Reasons traders and firms reduce exposure
Question
Why do participants in financial markets choose to hedge their positions?
Short answer
To remove risks they are not paid for or do not want, while keeping the ones they are. A corporate hedges currency or commodity exposure to stabilise cash flows; a market maker delta hedges to earn the spread rather than gamble on direction; a trader may hedge to isolate one view, such as volatility. Hedging also underpins pricing, since a perfectly hedgeable claim must cost its replication price, and it lowers capital and margin requirements.
Adapted from Wilmott, Frequently Asked Questions in Quantitative Finance, FAQ 15, p.73; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- The Law of One Price and Replication: No-Arbitrage Pricing from First Principles
- The One-Period Binomial Model: Replication, Delta Hedging, and Risk-Neutral Pricing
- Derivation — From Binomial Trees to Black-Scholes in the Continuous Limit
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