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Hedging
Hedging means reducing or controlling risk. This is done by taking a position in the futures market that is opposite to the one in the physical market with the objective of reducing or limiting risks associated with price changes.
Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will be countered by changes in the value of a futures position. For instance, a wheat farmer can sell wheat futures to protect the value of his crop prior to harvest. If there is a fall in price, the loss in the cash market position will be countered by a gain in futures position.
How hedging is done?
In this type of transaction, the hedger tries to fix the price at a certain level with the objective of ensuring certainty in the cost of production or revenue of sale.
The futures market also has substantial participation by speculators who take positions based on the price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and futures remain correlated.
