Hedge (finance)

In finance, a hedge is a position established in one market in an attempt to offset exposure to the price risk of an equal but opposite obligation or position in another market — usually, but not always, in the context of one's commercial activity. Hedging is a strategy designed to minimize exposure to such business risks as a sharp contraction in demand for one's inventory, while still allowing the business to profit from producing and maintaining that inventory. A typical hedger might be a farmer with 2000 acres of unharvested wheat in the ground, who would rather tend his crop without the distraction of uncertain prices. He's a farmer, not a speculator, yet his unharvested "inventory" may have lost 35% of its value ($285,000) in the three months he's been planning his planting. He might have decided he could live with a price of only eight or nine dollars a bushel, and to offset his planted position with an approximately equal but opposite position in the market for wheat on the Minneapolis Grain Exchange by selling ten wheat futures contracts for December delivery. This farmer is thereby a hedger indifferent to the movements of the market as a whole, and has reduced his price risk to the difference between the price he will receive from a local buyer at harvest time, and the price at which he will simultaneously liquidate his obligation to the Exchange. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis,"^[1] where the basis is the difference between today's market value of (in this example) wheat and today's value of the hedge. If that difference widens, he earns a little more at harvest time. If that difference narrows, he earns a little less. He has mitigated, but not eliminated, the risk of losing the value of his wheat as of the day he established his hedge.