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Hedging, also known as risk shifting,
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is a form of risk management
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where the company manages profits
and losses by taking one risk
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to offset another.
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While insurance provides protection
on the downside in case of losses,
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hedging technically eliminates
the risk exposure
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both on the downside
and the upside
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by modifying the distribution
of the potential outcomes.
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Fundamentally, hedging is based
on the principle of diversification,
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which in turn is based on
how assets move together,
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or their correlation.
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Hedging is typically implemented
using derivatives such as
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forwards, futures, options, and swaps.
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Hedging can be passive
or actively managed,
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depending on the
objective of the strategy.
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Here are some guidelines for the
manager who is looking to hedge.
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Identify what is worth
hedging and what is not.
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Anything that is worth controlling
is done through risk management.
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Determine how much hedging is necessary.
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If changes in interest rates, exchange
rates, or commodity prices
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lead to large imbalances,
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hedging probably makes a lot of sense.
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How sensitive are the company cash
flows to changes in the interest rates,
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exchange rates, or
commodity prices?
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And how sensitive are the investment
opportunities to these risk variables?
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Ensure alignment through risk management.
