Hedging
The word ‘Hedge‘ or ‘Hedging’ in the English Language means ‘to erect a railing or ‘fence’. As a farmer erects a railing of thorny bushes, to protect his fields, similarly a businessman entering into future transactions makes a special kind of contract called ‘Hedging Contracts’, to save him from the possible losses.
If a businessman makes a contract to buy a certain product in the future, he immediately enters into another contract to sell the same quantity of goods on the same date, with the object of saving himself from any loss, due to fluctuation in prices (i.e., on fall of prices) So that, the loss in purchase on one hand, is to be compensated by sale, on the other hand. Thus, it can be called a kind of insurance, which is used to safeguard against future risks. In modern produce exchanges, most of the transactions that take place are of such kind.
For Example – Ram sold 100 rolls of jute on 1st January 2012, whose payment is to be received on 1st May 2013. At present, the price of 1 roll of jute is Rs. 600. If the price of jute remains the same till 1st May 2013, then Ram will not bear any loss. On the contrary, if the price of rolls, rises or falls from Rs. 600, he may bear a loss or gain.
Suppose, the price of each roll on 1st May 2013 becomes Rs. 700, in that case, Ram will bear a loss of Rs. 100 per roll (because he had already contracted at Rs. 600 per roll to sell, on 1st January 2012), and if, the price of each roll falls to Rs. 500 on 1st May 2013, Ram will earn Rs. 100 per roll.
If, after contracting for the sale of 100 rolls, Ram feels that in this transaction he can suffer a loss of 100 rolls, then to protect himself from this risk, Ram can enter into a new contract, for the same date 1st May 2013, now to purchase (instead of sale) 100 rolls, which shall compensate the loss of the earlier contract. In this manner, he will be saved from a possible loss of 100 rolls. For big businessmen and speculators, these kinds of transactions are helpful in the prevention of risks and becoming profitable.