Basic Assumption in Hedging
The basic assumption in hedging is that the cash and the future prices will change equally and in the same direction. This comparable movement is the factor which gives the protection from price changes. Because the loss in one contract is offset by a gain in another or vice versa. The cash and the future prices move together ( it is assumed as such ) because—
(a) the factors influencing one price tend to influence the other (for, the cash and future prices are determined by the twin forces of demand and supply) ; and
(b) there is the possibility of shifting from one market to the other.
Advantages of Hedging in Agriculture
Hedging affords advantages to the farmer, middlemen, manufacturer and the consumer. Let us discuss the advantages to each of them one by one. Advantages to farmers It has already been said that hedging is mainly practiced by middlemen, manufacturers or processors and the farmer (or grower) does not usually take direct part in it. But yet the benefits that accrue to the farmers from hedging should not be lost sight of. The farmers are benefitted from hedging in three ways:
(1) Some farmers who grow agricultural commodities in large quantities directly benefit from a reduction in the risk of price changes by engaging in hedging. Some of them are also benefitted by selling futures against stored crops or by selling futures in advance of the harvest.
(2) Hedging enables the farmers to receive higher prices for their commodities and such benefit arises from the hedging operations of the manufacturers and middlemen. This is possible because the dealer in grain, in order to avoid bankruptcy, “would put the risk upon the farmer, by paying him much less than what he expected to get as his selling price. The shifting of the risk of price changes to speculators, through the purchase and sale of contracts for future delivery, costs the party who seeks to shift this risk practically nothing outside of the commissions involved in buying and selling the future contracts. This is so, because the risk is assumed by speculators, who carry it for nothing, their only hope for profit lying in getting it out of one another‘.”
It is evident that without hedging, commodities could not be dumped on the market by the growers in so short a time as it is without enormous risks being run by those who buy it. When buyers can not adequately hedge against price drops, they have to discount the possible loss from the price changes in order to cover the larger risks to which they are exposed. They can bear these risks only by retaining a wide margin between the price they pay the grower and the selling price.
(3) Hedging is also practiced by many marketing co-operatives with farmers as members.
Advantages of Hedging to Middlemen and Manufacturers
(1) Hedging permits the merchants and others who deal in agricultural commodities to handle goods on narrower mar-gins because the risk of price changes can be shifted to the specialized risk-takers. By means of hedging they are able to transfer those risks to speculators who assume them with the hope of making profit from the very price changes the hedger wishes to avoid.
(2) Hedging enables the country buyer to operate on a narrower margin and hence to pay the farmer a higher price. Also, it enables the wholesaler in the central market to operate on a narrower margin and hence to pay the country buyer a higher price or to sell at a lower price to manufacturers.
(3) Hedging protects the dealer’s trade profit. The dealer decides to hedge because the price of cash grain may fall before he sells the grain and thus tries to protect his profit or, in other words, to avoid loss.
(4) Hedging enables the owner of commodities to procure finance from banks at lower rates. Banks do not usually like to make loan on unhedged commodities because speculative undertakings (i.e., unhedged transactions) tend to increase the risk to the bankers. Bankers in central market often require the merchants to whom they make loan to hedge their transaction when that is possible.
(5) Hedging is also affords benefits to the mail-order houses and chain stores. They find it advantageous to minimize risk on their inventories by hedging transactions.