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Hedging is a strategy, usually some form of transaction, designed to
minimise exposure to an unwanted business risk.
Some form of risk taking is inherent to any business activity (if there were
no risk, it is likely there would be no reward). Some forms of risk are
"natural" to a business, whose competitive advantage is to manage the risk
well, i.e. to minimise the costs of the risk, against the profit it is
likely to achieve. Other forms of risk are not wanted, but cannot, as things
stand, be avoided. For example someone who has a shop, takes care of the
risk of competition, of poor or unpopular products, and so on, as "natural"
risks. The risk of their stock being destroyed by fire is unwanted, however.
Hedging consists in selling off the unwanted risk to those (such as those
who have computed the actuarial value of fire risk) who have the ability or
desire to take it.
For the following categories of risk, there now exist well-developed markets
in which the risk is commoditised or securitised, or put into some OTC
contract to be transferred between buyers and sellers.
* Insurance risk
* Market risk
* Credit risk
Hedging market risk
Common forms of market risk are
* Commodity Ð the risk, for prospective buyers, that prices of raw
materials (energy, metals, farm produce) will rise (or for sellers,
that they fall)
* Foreign exchange Ð the risk, for exporters, that the value of their
accounting currency will fall against the value of the importers
* Interest rate Ð the risk, for those who borrow, that interest rates
will fall, (or for those who lend, that they rise)
* Equity Ð the risk, for those whose assets are equity holdings, that the
value of the equity falls
Futures contracts and forward contracts are a means of hedging against the
risk adverse market movements. These originally developed out of commodity
markets in the nineteenth century, but over the last fifty years there has
developed a huge global market in products to hedge financial market risk.
Hedging Insurance risk
One of the oldest means of hedging against risk is the purchase protection
against accidental loss or damage to property, or injury, loss of life. See
Hedging Credit risk
Credit risk is the risk that money owing will not be paid by an obligor.
Since credit risk is the natural business of banks, but an unwanted risk for
commercial traders, naturally an early market developed between banks and
traders, that invovled selling an obligations on at a discounted rate. See
* bill of lading
* discounted bill
More recent forms of hedging have become available in the credit derivatives