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3 Dimensions of Risk Transfer: Hedging, Insuring and Diversifying (Differences Compared)

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One is said to hedge a risk when the action taken to reduce one’s exposure to a loss also causes one to give up of the possibility of a gain. For example, farmers who sell their future crops before the harvest at a fixed price to eliminate the risk of a low price at harvest time also give up the possibility of profiting from high prices at harvest time. So, they are hedging their exposure to the price risk of their crops.

Insuring means paying a premium (the price paid for the insurance) to avoid losses. By buying insurance, you substitute a sure loss (the premium you pay for the policy) for the possibility of a larger loss if you do not insure. For example, if you own a car, you almost surely have bought some insurance against the risks of damage, theft, and injury to yourself and others. The premium may be $1,000 today to insure your car for the next year against the potential losses stemming from these contingencies. The sure loss of $1,000 is substituted for the possibility of losses that can run to hundreds of thousands of dollars.

Diversifying means holding similar amounts of many risky assets instead of concentrating all of your investment in only one. Diversification thereby limits your exposure to the risk of any single asset.

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