Taking on one risk to off set another is hedging. The some of the tools required for hedging are futures, forwards, and swaps. With options, it is called as derivative instruments because one value of asset depends on the value of another asset.
Futures were developed originally for agricultural commodities. For example, a farmer expects to have 100 tons of wheat to sell next September. If he is worried that the price may decline, he can hedge by selling 100 tons of September wheat futures at a price that is set today. Farmer has to make delivery. On the opposite a miller will buy wheat after the harvest. The miller agrees to take delivery of wheat in the future at a price that is fixed today without option. The farmer has hedged risk by selling wheat futures; this is termed a short hedge. The miller has hedged risk by buying wheat futures; this is known as a long hedge. The price of wheat for immediate delivery is known as the spot price. When the farmer sells wheat futures, the price that he agrees to take for his wheat may be very different from the spot price. But as the date for delivery approaches, a future contract becomes more and more like a spot contract and the price of the future snuggles up to the spot price. The farmer may decide to wait until his futures contract matures and then deliver wheat to the buyer. In practice such delivery is very rare, for it is more convenient for the farmer to buy back the wheat futures just before maturity. If he is properly hedged, any loss on his wheat crop will be exactly offset by the profit on his sale and subsequent repurchase of wheat futures.
Commodity and financial futures
Futures contracts are bought and sold on organized futures exchanges. Note that our farmer and miller are not the only business that can hedge risk with commodity futures. The lumber company and the builder can hedge risk with commodity futures. The lumber company and the builder can hedge against changes in...
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