Hedging

Hedging is an investment strategy designed to offset a potential loss. In other words, hedging is investing to reduce the risk. Hedging against market price risk means to protect yourself from the adverse movements in prices by attaining a price lock. This is done by using offsetting contracts against the natural position you hold while hedging against credit risk.

Hedging can be done using derivatives, as the relationship between derivatives and their corresponding underlying is clearly defined in most of the cases. Other financial instruments like insurance, future contracts, swaps, options and many types of over-the-counter products are used to hedge.

Example

Let us assume company ABC produces corn flakes as a breakfast product to its consumers. Then for company ABC, fluctuations in the price of corn in the commodities market is a risk. Since company ABC is in a natural short position (since it is selling corn as corn flakes), it will have to make sure the price of the corn does not rise invariably during the process of procurement of corn. The company will enter into offsetting long contracts in the corn future market say at $400/bushel. Tomorrow, if the spot price of corn is $425/bushel, company ABC has successfully hedged this price variability by entering into long futures contract for its corn procurement. And if, the spot price is less than $400, say $375/bushel, still the company ABC will buy corn at $400/bushel since it has already entered into a future contract. Hence company ABC attained a price lock of $400/bushel.