An airline buys fuel futures to hedge its jet fuel exposure. Fuel prices fall sharply, so the airline pays less in the spot market but loses money on its futures position. How should we evaluate this hedge?
AThe hedge failed — the airline would have been better off without it
BThe hedge succeeded — the airline achieved its goal of price certainty, which is what hedging is for
CThe hedge was imperfect because a perfect hedge would have broken even regardless of price movement
DThe hedge failed because basis risk caused the derivative loss to exceed the spot market gain
This is the most common misconception about hedging. The purpose of a hedge is not to profit from the derivative — it is to exchange price uncertainty for price certainty. When the airline bought fuel futures, it accepted a fixed cost in exchange for protection against price spikes. If fuel prices fell, the spot market savings and the futures losses roughly cancel, and the airline pays approximately the futures price it locked in. That is exactly what it set out to do. Judging the hedge a 'failure' because prices moved favorably is like calling home insurance a failure because your house didn't burn down.
Question 2 Multiple Choice
A gold mining company hedges its entire expected production by selling gold futures. Which of the following statements best describes the economic rationale for hedging at the firm level rather than leaving it to shareholders?
AShareholders cannot hedge commodity exposure themselves, so firms must do it on their behalf
BThe hedge reduces systematic risk, lowering the firm's required rate of return
CGold price volatility threatens the firm's ability to fund operations and investment — cash flow stability has direct value when financial distress is costly
DRegulators require mining companies to hedge commodity exposure to protect employees
From portfolio diversification theory, shareholders can diversify away commodity price risk themselves — so hedging purely financial risk at the firm level doesn't add value in a frictionless world. Firm-level hedging is most valuable when cash flow volatility creates real costs: financial distress, inability to fund profitable projects, or uncertainty for suppliers and customers. A gold miner that could go bankrupt if gold prices fall has strong reason to hedge because distress costs are real and hedging reduces the probability of incurring them. Shareholders cannot avoid these corporate-level distress costs through personal diversification.
Question 3 True / False
A hedge that uses a derivative written on a closely related but not identical asset introduces basis risk, meaning the hedge may not fully offset the underlying exposure.
TTrue
FFalse
Answer: True
Basis risk arises whenever the derivative and the underlying exposure are not perfectly correlated. A wheat farmer hedging with corn futures faces basis risk from the spread between wheat and corn prices; a US firm hedging European sales in USD/EUR futures faces basis risk if actual invoices are in British pounds. The hedge reduces exposure but some residual risk remains. A perfect hedge — zero basis risk — is rare in practice and would require a derivative written on exactly the same asset, location, quantity, and date as the actual exposure.
Question 4 True / False
Hedging with derivatives is most valuable for companies facing risks that their shareholders can easily diversify away in their investment portfolios.
TTrue
FFalse
Answer: False
This is backwards. In efficient markets, risks that shareholders can diversify away through portfolio construction don't create value when hedged at the firm level — shareholders can simply hold a diversified portfolio and neutralize those risks themselves. Firm-level hedging is most valuable for risks that threaten the company's ability to operate — risks that, if they materialize, cause financial distress, constrain investment, or create stakeholder uncertainty. Commodity producers, exporters, and financial institutions hedge because their core operating risks are too large or concentrated to leave to shareholder diversification.
Question 5 Short Answer
Why does the economic purpose of a hedge mean that a derivative position that loses money can still represent a successful hedge?
Think about your answer, then reveal below.
Model answer: A hedge's purpose is to reduce or eliminate price uncertainty, not to generate profit. When a firm holds an underlying exposure (e.g., it will need to buy fuel at the market price in three months), it uses a derivative to lock in a price today. If prices move favorably, the derivative position loses money but the spot purchase costs less — the net outcome is approximately the locked-in price either way. The firm traded the possibility of a favorable outcome for the certainty of a known outcome. Calling this a failure confuses the goal of hedging (certainty) with the goal of speculation (profit).
This distinction between hedging and speculation is foundational to risk management. A speculator takes derivative positions hoping to profit from price movement; a hedger takes derivative positions to offset an existing exposure. For a hedger, the derivative is insurance — you pay a premium (or forego potential gains) to eliminate downside risk. A hedge that 'costs money' when prices moved favorably is functioning exactly as designed.