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Among the institutions which have been developed to aid the business man in avoiding the risks incident to our roundabout time-consuming methods of production and distribution, one of the most interesting is the system of shifting the risks of price changes, which is made possible through the use of the futures markets for "hedging" purposes. A hedging transaction may be defined as a coincident purchase and sale in the two markets, which are expected to behave in such a way that any loss realized in one may be offset by an equivalent gain in the other.
 As applied in the grain and cotton futures market, the term "hedging" refers to one of two types of transactions. The first, the hedging sale, arises when a country grain dealer, a terminal buyer, a miller, or an exporter buys grain in the cash market and sells futures contracts of an equivalent amount, as protection against a fall in price during the time that the grain is in his possession. The second, the hedge purchase, arises when a manufacturer has sold his product ahead at a fixed price and buys futures to protect himself against an advance in the price of raw material. The idea is that if the price of cash grain declines a similar decline will probably occur in the futures market, and the loss realized on the one transaction will be offset by a gain realized on the other. It goes without saying that such a protection cannot be obtained without giving up the chances of a profit from a price fluctuation in the opposite direction. Since the hedging transaction involves some costs for commissions, taxes, interest on margins, etc., it is clear that the average result of a long series of such trades should normally be a slight loss, but this loss is regarded as a premium paid for insurance against the risk of such heavy losses in an unfavorable season, as would disrupt the business and prevent its continuance through the long run, in which gains and losses from price changes could be expected to balance.
The question may arise, why any individual would engage in transactions of such a character that the chances of loss and the chances of gain offset one another. The answer is that in changing grain from country points to terminal markets, in milling, in jobbing flour, and in other operations incident to the production and distribution of grain production, the trade or manufacturing profit can be expected under ordinary conditions of competition without reference to any gain or loss from price changes. The hedge enables the operator to make his price and regulate his business on the basis of his ordinary trade profit, without the possibilities of speculative loss or gain which arises from the instability of prices. It is impossible to carry on such operations as these without owning grain or its products through a certain period of time, but the hedge enables the operator to isolate the ordinary risks of competition from the special risks, which arise from the instability of prices of the commodities in which he is dealing.
Several advantages result from such a separation. For one thing, the amount of credit which the grain or other operator can secure is much greater. This is true because the protection afforded a bank by the use of warehouse receipts for grain as collateral is much stronger, in case the owner is protected against loss by hedging contracts. The principle is the same as that involved in the custom by which the mortgagors are required to keep property insured for the benefit of mortgagees. In the second place, the use of the hedging contract makes it possible to do business on a much smaller margin of profit. Where hedging contracts are not available, commodities must be handled on a wide enough margin to compensate for the risk of adverse price changes. When the protection of the hedging contract is available, competition ordinarily brings about a narrowing of the profit margin in accordance with the reduced amount of risk. This is of no financial advantage to the grain dealers as a class, but makes it possible for consumers to receive the benefit of lowered prices, or grain producers to receive the benefit of higher prices, or for both these things to take place, and it also makes the grain dealers' business less speculative.
It is clear that the gains from the practice of hedging are entirely due to the reduction of uncertainty, and not to any reduction in the probability of the unfavorable contingency against which protection is sought. Whenever a man saves himself from loss by hedging through the futures market, someone has to lose to keep him even. The question therefore arises whether the total amount saved by hedgers as a group on transactions, where they would otherwise incur loss, is greater or smaller than the profits they lose in cases where the market moves in their favor. The theory generally accepted among economists is that the speculators who buy and sell hedges to grain dealers, millers, and other tradesmen are specialists in the art of discounting the future, more expert than those with whom they are dealing, and that hedgers as a class, therefore, lose something in the long run to the speculators as a class. This loss constitutes the compensation of the speculators for the service of reducing trade risk, and from the standpoint of the grain trader, should be figured like his commissions, as a premium paid for insurance against risks too great to be borne.
No statistics bearing on this question are available, but it does not seem probable that, as a matter of fact, speculators are more expert than the dealers with whom they trade. Grain dealers, millers, and others who habitually hedge probably stay in business much longer on the average than do speculators, and, therefore, accumulate more experience. The speculative group includes a certain number of professional large-scale operators who do succeed in staying in business year after year, and presumably are making satisfactory profits, but these are the survivors of a large number whose financial strength is exhausted, or whose taste for speculation is satisfied before they attain the dignity of professionals. A few speculators make very large profits, but in all probability the business of furnishing hedging contracts belongs in the list of services which, as a whole, are rendered for society without compensation. Another point which is frequently overlooked in the discussing of hedging is the question to what extent hedging contracts and practice furnish protection against price changes. The following selection summarizes the situation in this regard:
It has been the common custom in works dealing with market risks and their elimination to mention hedging contracts as one of the most effective social devices for reducing and transferring risk. There is in these discussions usually the implication, if not the definite statement, that hedging contracts, wherever they can be used at all, can be expected to give a complete protection to the user against the risk of adverse price changes. Such conclusions concerning hedging transactions, as they are carried on in the ordinary course of business through the futures markets, are not at all justified. They arise from an inadequate comprehension of the nature of a hedging contract or from an incomplete understanding of the relations of the two markets which are essential to the hedging process.
To see clearly the possibilities and limitations of hedging contracts on organized produce markets it is necessary to understand first what a hedging contract is. The essence of a hedging contract is a coincident purchase and sale in two markets which are expected to behave in such a way that any, loss realized in one will be offset by an equivalent gain in the other. If such behavior follows a perfect hedge has been effected. The commonest type of hedging transaction is the purchase and sale of the same amount of the same commodity in the spot and in the futures markets. Frequently, however, the trades are in different commodities, as when cottonseed oil is hedged in the lard market or flour in the wheat market.
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