Concept
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This technique mitigates risk by moving it from one party to another. This is done on the theoretical basis that the risk-averse party is willing to pay the loss-covering party a premium. An example of this is an insurance policy whereby a party pays frequent premiums. These premiums are determined bytaking into account a variety of factors, such as:
•The size of the potential loss,•The likelihood of the loss occurring, and•The profile of the risk-averse party.
In financial markets, participants can use one or a combination of the four above mentioned techniques to manage their risk. However, it is important to be aware that each approach has its own intrinsic cost. For instance, risk avoidance may remove the risk of non-payment as you are either not involved in the product at all, or you are receiving interest repayments from an entity who will not default(e.g. US government treasury bills).
This, however, still comes at the cost of lower investment returns (lower risk means lower repayment because compensation for risk is lower), which in turn undermines the repayment value through the erosion of the value of money over time due to inflation. Hedging, on the other hand, has an element of speculation which brings with it uncertainty, and therefore even greater risk.
Fundamentally, there is no participant operating in the financial market context that can be completely removed from the effects of risk. The best they can do is to attempt to manage it to an acceptable degree.