Hedging strategies appear throughout this book. This is to be expected because one of the principal uses of derivatives is in the management of risks. In this chapter, we focus on the use of non-interest-rate derivatives in hedging. Interest rate derivatives will be picked up in Chap. 21.

Introduction

One common thread throughout this book has been the management of risks. Risk management means selecting and maintaining portfolios with defined exposure to risks. Deciding which risks one is to be exposed to and which risks one is to be protected against is also an integral part of risk management. Evidence suggests that firms engaged in risk management not only are less risky but also perform better [813].

A hedge is a position that offsets the price risk of another position. A hedge reduces risk exposures or even eliminates them if it provides cash flows equal in magnitude but opposite in directions to those of the existing exposure. For hedging to be possible, the return of the derivative should be correlated with that of the hedged position. In fact, the more correlated their returns are, the more effective the hedge will be.

Three types of traders play in the markets. Hedgers set up positions to offset risky positions in the spot market. Speculators bet on price movements and hope to make a profit. Arbitragers lock in riskless profits by simultaneously entering into transactions in two or more markets, which is called arbitrage.

Hedging and Futures

The most straightforward way of hedging involves forward contracts. Because of daily settlements, futures contracts are harder to analyze than forward contracts.