Shedding Risks Through Hedging

One important function of speculative markets is to allow people to shed risks through hedging. Hedglag consists of reducing the risk involved in owning an asset or commodity by making a counteracting sale of that asset. Let’s see how it works. C r sider someone who owns a corn warehouse. She buys 2 million bushels of Kansas corn in the fall, s~ores it for 6 months, and sells it in the spring at a 1(kens per bushel profit, just covering her costs. . The problem is that corn prices tend to fluctuate. If the price of corn rises, she makes a large windfall gain. But if the price falls sharply, the decrease could completely wipe out her profits or even drive her into bankruptcy.

If the warehouse owner wants to earn her living by storing corn and wants to avoid .speculating on the price of corn, what can she do? The answer is that she can avoid all the corn-price risk by hedging her investments. The owner hedges by selling the corn the moment it is bought from the fanners rather than waiting until it is shipped 6 months later. Upon buying 2 million bush~ls of corn in September, she sells the corn immediately for delivery in the future at an agreed-upon price that will just yield a l(kents-per-bushel storage cost. She thereby protects herself against all corn-price risk. Hedging by making 1M counterpart sale allows businesses to insulate them sloes from 1 M risk of price changes .

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