that is eliminated. The smaller the basis risk compared to the price risk, the more effective is the hedge in fulfilling its objective. Discuss when you would use terminal instruments and when you would use options.
Derivatives are tools for managing risk.
In essence, they are used to modify the risk profile of an existing cash market position. They provide other uses such as the potential to provide higher returns and to reduce funding costs. To hedge price risk at minimum cost. Their cost is hidden in the price. As a substitute for direct exposures to the underlying assets and to anticipate future cash investments and disinvestments.