Hedging is used in banking, exchange and commercial practice for designation of various methods of insurance of currency risks.
So, in the book Dolan E. Dzh., etc. "Money, banking and monetary policy" this term is given the following definition:
Hedging - the system of the conclusion of terminal contracts and transactions considering changes of exchange currency rates probabilistic in the future and pursuing the aim to avoid adverse effects of these changes".
In domestic literature the term "hedging" began to be applied in a broader sense as risks insurance from the adverse changes in price for any inventory items under the contracts and commercial transactions providing deliveries (sale) of goods in future periods.
The contract which serves for an insurance from risks of change of rates (prices) carries the name "hedge".
The economic entity performing hedging is called "hedger".
There are two transactions of hedging: hedging on increase and hedging on lowering.
Hedging on increase, or hedging by purchase, represents exchange operation on purchase of terminal contracts or options.
Hedge on increase is applied when it is necessary to be insured from possible price increase (rates) in the future.
It allows to establish purchase price much earlier, than the real goods were purchased.
We will assume that the goods price (currency rate or securities) in three months will increase, and the goods will be necessary in three months. For compensation of losses from expected increase in prices it is necessary to purchase at today's price the terminal contract connected with these goods now and to sell it in three months while the goods are purchased. As the price of goods and of the related terminal contract changes in proportion in one direction, the contract purchased earlier can be sold more expensively almost on as much on how many the goods price will increase by this time.
Thus, the hedger performing hedging on increase insures himself against possible price increase in the future.
Hedging on lowering, or hedging by sale is an exchange transaction with sale of the terminal contract.
The hedger performing hedging on lowering assumes to make in the future sale of goods and therefore, selling the terminal contract or the option at the exchange, it insures itself(himself) against possible reduction of prices in the future.
We will assume that the goods price (currency rate, securities) in three months decreases, and the goods will need to be sold in three months.
For compensation of expected losses from reduction of price the hedger sells the terminal contract at high price today, and at sale of the goods in three months when the price of it fell, buys the same terminal contract on reduced (almost so) the price.
Thus, hedge on lowering is applied when the goods need to be sold later.
The hedger seeks to reduce the risk caused by uncertainty of the prices in the market by means of purchase or sale of terminal contracts.
It gives the chance to record the price and to make income or expenses more predictable. At the same time the risk connected with hedging does not disappear.
It is undertaken by speculators, i.e. entrepreneurs taking the certain, in advance calculated risk.
Speculators in the market of terminal contracts play a large role.
Assuming risk in hope for profit earning at a game on a difference of the prices, they carry out a role of the stabilizer of the prices.
Upon purchase of terminal contracts at the exchange the speculator brings a guarantee fee by which the size of risk of the speculator is defined.
If the goods price (currency rate, securities) decreased, then the speculator who purchased earlier the contract loses the amount equal to a guarantee fee.
If the price of goods increased, then the speculator returns himself the amount equal to a guarantee fee, and gains an additional income from a difference in the prices of goods and the purchased contract.