ABSTRACT
This chapter sets out the alternative views of the purpose of hedging and, following the previous literature, the primary concern is with the risk-minimising hedge. In order to create a hedge, the trader must select a particular futures contract for use in offsetting the initial risk. The objective of this choice is generally taken to be to select that futures contract which produces a hedged position with the lowest risk. A fundamental requirement in devising hedge ratios and in measuring the effectiveness of hedging decisions is the objective of the hedge. The risk-minimizing hedge ratio is then restated using the Capital Asset Pricing Mode (CAPM) beta. Whether the risks of a company should be hedged, and whether this should be done by the company or its shareholders are discussed. Finally, the problems associated with alternative ways of estimating the risk-minimising hedge ratio are covered; followed by a summary of the available empirical evidence.
