ABSTRACT
T o hedge means to reduce risk. In the context of derivative pricing, the goal of hedging is to combine the derivative security with other assets in order to
minimize the risk of the resulting portfolio. In this chapter, we present two main approaches to hedging. In the first, we
recognize that risk comes from the factors. Thus, hedging is based on eliminating factor risk. In the second approach we consider a derivative to be a function of underlying variables. We are then hedged against variations in these underlying variables if the (calculus-based) derivative of the value of our portfolio with respect to the underlying variables is zero. That is, our portfolio is not sensitive to small variations in the underlying variables.
