Hedging

Historically, futures market participants have been divided into two broad categories: hedgers, who seek to reduce risks associated with dealing in the underlying commodity or security, and speculators (including professional floor traders), who seek to profit from price changes. More recently, a new category of participant has emerged--the portfolio manager who uses futures and options as essential elements of portfolio management. For speculators, the attraction of futures markets includes their leverage, the diversification they add to a portfolio, the ease of assuming short as well as long positions, and the low cost of market entry and exit. Speculators and market-makers assume the risk transferred by hedgers and provide the liquidity that assures low transaction costs and reliable price discovery in futures markets.

Hedging is central to Futures and Options on Futures Markets, and a familiarity with hedging practices is necessary to understand how these markets work. In simplest terms, hedgers:

• Identify their price risk,

• Decide how much to hedge, and

• Decide where and how to hedge.

Examples of the types of risk - management activities that rely on the use of futures include:

• Stabilizing cash flows;

• Setting purchase or sale prices of commodities and securities;

• Diversifying holdings;

• More closely matching balance sheet assets and liabilities;

• Reducing transaction costs;

• Decreasing costs of storage; and

• Minimizing the capital needed to carry inventories.