A wheat producer and the wheat futures market are a classic example of protection. The farmer plants his seeds in the spring and sells his crop in the fall. In the meantime, the farmer is exposed to the price risk of wheat falling in the fall. While the farmer wants to make as much money as possible with his crop, he does not want to speculate on the price of wheat. So if he plants his wheat, he can also sell a six-month futures contract at the current price of $40 a bushel. This is called a forward hedge. Portfolio managers, individual investors and companies use hedging techniques to reduce their risk relative to different risks. However, in financial markets, coverage is not as simple as paying an annual insurance tax for an insurance company. Risks are an essential element, but a precarious element of investment. No matter what kind of investor you want to be, a basic knowledge of hedging strategies will increase awareness of how investors and companies work to protect themselves. Only if BlackIsGreen chooses to do delta-hedging as a strategy will real financial instruments for coverage (in the usual and stricter meaning) come into play. The best way to understand coverage is to consider it as a form of insurance.
When people decide to cover themselves, they insure themselves against the consequences of a negative event on their finances. This does not prevent all negative events from occurring. However, if a negative event occurs and you are properly protected, the impact of the event will be reduced. To protect against the uncertainty of agave prices, CTC may enter into a futures contract (or its less regulated cousin, the futures contract). A futures contract is a kind of hedging instrument that allows the company to buy the Agave at a certain price at a certain price at some point in the future. Now, CTC can budget without worrying about the fluctuation of Agave`s price. Another example of conventional coverage is a company that depends on a particular product. Suppose Corys Tequila Corporation is concerned about the volatility of the price of agave (the plant used to make tequila). The company would be in great difficulty if the price of the agave were to soar because it would severely affect its profits. For investors who fall into the buy-and-hold category, there seems to be little or no reason to know more about hedging. However, given that large companies and investment funds tend to engage in regular security practices and because these investors could follow or even participate in these large financial firms, it is useful to understand what hedging measures involve to better track and understand the actions of these larger players. Suppose six months pass and the farmer is willing to harvest and sell his wheat at the prevailing market price.
Indeed, the market price fell to only $32 a bushel. He sells his wheat for that price. At the same time, he redeemed his short-term contract at $32, generating a net profit of $8. So he sells his wheat for $32 plus $8 hedging profit – $40. He basically blocked the $40 price when he planted his crop. A hedging strategy generally refers to the general risk management policy of a company acting financially and physically, on how to minimize its risks. As the term «hedging» indicates, this risk reduction is generally achieved through the use of financial instruments, but a hedging strategy, as used by commodity traders and large energy companies, generally refers to an economic model (including financial and physical transactions). In practice, protection takes place almost everywhere. For example, if you take out homeowner`s insurance, you are prepared for fires, burglaries or other unforeseen disasters.