-This is a risk reducing strategy of taking offsetting positions in the ownership of a derivative security and an underlying asset.
-A hedge is a transaction that limits the risk associated with market price fluctuations for a particular investment position.
It uses a futures contract (or an option) to offset risk exposure in the cash market.A futures contract is a standardized contract, traded on an organized exchange, to buy or sell a fixed quantity of a defined commodity at a set price in the future.
Hedging can also be achieved using forward contracts i.e. a contractual agreement between two parties to exchange a commodity at a set price in the future.
-The different between future contracts and forward contracts are that forward contracts are not actively traded on an organized exchange (not in standardized goods) and also one party may break the agreement (has risk). In contrast, futures contracts do not carry such performance risk because they are guaranteed by the exchange on which they are traded.
-Futures and forward contracts create the legal obligation for the buyer (or seller) to purchase (or sell) the goods specified in the contract at the agreed upon price at some future point in time. Goods involved are minerals, agriculture goods, TBs, bonds, forex, stock etc.
An option gives the buyer the right but not the obligation, to either buy or sell the underlying commodity.
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