This is the first of two chapters in the book dealing directly with risk management. Businesses face risk every day and it is not possible to earn significant returns for stockholders without taking risk. However, managers would like to reduce or eliminate the kinds of risk that does not give additional returns for taking the risk. These types of risk may relate to key inputs like raw materials, the main products of the business, or financial variables like interest rates or foreign exchange rates. Risk reduction of controllable risk allows financial managers to worry about the things that are worth worrying about and they are in the best position to handle. This chapter focuses on business related risk from commodity prices and interest rate changes. Thanks to financial innovation and development of financial derivatives, corporate financial managers have considerable flexibility in deciding the kind of risk they want to be exposed to and the kind of risk they want to hedge.

Hedging offsets risk and is accomplished with futures, forward contracts, options or and often with custom designed derivatives. Risk management through hedging with appropriate financial tools is the focus of this chapter. The primary purpose of hedging is to control individual risks thereby controlling a firm's total risk. Such hedging techniques are part and parcel of today's financial manager's tool book. The point of hedging is to minimize the risks the manager is not equipped to handle. Typically hedging involves finding the number of units of an asset (or liability) that is needed to offset changes in the value of an obligation (or asset) and then taking the appropriate derivative position to reduce or eliminate the risk.