The Long Hedge
If a food manufacturer (buyer) is expecting to purchase corn in several months’ time, that manufacturer may elect to buy (or go long) futures now, matching the quantity of physical corn he will buy in the “spot” or cash market later. If the price of corn rises significantly, the buyer will have locked-in a price (the amount he paid for the contract) that is (hopefully) lower than the current price of corn. If the buyer opts for delivery, the bushels of corn will be purchased and delivered at the price at which he purchased the futures contract(s). If the buyer decides to offset the futures contract prior to the delivery date, then the profit resulting from the appreciation of the futures contract may compensate for the rise in price of the physical corn which he will purchase in the cash market.
The Short Hedge
Let’s suppose that the price of corn were to significantly fall in several months’ time. For the farmer (the seller), this can mean a significant reduction of revenue from the impending sale. In anticipation of a reduction in corn prices, the seller can make a decision to sell futures contracts (a short position) matching the quantity of corn she is expecting to sell later in the cash market. Should the price of corn fall significantly, the farmer’s short position in the futures market will call for delivery of her corn at the price at which she sold her corn futures. If the farmer decides to offset her short position prior to the delivery date, then the potential loss in revenue due to the fall in physical corn prices may be offset by the profit accumulated in the short futures position.
A hedge is a type of investment aimed at mitigating the price risk of an underlying asset. The participants—buyers and sellers—who have a commercial interest in commodities and hedge against price risk in the futures markets are called hedgers.