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Hedging can be a valuable tool to minimize price uncertainty for producers. There are two types of hedges producers may use, a short hedge and a long hedge. Short hedges are used to lock in a net selling price when prices are expected to fall, while a long hedge is used to lock in a buying price when prices are expected to rise for a commodity that is bought and used as an input.
A short hedge is initiated by selling a contract on the futures market. The contract is generally bought back close to the time the contracted commodity is sold in the cash market. If the futures contract value decreases, money is made on the transaction. If the futures contract increases in value as time passes, money is lost on the transaction. The resulting gain/loss on the futures contract transactions offset changes in the cash market due to price changes for the commodity, resulting in the net amount paid or received being close to the expected price. The reason this works in deferring risk is that movements in the cash price generally reflect the futures price, with the difference defined as the basis. If basis behaves in a normal way, the actual payoff or net price received will be the same as the expected price. A long hedge is the reciprocal of the short hedge. A long hedge is initiated to protect the producer from the expectation of rising costs.