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What is the theoritical purpose of hedging?

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2014-10-31 13:35:47
2014-10-31 13:35:47

Hedging is a tool to reduce risk.

Companies hedge because currency and/or commodity values fluctuate. The hedge allows for a control valve on price changes. In the most simple sense:

A farmer is thinking about growing corn. He sees by the price of corn in the futures market that growing corn would generate a good profit, but what if the price changes between right now and when the corn is grown? He could "lose the farm." So he hedges. He calls his broker and sells corn on the futures market today (Sells Short.)

Three months later the corn has grown and he brings it to market, but the price has changed! Not to worry, he hedged. He receives $1 less per bushel due to the price change, BUT then he goes home and calls his broker and "Offsets" the hedge at the exchange resulting in a $1 per bushel profit. The exchange gain has offset the corn actual market loss, and the farmer has earned his expected profit. The hedge saved the farm.

This is the most common and simple hedge - A Sell Hedge.

Conversely, let's say you are an American Tequila Importer. In May you place an order for tequila, to be delivered in August. The manufacturer insists on being paid in Pesos. So in essence, in August you will need to take your dollars, and BUY (convert to) Pesos. But what if the price of the peso changes (Goes Up)? We could lose our potential profit! So we hedge. We go into the currency futures market and BUY August Pesos today. We are now long in the market, and "hedged". When August comes, if the actual pesos cost us more, we can offset the loss with our market profit. Inversely, if the pesos cost us less than we expected, we take that savings to pay off our market loss.

This is an example of a BUY Hedge.

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