Hedging is the process of reducing the financial risks that either arise in the course of normal business operations or are associated with investments Hedging is one of the most important uses of financial markets, and is an essential part of modern industrial activity One form of hedging is insurance where, by paying a fixed amount (a premium), you can protect yourself against certain specified possible losses—such as losses due to fire, theft, or even adverse price changes—by arranging to be paid compensation for the losses you incur More general hedging can ar ise in the following way Imagine a large bakery. This bakery will purchase Hour (made from wheat) and other ingredients and transform these ingredients into baked goods, such as bread. Suppose the bakery wins a contract to supply a large quantity of bread to another company over the next year at a fixed price. The bakery is happy to win the contract, but now faces risk with respect to flour prices The bakery will not immediately purchase all the flour needed to satisfy the contract, but will instead purchase flour as needed during the year. Therefore, if the price of flour should increase part way during the year, the bakery will be forced to pay more to satisfy the needs of the contract and, hence, will have a lower profit, In a sense the bakery is at the mercy of the flour market. If the flour price goes up, the bakery will make less profit, perhaps even losing money on the contract. If the flour price goes down, the bakery will make even more money than anticipated
The bakery is in the baking business, not in the flour speculation business It wants to eliminate the risk associated with flour costs and concentrate on baking It can do this by obtaining an appropriate number of wheat futures contracts in the futures market Such a contract has small initial cash outlay and at a set future date gives a profit (or loss) equal to the amount that wheat prices have changed since entering the contract The price of flour is closely tied to the price of wheat, so if the price of flour should go up, the value of a wheat futures contract will go up by a somewhat comparable amount Hence the net effect to the bakery—the profit from the wheat futures contracts together with the change in the cost of flour—is nearly zero.
There are many other examples of business risks that can be reduced by hedging And there are many ways that hedging can be carried out: through futures contracts, options, and other special arrangements Indeed, the major use, by far, of these financial instruments is for hedging—not for speculation
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