Hedgers want to protect themselves against unfavorable price changes between the time they buy or sell a futures contract and the time when they will need to buy or sell the actual commodity on the cash market.
If the hedge works perfectly, they make up in one market what they lose in the other. But, of course, the perfect hedge seldom exists.
A corn farmer at planting time wants to hedge against the possibility that corn prices will drop below a certain price and provide no profit from the harvest. The farmer sells a corn futures contract at $2.80 per bushel. That's the preset price needed to guarantee enough revenue to cover planting and harvest costs and secure a profit.
If the price of corn rises to $2.85 per bushel, the farmer will lose 5 cents per bushel when buying the offsetting futures contract, but earn 5 cents more per bushel in the cash market when selling the actual corn. The 5-cent loss in the futures market is covered by the 5 cents of unexpected profit in the cash market. The farmer misses out on the favorable price change, but achieves the stability of a guaranteed price.
Futures market:
$2.80 - $2.85 = - $0.05
Cash market:
$2.85 - $2.80 = $0.05
Net gain/loss = $0
If the price of corn falls to $2.75 per bushel, the farmer will earn $0.05 per bushel when selling the offsetting futures contract, but lose $0.05 per bushel in the cash market when selling the actual corn. The $0.05 gain in the futures market is erased by the $0.05 loss in the cash market. But the farmer successfully protected against an unfavorable price drop between planting time and taking the corn to market.
Futures market:
$2.80 - $2.75 = $0.05
Cash market:
$2.80 - $2.75 = $0.05
$2.80 - $2.75 = $0.05
Similarly, in August, a textile company knows that it has orders pending for delivery in January that will require substantial cotton purchases in December. The textile company wants to hedge against the possibility that cotton prices will go up, increasing the price of producing textile to an unprofitable level. The textile company buys December cotton futures at 58 cents a pound.
If the price of cotton rises to 68 cents a pound, the textile company will earn a profit of 10 cents a pound when it sells the offsetting futures contract, but it will pay 10 cents a pound more for the actual cotton on the cash market. The 10 cents a pound gain on the futures market is erased by the 10 cents a pound higher price on the cash market, but the textile company successfully hedges against a rise in cotton prices.
Futures market:
68 cents - 58 cents = 10 cents
Cash market:
58 cents - 68 cents = -10 cents
Net gain/loss = 0
If the price of cotton falls to 48 cents a pound, the textile company will lose 10 cents a pound when it sells the offsetting futures contract, but it will pay 10 cents a pound less for actual cotton on the cash market than it budgeted for. The 10 cents a pound loss on the futures market is covered by the 10 cents a pound saved on the cash market. The textile company misses out on the favorable price change, but achieves the stability of a guaranteed price.
Futures market:
48 cents - 58 cents = -10 cents
Cash market:
58 cents - 48 cents = 10 cents
Net gain/loss = 0
Two notes
To keep the calculations of these examples clear and simple, they do not take into account commissions and other transaction costs, which apply regardless of whether the trader gains or loses. These costs are the price a hedger pays to protect against unfavorable price changes.
Further, the examples illustrate perfect hedges, where gains and losses offset each other exactly. In most cases, hedges do not eliminate all price risk. Among the reasons are that, while futures contracts are standardized in terms of size, delivery date, and product, a hedger's needs usually are not.
