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hedging with financial derivates in
the oil business
Hedging is a technique designed to eliminate or reduce risk.
Derivatives allow risk about the price of the underlying asset to be transferred
from one party to another. For example, a wheat farmer and a miller could sign a
futures contract to exchange a specified amount of cash for a specified amount
of wheat in the future. Both parties have reduced a future risk: for the wheat
farmer, the uncertainty of the price, and for the miller, the availability of
wheat. However, there is still the risk that no wheat will be available because
of events unspecified by the contract, like the weather, or that one party will
renege on the contract. Although a third party, called a clearing house, insures
a futures contract, not all derivatives are insured against counterparty risk.
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