Hedging Long Term Exposure

Price fluctuations can also be longer-run, more permanent changes. These result from fundamental shifts in the underlying economics of a business. If improvements in agricultural technology come about, for example, then wheat prices will permanently decline (in the absence of agricultural price subsidies!). If a firm is unable to adapt to the new technology, then it will not be economically viable over the long run.

A firm's exposure to long-run financial risks is often called its economic exposure. Because long-term exposure is rooted in fundamental economic forces, it is much more difficult, if not impossible, to hedge on a permanent basis. For example, is it possible that a wheat farmer and a food processor could permanently eliminate exposure to wheat price fluctuations by agreeing on a fixed price forever?

The answer is no, and, in fact, the effect of such an agreement might even be the opposite of the one desired. The reason is that if, over the long run, wheat prices were to change on a permanent basis, one party to this agreement would ultimately be unable to honor it. Either the buyer would be paying too much, or the seller would be receiving too little. In either case, the loser would become uncompetitive and fail. Something of the sort happened in the 1970s when public utilities and other energy consumers entered into long-run contracts with natural gas producers. Natural gas prices plummeted in later years, and a great deal of turmoil followed.

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