Risk Avoidance, Transfer, Reduction, and Retention in Hedging
Summary
The document distinguishes avoiding a risk from transferring it. Avoidance means choosing not to take on the exposure, such as declining an investment; transfer means accepting the exposure while using a hedge or insurance-like instrument to offset its financial consequences. A hedge may pay when the adverse event occurs, but the underlying exposure still exists.
It also places these choices alongside risk reduction through diversification and risk retention by taking no protective action. The examples explain how an airline might hedge fuel-price exposure with futures while avoiding a separate investment it does not want, and how a bond investor could use a default-linked product to offset credit losses. The illustrations are conceptual: the fuel contract is hypothetical, and a hedge may not perfectly match the exposure or eliminate every related cost and risk.
Key ideas
- Risk avoidance means declining an exposure before taking it on.
- Risk transfer uses a hedge or insurance-like instrument to offset losses while the underlying exposure remains.
- Diversification can reduce risk, while taking no protective action retains it.
- A fuel user can hedge price exposure with futures without avoiding the underlying need to buy fuel.
- Credit exposure can be offset with a product that pays upon default, though the example does not address hedge imperfections.
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Full text
# Difference between Risk avoidance and Risk transfer # Difference between Risk avoidance and Risk transfer I was hoping some could explain the two terms namely, risk avoidance and risk transfer. Also, can a risk be avoided by transferring it? ## Answer by AfterWorkGuinness (score 2) https://quant.stackexchange.com/a/20880 TL;DR Risk avoidance is not taking on the risk in the first place by not investing in the product that has the said risks.Risk transfer is akin to buying insurance. You make the investment, are exposed to the risk, but are protected if it happens. The board of directors sets the firm's risk appetite which is what risks investments they are willing to be exposed to (in the hopes of making money) and what risks they are not. For the risks the firm is willing to be exposed to in the hopes of making a profit, take they must decide how to handle them. - They can protect themselves by hedging (investing in products that pay if the risk is realized; like insurance). This is risk transfer. - They can diversify and bring down the risks that way. This is risk reduction. - They can ignore them, do nothing and hope for the best. This is retaining the risk For the risks the firm chose not to be exposed to, they have avoided them (risk avoidance) by not being exposed to them in the first place. For example: Imagine an airline like Air Canada, in the course of doing their business of flying people around the globe, they are exposed to the risk of increasing prices of jet fuel. Jet fuel costs go up and it eats into their profit. They want to protect against increases in the price of jet fuel in the spot market and the board will say we are OK with our traders taking positions in jet fuel futures (there are no jet fuel futures, but lets pretend there are for simplicity) to protect against adverse price movements. They may not be OK with their traders taking positions in very complicated products like synthetic CDOs. In this case, they have decided to transfer the risk of the increasing spot price of jet fuel by hedging (investing in futures). They have not avoided it, because if it happens, the price at which they buy jet fuel is going to go up and they will have to pay the higher price. Since they transferred the risk by hedging, it won't negatively affect them since if the price does go up, they will make money from the futures; like an insurance policy. The board decided not to invest in the super complicated synthetic CDOs and thus have avoided the risk that comes from that investment. A simpler example would be a company deciding to invest in corporate bonds to make a profit. They are exposed to the risk that the companies they invest in will go bankrupt and their investment loses all its value. To transfer this risk and protect themselves, they can hedge and buy a product that will pay them if one of the companies they invested in defaults.
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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.