Risk Exposure and Hedging

11 Pages Posted: 21 Oct 2008

See all articles by Samuel E. Bodily

Samuel E. Bodily

University of Virginia - Darden School of Business

Lee Fiedler

affiliation not provided to SSRN

Abstract

The concept of exposure, or uncertainty that matters, is developed as the target of hedging. Then, how to hedge that exposure--in particular, how to use regression analysis to obtain a hedging ratio--is described. The note concludes with a discussion of hedging multiple uncertainties and how to use correlations in developing a hedging strategy.

Excerpt

UVA-QA-0595

RISK EXPOSURE AND HEDGING

Everyone faces uncertainties, but only some of those uncertainties matter to your business. For example, a farmer might see that future exchange rates, employment levels, crop yields, and commodity prices are all uncertain. Of these uncertainties, crop yields and prices are likely the only ones that really affect the farmer's business. These types of uncertainties are true risks; the others are uncertain, but are not truly risks to the farmer. It is common to say that people have “exposure” to risks. Exposure then relates to uncertainties that “matter.”

While this explanation of exposure may seem straightforward, analyzing and managing exposure requires careful consideration of the degree of exposure. To manage exposure, one must be able to determine exactly which uncertainties are important and measure their effects. This requires two key steps:

· Determine whether a change in a given variable will make you better or worse off. If you are unaffected by changes in the variable, there is no exposure. If the variable matters to you, you have exposure to it.

· Once you have identified the variables to which you have exposure, quantify the relationship between an incremental change in each variable and the resulting change in your NPV (or something else you care about—quarterly profits, project costs, etc.). Exposure is often described in incremental terms—“an incremental increase in variable X will result in an adverse impact on NPV of Y.”

. . .

Keywords: hedging, risk analysis, risk managment

Suggested Citation

Bodily, Samuel E. and Fiedler, Lee, Risk Exposure and Hedging. Darden Case No. UVA-QA-0595. Available at SSRN: https://ssrn.com/abstract=912023

Samuel E. Bodily (Contact Author)

University of Virginia - Darden School of Business ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
434-924-4813 (Phone)
434-293-7677 (Fax)

HOME PAGE: http://www.darden.virginia.edu/faculty/bodily.htm

Lee Fiedler

affiliation not provided to SSRN

No Address Available

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