In the practice of exchange trade one divides hedging and speculation. Hedging is the exchange protection against the unfavorable change in price, based on distinctions in the dynamics of costs of cash commodities and costs of futures contracts for the same commodity or prices on "physical" and futures markets.

Stock exchange speculation is the method of profit gaining in the process of exchange futures trade, based on distinctions in the dynamics of costs of futures contracts in time, space and on different types of commodities.

In political and economic sense, both hedging and stock exchange speculation are simply speculation, i.e. method of profit gaining, based not on the production, but on the difference in prices. Hedging and stock exchange speculation are two forms of speculation on the market, coexisting and complementing each other, but different at the same time. It is two sides of the same coin. Hedging is impossible without stock exchange speculation and vice versa.

Hedging on a stock exchange is carried out, as a rule, by enterprises, organizations, individual persons, who are simultaneously participants of cash commodities market: producers, processors, merchants.

The members of stock exchange are usually engaged in stock exchange speculation and those, who wish (usually individual persons) to play on the difference in the dynamics of costs of futures contracts.

On practice there is no strict differentiation between subjects, engaged in hedging, and subjects activity of which concerns stock exchange speculation, because the participants of cash commodities market are also engaged in stock exchange speculations, because in the market economy the main is profit gaining regardless of due to what exchange operations this aim is achieved.

Hedging pursues an aim – to compensate losses by means of an income, gained from realization on the cash commodity market.

On the whole the exchange trade for all organizations and persons, participating in this trade, is the special form of commercial activity with the aim of gaining the most income along with other existing forms of business. Hedging due to the double character, i.e. simultaneous support on the cost of cash commodity and on the cost of futures contract on the same commodity, has an important practical value. It provides indirect connection of stock exchange market of futures contracts with the cash commodity market.

Hedging executes the function of the stock exchange protection from price losses on the cash commodity market and provides compensation for some expenses (for example, on storage of commodities). The hedging technique is as follows. The seller of available commodity, striving to protect himself against the supposed price reduction, sells the futures contract on this commodity on a stock exchange (hedging by sale). In case of price dropping he buys the futures contract back, a price on which has dropped also, and gains profit on the futures market that has to compensate the profit he did not receive on the cash commodity market.

Example 1

A seller gained from the sale of commodity (80 units) and from the futures (20 units) in the end, i.e. that sum of profit, which he expected to gain as of January, 1 (100 units).

The buyer of cash commodity is interested not to sustain losses from a price increase on a commodity. Therefore, supposing that prices will grow, he buys the futures contract for this commodity (hedging by purchase). In case if a tendency is guessed, a buyer sells his futures contract, the cost of which has also grown in connection with a price growth on the cash commodity market, and compensates his additional expenses for purchase of cash commodity.

Example 2

The expenses of a buyer on the cash commodity market (120 units) due to the gained profit from the futures trade (20 units) did not exceed the sum of expenses, planned by him as of January, 1 (100 units).

Both given examples expose the essence of protection function of hedging.

We will give two examples more (see examples 3, 4), illustrating the technique of hedging.

   Example 3. Hedging by sale of futures contract ("short hedge")

Enterprise produces a commodity (for example, aluminium) and sells it. A current price on the cash market satisfies an enterprise, but it is assumed that in 3 months a price can drop and then a commodity will become unprofitable. To protect from the possible price dropping, an enterprise sells a three months futures contract for supply of aluminium. We will suppose that a forecast has authorized. Prices on the cash and futures market have reduced.

In 3 months an enterprise sells its commodity on the cash market and buys back the futures contract on a stock exchange.

   Cash market

Price as of May, 1 – $1000 000 per commodity unit.
Price as of July, 25 – $800 000 per commodity unit.
1. An enterprise sells produced by this time commodity at a price of $800 000 per commodity unit.

   Futures market

Price as of May, 1 of futures contract – $1050 000 per commodity unit.
1. An enterprise sells a three months futures contract at price $1050 000 per commodity unit.

Price as of July, 25 of futures contract – $850 000 per commodity unit.

2. An enterprise buys an analogical three months futures contract for $850 000 per commodity unit.

  Hedging results

Profit on the cash commodity market equals $800 000 per commodity unit.

Income on the futures market equals $200 000 ($1050 000 – $850 000) for every commodity unit.

Total profit of enterprise equals $1000 000 ($800 000 + $200 000) for every commodity unit.

Conclusion. In spite of market price dropping on a commodity, enterprise, having carrying out hedging on the exchange futures market, realized for every commodity unit in $1000 000, i.e. got a price which suits an enterprise.

   Example 4. Hedging by purchase of futures contract ("long hedge")

A mill enterprise buys wheat and produces flour. A current price on the cash market of grain satisfies a mill enterprise, but it is assumed that in 3 months a price on grain can rise and then the production of flour will become unprofitable. To protect from the possible increase of price on grain, an enterprise buys the three months futures contract on wheat. We will suppose that a forecast has authorized. Prices on cash and futures markets grew. In 3 months an enterprise buys wheat on the cash market at new price and sells its futures contract.

   Cash market

Price as of February, 1 – $1000 000 per commodity unit.
Price as of April, 25 – $1100 000 per commodity unit.
1. An enterprise buys wheat at a price $1100 000 per commodity unit.

   Futures market

Price as of February, 1 of futures contract – $1050 000 per commodity unit.
1. An enterprise buys the three months futures contract at a price $1050 000 per commodity unit.
Price as of April, 25 of futures contract – $1150 000 per commodity unit.
2. An enterprise sells this futures contract at a price $1150 000 per commodity unit.

Expenses on the cash commodity market – $1100 000 per commodity unit.

Income on the futures market totals $100 000 ($1150 000 – $1050 000) for every commodity unit.

Total expenses for wheat buy equal $1000 000 ($1100 000 – $100 000) for every commodity unit.

Conclusion. In spite of market price increase for wheat, a mill enterprise, having carried out hedging on the exchange futures market, spent $1000 000 for each commodity unit, i.e. provided itself with the normative level of expenses.

The use of mechanism of futures trade, as it follows from the given examples, allows sellers to plan their return, and income also, and buyers – expenses. In practice it is difficult to guess a price change for the long-term period. Dynamics of prices of cash commodity and futures markets do not coincide; therefore, as a rule, hedging does not cover all mass of produced exchange commodities.

There are different forms (methods) of hedging depending on who is its participant and for what aim it is carried out. Hedging can be conducted: on all cash commodity or on its part: on a present cash commodity or commodity, lacking at the moment of conclusion of the futures contract; on combination of different dates of supplies and execution of futures contract etc.

Hedging allows getting an additional income. A middle difference between the price of cash commodity and futures contract for the proper month of delivery is a "basis" and depends from charges on storage and other difficult to predict factors. In case of hedging a seller of commodity, wishing to gain additional income, should strive to sell the futures contract on his commodity at price, exceeding relevant market price of cash commodity per size of basis.

If a basis will reduce in future, hedger (i.e. that, who carries out hedging) wins, because either a price growth on the futures market falls behind a price growth on the cash market or price dropping on the futures market passes ahead a price dropping on the cash market. In case of basis increase hedger-seller loses. The buyer of commodity, wishing to gain an additional income, bases in his prognoses on other change of basis, i.e. at its growth hedger wins, and at basis reduction – loses.

In the indicated variants the final price for hedger equals his target price plus the change of basis.
Fp = Tp + B
where Fp – final price for hedger;
Tp – target price for hedger;
B – basis change.

If hedger is a seller, he will have an additional income in case when the target price will be higher than a target one. It is possible at basis reduction.

The participants of exchange trade carry out their activity on many directions at once, using all available types of futures contracts, options and their combinations. Thus there is exchange price protection in general, i.e. protection from prices’ changes for futures contracts, options etc., but not protection related to the price change on the cash commodity market. In this sense not only owners of cash commodity start to be engaged in hedging but exchange speculators also, and therefore distinctions between hedging and exchange speculation are erased. Hedging is carried out with the aim of providing of additional income gaining from exchange transactions, and exchange speculation grows into the form of hedging.