It is the act of reducing uncertainty about future (unknown) price movements in a commodity (rubber, tea, etc.), financial security (share, stock etc.) and foreign currency. This can be done by undertaking forward sales or purchases of the commodity, security or currency in the forward market; or by taking out an option which limits the option holder’s exposure to price fluctuations.
Hedging shuns the risk of price change and look for ways to transfer it, while speculations assumes the risk of price change by taking one position (either long or short) in a market, and waiting for the price of their commodity to go in “their” direction. Hedging, on the other hand, has a position, either long or short, usually in the cash market, and attempts to limit the risk of price change loss by entering into an opposite and approximately equal position in another market (usually futures or options).
For instance, if a manufacturer of copper wires expects the copper prices to rise in the next three months, he will buy a position in the futures market at current prices to offset the likely price increase. Similarly, if the prices are likely to fall, he will sell in the futures market at current prices against the physical goods he holds.
Every large buyer, seller and processor of commodities needs to hedge against price volatilities throughout the year. Though seasonal price fluctuations can be anticipated, the intensity of volatility cannot be predicted. Besides, there are many factors other than the seasonality that cause price volatility. Therefore, there is constant need for hedging.
All large buyers, sellers and processors and users of commodities need to hedge because they all stand vulnerable to price volatility. They include: commodity producers, large consumers, manufacturers for whom a commodity is major raw material, processors of commodities, importers, exporters, traders and so on.
In case of futures, the party hedging would have to pay a margin – a percentage cost of the contract value (usually between 5-8%). For options, they would have to pay a premium, which is market-driven. Over and above this, a brokerage fee is due.
Hedging is generally not considered risky if it is based on covering short-term requirements. However, if the hedging party places a wrong bet, then they may miss out on potential savings. For instance, if a copper manufacturer has a capacity of 200 tons and decides to sell 300 tons on the futures exchange the remaining 100 tons is considered as speculation in the market. If prices fall then he stands to benefit, however if prices go up the 200 tons he produces can be delivered on the exchange but he would have to incur losses on the additional 100 tons.