Question

1. Reasons both for and against hedging by non-financial companies (non-banks).
   

1. List three economic arguments in support of the view that energy companies can create value by managing their risk exposure.

2. List three economic arguments against a company managing risk exposure.

Answer 1

The reasons in favor of hedging by non-financial company

· Hedging is one of the most effective way to reduce the exposure of your position and you can reduce the risk for your current as well as future position.

· By hedging the prices, you can actually limit the impact on the financial statement mainly the impact of revenue on income statement and there is high certainty regarding that revenue level will be obtained.

· The energy company can reduce the volatility of the cost of raw material in their production by hedging their position.

Arguments against the hedging

· The cost of hedging sometimes outweighs the benefit of the hedging and that has to be taken care of.

· When you are hedging your position then you are also limiting your upside potential, not just limiting your downside.

· To hedge your position, you have to find an asset which exactly matches the price movement of the asset, their movement should be same which is not always feasible.