Similarly, if a company is depended on a certain commodity for its production and fears that the price of the commodity is going to increase in future, it can reduce the loss of such outcome by getting into forward or future contracts. By doing so the company would be able to purchase the commodity at a set price at a future date. This would reduce the fear of fluctuating commodity price.Hedging in the financial markets is complicated and requires a good understanding of the derivatives instruments. Most widely used derivatives are options, futures and forwards. One can hedge against risks arising due to change in interest rate, commodity prices, stock prices, currency exchange rate fluctuation, credit risks and even weather changes. For a fund manager portfolio protection is as important as portfolio appreciation.
Although one might think that hedging would help in increasing the profits without any risk involved, the truth is, one should do the tradeoff between risk and return as lower risk means lower return. Hedging comes at a cost. The cost is the price of the derivative and the amount by which profits were reduced in the transaction. Hedging involves huge amount of money and so retail investors would like to hold on to their stock till the market bounces back. The active players in hedge are Institutional investors and the big fund houses which manages huge sum of money. Nonetheless, one should understand the use of hedging as risk minimization strategy.