Hedging
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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 wannted, 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 of 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 the risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk
- Interest rate – the risk, for those who borrow, that interest rates will rise, (or for those who lend, that they fall)
- 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 of 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 of 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 involved selling obligations at a discounted rate. See for example forfeiting, bill of lading, or discounted bill
More recent forms of hedging have become available in the credit derivatives market.