Insurance and Shared Risk

• When you buy an insurance policy, you are essentially agreeing to share risk with a group of other people. Everyone who owns an insurance policy pays a premium, which is added to an account. The idea behind insurance is that a certain number of people who buy insurance will incur a loss, requiring them to make a claim. The premiums paid by those who do not need to make an insurance claim are used to pay for those who do.
  
  

Hedging Basics

• If you are perfectly hedged, you cannot lose any money, but you also cannot earn a profit. For example, assume that when the dollar rises the Euro falls by the same amount and when the Euro rises the dollar falls by the same amount. If you own $1,000 worth of dollars and $1,000 worth of Euros and the dollar rises, the price increase of your dollars will offset the loss incurred with your Euros. Because the dollars and Euros offset one another, you cannot lose money, but you also cannot earn any money.
  
  

Practical Hedging Example

• Assume you are a farmer and you have a crop of corn that will be ready for harvest in two months. A buyer offers to pay you $5 per bushel when your harvest is ready if you agree to accept his offer today. If you agree to accept the offer, you lock in the price and you are guaranteed to earn at least $5 per bushel regardless of what the market price is when your harvest is ready. In this case, you are hedged against a future price drop below $5. However, your hedge also limits your earnings to $5 even if the price of corn is selling for more than this amount when your harvest is ready.
  
  

Practical Insurance Example

• Now assume instead of offering you $5 per bushel of corn today, a buyer offers you a contract that gives you the right, but not the obligation, to sell your corn for $5 a bushel when it is ready for harvest. For this right, the buyer charges you $200. In this case, you are insured against a future price drop below $5 per bushel. However, if the market price for corn is higher than $5 when your crop is ready for harvest, you can sell it for the higher price; thus, you insured yourself against downside risk without limiting your potential profits.