Monday, August 24, 2009

Opening and closing a hedge

Suppose an agricultural firm produces a commodity such as wheat and is anticipating a decline in wheat prices. This unfavorable price movement can be hedged by selling futures contracts equal to the current value of the wheat. Sale of these contracts, which promise the future delivery of wheat days, weeks, or months from now, is called "opening a hedge." when the firm does sell its wheat, it can buy back the same number of futures contracts as it sold originally and "close the hedge."
Of course, the firm could deliver the wheat as specified in the original futures contracts. However, this is not usually done. If the price of wheat does decline as expected, then it costs the firm less to repurchase the futures contracts than it originally sold them for. Thus, the profit on the repurchase of wheat futures offsets the decrease in the price of wheat it self. The firm would have perfectly hedged itself against any adverse change in wheat prices over the life of the futures contract.
What would happen if wheat rose in price instead of declined? A perfect hedge would result in a profit on the sale of the wheat itself, but a loss on the futures contract. This happens because the firm must repurchase its futures contract at a higher price than its original cost due to the higher price for wheat.

No comments: