Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVIII. Topics in Corporate
Finance- Risk Management: An
Introduction to Financial
Engineering
(^810) © The McGraw−Hill
Companies, 2002
know what the size of the crop will be ahead of time. If the crop is larger than expected,
then some portion of the crop will be unhedged. If the crop is small, then the grower will
have to buy more to fulfill the contract and will thereby be exposed to the risk of price
changes. Either way, there is some exposure to wheat price fluctuations, but, by hedg-
ing, that exposure is sharply reduced.
There are a number of other reasons why perfect hedging is usually impossible, but
this is not really a problem. With most financial risk management, the goal is to reduce
the risk to more bearable levels and thereby flatten out the risk profile, not necessarily
to eliminate the risk altogether.
In thinking about financial risk, there is an important distinction to be made. Price
fluctuations have two components. Short-run, essentially temporary, changes are the
first component. The second component has to do with more long-run, essentially per-
manent, changes. As we discuss next, these two types of changes have very different im-
plications for the firm.
Hedging Short-Run Exposure
Short-run, temporary changes in prices result from unforeseen events or shocks. Some
examples are sudden increases in orange juice prices because of a late Florida freeze, in-
creases in oil prices because of political turmoil, and increases in lumber prices because
available supplies are low following a hurricane. Price fluctuations of this sort are often
called transitorychanges.
784 PART EIGHT Topics in Corporate Finance
FIGURE 23.5
Risk Profile for a Wheat
GrowerVRisk profilePwheatFor a grower, unexpected increases in wheat prices increase the
value of the firm.