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hedging an agricultural commodity price
a typical hedger might be a commercial farmer. the market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that: forecasts. once the farmer plants wheat, he is committed to it for an entire growing season. if the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined.
if the farmer sells a number of wheat futures contracts equivalent to his crop size at planting time, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. he has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. he no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.
[edit]hedging a stock price
a stock trader believes that the stock price of company a will rise over the next month, due to the company's new and efficient method of producing widgets. he wants to buy company a shares to profit from their expected price increase. but company a is part of the highly volatile widget industry. if the trader simply bought the shares based on his belief that the company a shares were underpriced, the trade would be a speculation.
since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares × price) of the shares of company a's direct competitor, company b.
the first day the trader's portfolio is:
long 1,000 shares of company a at $1 each
short 500 shares of company b at $2 each
(notice that the trader has sold short the same value of shares.)
if the trader was able to short sell an asset whose price had a mathematically defined relation with company a's stock price (for example a call option on company a shares), the trade might be essentially riskless. but in this case, the risk is lessened but not removed.
on the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. company a, however, because it is a stronger company, increases by 10%, while company b increases by just 5%:
long 1,000 shares of company a at $1.10 each: $100 gain
short 500 shares of company b at $2.10 each: $50 loss
(in a short position, the investor loses money when the price goes up.)
the trader might regret the hedge on day two, since it reduced the profits on the company a position. but on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. nevertheless, since company a is the better company, it suffers less than company b:
value of long position (company a):
day 1: $1,000
day 2: $1,100
day 3: $550 => ($1,000 − $550) = $450 loss
value of short position (company b):
day 1: −$1,000
day 2: −$1,050
day 3: −$525 => ($1,000 − $525) = $475 profit
without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling company b's shares to buy company a's shares as well). but the hedge – the short sale of company b – gives a profit of $475, for a net profit of $25 during a dramatic market collapse.
[edit]hedging fuel consumption
main article: fuel hedging
airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel. they know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. by using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), southwest airlines was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the u.s. rose dramatically after the 2003 iraq war and hurricane katrina.
[edit]types of hedging

the stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. as investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly.
[edit]hedging strategies
examples of hedging include:
forward exchange contract for currencies
currency future contracts
money market operations for currencies
forward exchange contract for interest (fra)
money market operations for interest
future contracts for interest
this is a list of hedging strategies, grouped by category.
[edit]financial derivatives such as call and put options
risk reversal: simultaneously buying a call option and selling a put option. this has the effect of simulating being long a stock or commodity position.
delta neutral: this is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. this is also a type of market neutral strategy.
[edit]natural hedges

many hedges do not involve exotic financial instruments or derivatives such as the married put. a natural hedge is an investment that reduces the undesired risk by matching cash flows, i.e. revenues and expenses.
for example, an exporter to the united states faces a risk of changes in the value of the u.s. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. another example is a company that opens a subsidiary in another country and borrows in the local currency to finance its operations, even though the local interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the local currency, the parent company has reduced its foreign currency exposure. similarly, an oil producer may expect to receive its revenues in u.s. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in u.s. dollars.
one of the oldest means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.
[edit]categories of hedgeable risk

for the following categories of risk, for exporters, that the value of their accounting currency will fall against the value of the importers, also known as volatility risk.
interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. interest rate risks can be hedged using fixed-income instruments or interest rate swaps.
equity: the risk (or sometimes reward), for those whose assets are equity holdings, that the value of the equity falls.
securities lending: hedged portfolio stock secured loan financing is a form of individual portfolio risk reduction that typically results in a limited recourse loan.
futures contracts and forward contracts are means of hedging against the risk of adverse market movements. these originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.
[edit]hedging credit risk

credit risk is the risk that money owing will not be paid by an obligor. since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate. (see forfeiting, bill of lading, factoring, or discounted bill.)