Hedging comes in various forms. Grain merchants in the United States ensure buyers and sellers purchased the produce with a certain fixed future price resulting in forward contracts. This acted as a hedging instrument. But defaulting started to rise if the price moved unfavourably to either side. The issue was resolved by the establishment of the Chicago Board of Trade (CBOT) in 1848 which provided a centralised location for standard contracts to be traded. Since the advent of the exchange and development of technology the financial marketplace for hedging has grown immensely. Hedging has become an important topic for the overall risk management strategy of the organisation.
A company needs to buy cotton as a raw material – the company is exposed to the risk of price increasing at a certain future date i.e., commodity price risk on procurement. As a result, the company may decide to buy a plain vanilla call option to hedge this exposure for that tenor. As the prices are rising, they have to pay more for the cotton to the producer although this loss is offset by the gain, they will realise the long call option. Overall impact will be purchasing cotton at a certain price which the company had envisaged.
