HEDGING, a method by which traders in commodities may partially or entirely insure themselves against loss from price fluctuations. The technique of hedging is the making at about tht same time of two contracts of an opposite though correspond ing nature ; one a genuine trade contract in a cash or "spot" market, with a view to obtaining a dealer's ordinary trade profit, the other an insurance or protective contract in the speculative or "futures" market which counteracts loss (and profit) on the first transaction through price fluctuations. In simpler terms, hedging is the offsetting of a cash transaction in a commodity by an opposite and corresponding future transaction ; one involves a purchase and the other a sale. Both involve the same amount of commodity.
The following example illustrates the execution of a simple "hedge" by a grain elevator in a local growers' market. A grain elevator operator in Walhalla, N.D., buys on Oct. 5, 5,00o bu. of No. i red winter wheat at $1.33 per bushel from a farmer who has delivered the wheat to the elevator, knowing that the cash price of this grade of wheat in Minneapolis, Minn., is $1.41, 8 cents more than he pays the farmer. This difference is represented by the elevator operator's estimate of a cost of 5 cents per bushel to pay the freight from Walhalla to Minneapolis, and by the neces sary margin for handling wheat of 3 cents per bushel. The purpose of hedging is to protect the trade profit in this case, a portion of the 3 cent margin. Conse luently, the elevator operator telegraphs a broker holding a membership on the Minneapolis Chamber of Commerce to execute on the exchange a sale of 5,000 bu. of wheat for delivery in December. The price of a December futures contracts on Oct. 5, in Minneapolis, is $1.45. The difference between the cash price of $1.41 and the December futures price of $1.45 is theoretically what the price difference should be to cover the cost (storing, insuring, etc.) of carrying the wheat from October to December. With the conclusion of the future sale on the Minneapolis exchange, the elevator operator has pro tected his cash wheat either entirely or partially from loss (and profit) because of price fluctuations. As soon, however, as the trade transaction is terminated by a cash sale, the future sale, at that moment a "short" sale, must also be terminated, i.e., covered by a purchase on the exchange. Both contracts are entered into at about the same time, and both must be terminated at about the same time if the hedger wishes to avoid pure speculation.
Hedging is actually a relatively imperfect form of price in surance because of its dependency upon a parallel movement of cash (spot) and future prices. In practice, the future price often runs at a discount under the cash (spot) price for long periods and the more distant delivery months of ten sell at a discount under the near months. Moreover, occasionally the future price may run at a premium over the cash (spot) price, a premium higher than is necessary to cover carrying charges. In such cases speculative losses and profits are possible. Hedging has reached its highest stage in the cases of wheat and cotton. It is used, how ever, in trading in rubber and in many other commodities, wher ever orgiized commodity exchanges permit future contracts under careful regulation.