What Is a Hedge Contract?

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. In simple language, a hedge is used to "hedge" the initial investment risk.

Hedging is the practice of taking a position in one market to offset potential losses or gains in another market. It prevents significant losses by reducing the risk that an unexpected move will cause a loss greater than the original investment. It generally involves using derivatives (options, futures, and swaps) or synthetic instruments (forwards, futures and swaps). Hedges can also be used to protect against currency fluctuations and other risks. 

A hedge contract is a type of derivative instrument similar to a forward contract, but with some important differences. A forward contract is an agreement between two parties to buy or sell an agreed quantity of a particular commodity at a set price on a given date in the future that allows the purchaser to fix their costs for the product or service, which can be useful if the price of the commodity increases and may provide a significant financial advantage to the buyer.

Hedge contracts can be used as a form of insurance against adverse changes in prices. As a result, they are often used by businesses as part of their risk management strategy and by commodity producers like farmers who have substantial assets in the form of crops that may decrease significantly in value if there is a bad harvest.

Forward Contract. This is a hedging tool that involves the sale of a certain commodity, currency, or security at a specified price to be delivered on a set date. The purpose of this forward contract is to mitigate risk for both parties involved. For example, let's say you own some oil wells in California and you worry about the price of oil dropping before you can make your next shipment. You could purchase a forward contract that would ensure that you get $100 per barrel for your shipment, regardless of the market value when you ship it.

Futures Contract. A futures contract is an agreement between two parties to buy or sell a commodity or financial instrument at a specific price at a specified time in the future or at an agreed-upon date in the future. The futures contract buyer is said to have taken a long position while the seller has taken a short position. This transaction aims to decrease risk by locking in the price before you actually need to buy or sell the commodity or financial instrument. Futures contracts are standardized, which allows them to be easily traded on exchanges. Both parties agree on the quality and quantity of what will be exchanged. Many commodities are traded on futures exchanges, such as agriculture, metals, and crude oil.