Learn with ETMarkets: What is Hedging?

Hedging is the act of managing the risk of possible adverse price movements, by using derivatives. Though one can hedge using several types of derivatives instruments, exchange-traded futures or options are most popular.

HOW DOES ONE HEDGE WITH FUTURES?
For hedging using futures, the hedger can take a position in the futures market and lock-in prices. For instance, a cotton farmer who faces the risk of fall in price after harvest, can hedge by selling cotton futures much ahead of harvest. The prevailing price at which he enters the market will become the effective price irrespective of which way the price moves later. Similarly, a copper procuring firm, facing the risk of a possible rise in prices, can hedge by buying copper futures and locking-in the metal’s effective price. In each case, the hedger can exit the market by either actually selling/ buying the commodity in/from the exchange-accredited warehouse, or financially settling by taking the reverse position. Whatever be the choice, the hedger’s effective price is locked-in at the time he entered the futures market.

HOW DOES ONE HEDGE USING OPTIONS?
The hedger facing the risk of a fall in price (like the cotton farmer) can buy a ‘put’ option. Similarly, one (like the copper buyer) can hedge against possible a rise in price by buying a ‘call’ option. An option gives the holder the right (but not the obligation) to buy/ sell at a pre-determined price.

PRODUCTS AVAILABLE FOR HEDGING…
Currently, there are futures on a number of commodities available for hedging on Indian exchanges — in agriculture (cotton, crude palm oil, refined soy oil, chana, maize, etc.) metals (copper, zinc, aluminium, etc.), bullion (gold and silver) and in energy (crude oil and natural gas). Indian exchanges also offer options on many of these commodities.

WHO ARE THE COUNTERPARTIES TO THE HEDGERS?
Hedgers enter the commodity derivatives market to shed their risk exposure; their counter-parties are all those who participate to make a profit. Hence, in a way, counter-parties to hedgers absorb the risk that hedgers want to shed.





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