Question

What risks are hedged and what risks are unhedged?

Hint: Price vs Quantity risk

Why do airlines avoid hedging 100% of their fuel consumption or avoid being “overhedged”

Answer 1

Hedging is a security against undesirable price movement of the asset which is being hedged upon. There are various conditions where hedging is very useful to prevent the unexpected losses. Hedging is generally done when there is a high volatility in the prices of underlying. But it is to be noted that it's not always that hedging is useful, there are various conditions when hedging can not only incur hedging costs but also it may lead to huge losses. For example, hedging with the help of forward and future contracts.

Price Risk: This risk incur when there is uncertainty about the desirable movement of prices of assets and these kinds of assets are generally hedged to generate the constant profit. The price risk occurs in the price of stocks

Quantity Risk: This risk occurs when the quantity of asset is uncertain. These risks are generally unhedged because the rate of decline in the quantity of the asset is generally known beforehand.

Therefore it can be said that the risks which are highly volatile and their price movement cannot be predicted and also there is a huge scope of losses which may occur if there is an undesirable change in price only those kinds of hedges are being hedged. For example, a price of a stock. On the other hand, assets phones price trends are fixed and known beforehand need not to be hacked. For example Government bonds.

In the case of airline business also It is never advisable to hedge 100% of their fuel consumption because they can hedge against increased price of the fuel but if the price goes down they will have to forgo their profit and also have to pay the cost of hedging. Therefore, to harness the maximum profit of the change in the prices of the fuel it is not advisable to have the 100 % fuel consumption.