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For a grower, unexpected increases in wheat prices increase the value of the firm.

know what the size of the crop will be ahead of time. If the crop is larger than expected, then some portion of the crop will be unhedged. If the crop is small, then the grower will have to buy more to fulfill the contract and will thereby be exposed to the risk of price changes. Either way, there is some exposure to wheat price fluctuations, but, by hedging, that exposure is sharply reduced.

There are a number of other reasons why perfect hedging is usually impossible, but this is not really a problem. With most financial risk management, the goal is to reduce the risk to more bearable levels and thereby flatten out the risk profile, not necessarily to eliminate the risk altogether.

In thinking about financial risk, there is an important distinction to be made. Price fluctuations have two components. Short-run, essentially temporary, changes are the first component. The second component has to do with more long-run, essentially permanent, changes. As we discuss next, these two types of changes have very different implications for the firm.

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