What is Hedging?

To demonstrate how a hedge works, assume Hedger A buys, or longs, 5,000 bushels of corn, which is currently worth $2.40 per bushel, or $12,000=$2.40x5000; the date is May 1st and Hedger A wishes to preserve the value of his corn inventory until he sells it on June 1st. To do so, he takes a position in the [[futures]] market that is exactly opposite his position in the [[spot]] "current cash" market.

For example, Hedger A sells, or shorts, a July futures contract for 5,000 bushels of corn at a price of $2.50 per bushel. Put differently, Hedger A commits to sell in July 5,000 bushels of corn for $12,500=$2.50x5000. Recall that to sell (buy) a futures contract means to commit to sell (buy) an amount and grade of an item at a specific price and future date.

Absent basis risk, Hedger A's spot and futures markets positions will preserve the value of the 5,000 bushels of corn that he owns, because a fall in the spot price of corn will be matched penny for penny by a fall in the futures price of corn. For example, suppose that by June 1st the spot price of corn has fallen five cents to $2.35 per bushel. Absent basis risk, the July futures price of corn has also fallen five cents to $2.45 per bushel.

So, on June 1st, Hedger A sells his 5,000 bushels of corn and loses $250=($2.35-$2.40)x5000 in the spot market. At the same time, he buys a July futures contract for 5,000 bushels of corn and gains $250=($2.50-$2.45)x5000 in the futures market. Notice, because Hedger A has both sold and bought a July futures contract for 5,000 bushels of corn, he has offset his commitment in the futures market.

This example of a textbook hedge "one that eliminates price risk entirely" is instructive but it is also a bit misleading because: basis risk exists; hedgers may choose to hedge more or less than 100% of their cash positions; and hedgers may cross hedge-trade futures contracts whose underlying assets are not the same as the assets that the hedger owns. So, in reality hedgers cannot immunize entirely their cash positions from market fluctuations and in some cases they may not wish to do so. Thus, the purpose of a hedge is not always to avoid risk, but often to manage or even profit from it.