Question

How would a company determine whether or not it should use a particular risk management or hedging technique?

Answer 1

The company should decide whether to use a particular technique based on the current market conditions and the financial analyst's perspective of future prices.

For example, if you are an oil marketing company. If you (the financial analyst) believe that the crude prices are expected to increase, then the hedging method should be to enter into a futures contract based on the current prices. On the other hand, if the analyst expects the crude prices to reduce further, then the best hedging method is to do nothing as the prices will themselves fall. If the analyst is unsure of the future crude oil prices, then the best hedging method is use crude oil options where the business can choose to exercise the option based on the actual future price at the expiry date of the option.

Therefore, based on the expected future price, the business can choose either futures or options to hedge.