Simple Hedging Strategies

Hedging can be traced to 350 bc to Greek merchants who initiated the first futures markets for olive harvests. Commodity futures are conceptually intuitive and it makes sense to use these markets to introduce the idea of hedging risk. Ranchers and farmers through antiquity have grappled with the uncertainty of future prices for livestock and produce when brought to market. Their risk lies in the possibility that market prices may fall between the present and some future date when they need to find buyers for their output. With futures markets, they could eliminate that risk by locking in prices today by selling their output forward, using futures. A livestock rancher, for example, may need to drive 1,000 head of cattle to a distant stock yard six months from now. He would like to hedge the risk that beef prices may fall in the interim by finding a counterparty (for example, a meatpacking company) that will agree today to buy those cattle at an agreed-upon price and take delivery in six months. Futures markets make this possible—the rancher, who has a long position in cattle today hedges price risk by selling cattle short in the futures market, that is, by selling (writing) a futures contract for future sale. The counterparty takes the other end of that contract; he is currently short cattle and therefore goes long by buying a futures contract agreeing to pay a fixed price when the contract expires and thereby locking in a buying price. It is possible as ...

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