Chapter 6 - Risk Management: Hedging and Diversification

Abstract

This chapter states that corporate risk management can be achieved through diversification, hedging and insurance. In some cases such as globally diversified investment funds, diversification is an integral part of risk management. It is possible to decompose the optimal solution for the risk management decision problem into a speculative component and a risk minimizing component. Hedging techniques can be explained with the help of two approaches: transaction hedging and optimal hedging. The transaction hedging approach emphasizes the trading mechanics involved in fully hedging a specific transaction. Transaction hedging involves cash flow matching, so it is desirable to have only a small number of truncations to manage. A hedge can be constructed by using an appropriately weighted combination of a number of different future contracts. The objective of increasing the number of different future contracts used in the hedge is, to improve hedge performance. At some point this can be a fruitful exercise because there would be so many future contracts to monitor, and transaction cost would increase accordingly. While transaction hedging takes the optimal hedge ration to be one, optimal hedging requires estimating the hedge ratio from empirical data.