Thread: Hedging

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Hedging - October 19th, 2010

A hedge is a position established in one market in an attempt to offset exposure to price fluctuations in some opposite position in another market with the goal of minimizing one's exposure to unwanted risk. There are many specific financial vehicles to accomplish this, including insurance policies, forward contracts, swaps, options, many types of over-the-counter and derivative products, and perhaps most popularly, futures contracts. Public futures markets were established in the 1800s to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.

Even options can be used as hedging toll for example, options are used to lock a price, at which one can buy or sell the underlying commodity, but has the choice to let the contract expire if the price movement is not to one’s satisfaction, unlike in futures contract.

Illustration: A wheat farmer from Gujarat expects his harvest in three months time. In order to lock the price at which to sell, he can buy a put option to sell wheat at Rs. 5 per Kg. Assuming that the size of the contract for wheat (commodity options in a certain exchange is 10,000 Kg.), the contract size will be Rs. 50,000 and the premium would be say Rs.1000. Now, when the harvest takes place, if the price of wheat falls to Rs.3 per Kg., the farmer has the right to deliver his crop at Rs.5 per Kg.; but if the price of wheat has risen to Rs.7 per Kg’s., the farmer may let the contract expire and sell the wheat in the open market, but foregoing a loss of Rs. 1000, which is the premium he paid to the writer of the option.

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