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Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)

Reduced to its simplest terms, a form of insurance used among traders or dealers in grain, cotton, foreign exchange, or securities, to prevent loss through price fluctuations.  It is not speculation, but the avoidance of speculation.  Hedging is the process of protecting one transaction by means of another, and in the commodity markets takes the form of selling a  FUTURES contract in an amount equivalent to necessary cash purchases.  The process of hedging is based on the theory that the spread between a cash commodity and its futures is constantly uniform - that is, futures prices should be higher than cash prices by an amount representing the cost of storage, insurance, etc., from the time of the transaction until the arrival of the futures month.  Hedging in grain is commonly practiced by elevator companies, millers, and exporters.  Foreign exchange bankers, brokers, and dealers also practice hedging - the selling by one who is "long" and the buying by one who is "short" of an equal amount of the item dealt in.  Thus a person who hedges is in a neutral position:  he is committed to both "long" and "short" contracts for an equal amount.

A typical illustration of hedging is that practiced by a flour mill.  Suppose a miller has contracts to deliver to customers 4,000 barrels of flour a week for the next six months at a stipulated price.  This output will require approximately 470,000 bushels of wheat, more than even the largest miller can carry in stock.  It represents a value, moreover, that if purchased at, say, $4.50 a bushel, earns an investment of $2,115,000.  Should the wheat decline only $0.01 a bushel, a loss of $47,000 is involved.  This risk is so great that millers as a class cannot afford to take it.  Millers are not speculators but are in the business of milling and derive their profits from milling operations, not through price fluctuations.  To avoid assuming this risk, therefore, the miller sells in the futures market an equal amount of wheat, distributing his futures sales contracts to mature at times when he will need to buy cash wheat to fill his flour contracts.  In other words, as fast as he buys cash wheat from samples that meet his milling requirements, he sells an equal amount of futures contracts at a stipulated price.  Instead of actually making delivery on the futures contracts, however, millers usually sell their futures contracts to professional speculators or others who may want wheat at the delivery time on the futures.  In case the price of wheat goes up, the miller has made a profit on his holdings of cash wheat.  This profit, however, is offset by the necessity of having to pay a higher price when he covers his contract on delivery date.  What he gains in the cash transaction is lost in the futures transaction.  On the other hand, if the price declines, the loss on his holdings of cash wheat is offset by having to pay a lesser price when he covers his contract on the delivery date.  Thus, whether the price rises of falls, the hedger gains (or loses) as much on his cash contracts as he loses (or gains) on his futures contracts.

A person who is "long" in stocks may also hedge.  The hedging short sale, for example, may be used for this purpose.  Suppose one owns 100 share of U.S. Steel purchased at 25.  The price has declined to, say, 24, and the outlook indicates a still greater decline.  By selling 100 shares short, with the intention of subsequently buying ("covering") at lower price, one hedges.  Thus if the stock declines to 20, the hedger covers at a 4-point profit, thus offsetting most of the loss on his original purchase.  If the stock should instead rise, to, say, 30, the hedger can cover his short sale by delivering his original purchase without loss of the transaction.  Or, similarly, a hedge against a possible market decline, may be accomplished by the purchase of a put, entitling the holder to sell 100 shares of U.S. Steel at 25 to the maker of such put for a specified period of time.  Should the decline eventuate as expected, to, say, 20, the put may be exercised within its duration at the put price of 25.

Contrary to popular impression, hedging, therefore, whether in commodities, foreign exchange, or securities, is the very opposite of speculation, as it is undertaken for the purpose of protecting against risk of price change.

Banks use interest rate futures to hedge a portfolio security.  If interest rates rise, the price of the security falls.  The loss will be offset by delivering the security at the price specified in the futures contract or by purchasing back the future at a lower price prior to the specified delivery date.  Fixed-rate liabilities can be hedged by buying futures.  A six-month CD can be turned into a three-month CD by buying a three-month CD future.  Financial futures hedging strategies can protect against unfavorable interest rate movements by locking in a certain position.  This strategy also prevents the bank from benefiting from favorable movements in interest rates.  Regulatory approval is not required before a bank enters into futures transactions; approval of the bank's board of directors is usually sufficient.  The board would normally be interested in having problems or opportunities identified, financial risks quantified, alternative courses of actions and their consequences identified, and operating, control, and record-keeping procedures for financial futures explained for purposes of review.


ANDERSEN, T.J.  Currency and Interest-Rate Hedging.  New York Institute of Finance, New York, NY, 1978.

BARKER, B.  "Hedging Techniques for Interest Rate and Currency Risks."  Banking and Finance Law Review, October 1988.

KRAMER, S.L., and others.  Options Hedging Handbook.  Center for Futures Education, Spring Mill, PA, 1985.

MCKENZIE, J.L., and SCHAP, K.  Hedging Financial Instruments.  Probus Publishing Co., Chicago, IL, 1988.

NODDINGS, T.  Superhedging.  Probus Publishing Co., Chicago, IL, 1986.

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