'Hedging' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
In the world of finance, hedging is the act of putting together a hedge. Hedging involves building up a position in one market whose goal is try to counteract risk from changes in price in another market’s position that is the opposite. The ultimate goal is to diminish or eliminate the business or person’s possibilities of risk that they wish to avoid. A number of specific vehicles exist to help with hedging. These typically include forward contracts, swaps, insurance policies, options, derivatives, and products sold over the counter. Futures contracts prove to be the most popular version of hedging instruments.
In the 1800’s, futures markets open to the public came into existence. These were set up to permit a standardized form of effective, viable, and open hedging of commodity prices in agriculture. In the intervening century, these have grown to include all manners of futures contracts that allow individuals and businesses to hedge precious metals, energy, changes in interest rates, and movements in foreign currencies.
There are countless examples of individuals who might be interested in hedging. Commercial farmers are common types of people who practice hedging. Prices for agricultural crops like wheat change all the time as the demand and supply for them fluctuates. Sometimes these price changes are significant in one direction or the other. With the present prices and crop predictions at harvest time, a commercial farmer might determine that planting wheat for the season is smart.
The problem that he encounters is that these predicted prices are simply forecasts. After the farmer plants his wheat crop, he has tied himself to it for the whole growing season. Should the real price of wheat soar in between the time that the farmer plants and harvests his crop then he might make a great amount of money that he did not count on, yet should the real price decline by the time the harvest is in then the farmer might be ruined completely.
To remove the risk from his wheat crop equation, the farmer can set up a hedge. He does this hedging by selling a certain quantity of futures contracts for wheat. These should be sold at an amount equal to the wheat crop size that he expects when he plants it. In such a way, the commercial farmer fixes his price of wheat at planting time. His hedging contract proves to be a pledge to furnish a particular quantity of wheat bushels to a certain place on a fixed date in time at a guaranteed price. Now the farmer is hedged against changes in the prices of wheat. He does not have to worry anymore about the wheat prices and whether they are falling or rising, since he has been promised a fixed price in his hedging wheat futures contract. The possibility of him being totally ruined by falling wheat prices is completely removed from the realm of possibility. At the same time, he has lost the opportunity of realizing extra money as a result of rising wheat prices when harvest time arrives. These are the upsides and the downsides to hedging; both the positives and the negatives of uncertainty are eliminated.
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