Hedging

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 � the risk, for prospective buyers, that prices of raw materials (energy, metals, farm produce) will rise (or for sellers, that they fall)
Foreign exchange � the risk, for exporters, that the value of their accounting currency will fall against the value of the importers
Interest rate � the risk, for those who borrow, that interest rates will fall, (or for those who lend, that they rise)
Equity � 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 Insurance.

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 for example

forfeiting
bill of lading
discounted bill

More recent forms of hedging have become available in the credit derivatives market.

See also