Question

Discuss three reasons why firms hedge their risk.

Answer 1

The very basic and most important reason for hedging is risk reduction for firms.Now, risk is the broader term and based on the organization and it's business, products, nature of business, different risks impact them differently.

Reason1:For any firm, which is involved in import, export business, their primary concern is fluctuation in currency exchange rate. They would primarily opt for hedging to cover the risk of curreny exchange rate pluctuation.

Reason2: For a commodity trading firm, hedging is principally done to cover from the fluctuation in underlying commodities price fluctuation risk.

Reason3:Firms go for hedging to balance or increase competitiveness in the market. Firms having good hedging startegy as part of risk management process, can sustantially reduce their cost of funding.Also shareholders of the firms use the hedging principle to evaluate performance and risk management indicators for the firm.