Hedging is a position in a financial instrument which intends to offset the risk or the loss of another position. Futures contracts are a very reliable way for companies to protect their profits from unpredictable shifts or plan their expenses.
Simplistic corporate hedging example
Suppose that company A is an oil importer and it has 10,000 barrels in its storage facilities. The price at which these barrels were bought was $95/barrel. Company B is a factory that constructs products made of plastic, so it uses oil as raw material in the construction procedure. Company A has agreed today to deliver 10,000 barrels of oil after 1 month to company B at $105/barrel. The profit that company A will have is $10/barrel (total $100,000). The spot price of oil at the time of the agreement is also $105/barrel.
The next day of the agreement the management of company A, due to various reasons, is starting to worry that the price they decided to sell to company B is very low because they think that in one month it will be at almost $115/barrel. If this is correct company A will lose a potential profit of $20/barrel ($115-$95) and make instead only $10/barrel ($105-$95). What they can do in order to offset this potential loss? They can buy 10 oil futures contracts (every contract is 1000 barrels) at $105/barrel and last trading day after one month. If they are right then the price of oil will be at $115/barrel and company A will have a profit of $10/barrel from the selling of the contracts ($115-$105), as expiration is approaching.
The purpose here isn’t to take the actual delivery of the commodity but only to earn the extra $10/barrels. So, their cumulative profit after one month will be $10/barrel from the selling to company B ($105-$95), plus $10/barrel from the selling of the contracts being bought at $105 ($115-$105), equals to $20/barrel. In that way company A will offset the unpredictable rise in oil prices.
What would have happened if the price of oil after one month had fallen to $100 instead of rising to $115? Then company A would have a loss of $5/barrel from the long position in the contracts, which would effectively have lessened the profits from the selling of oil to company B by $5/barrel.
Now let’s examine the same case from the point of view of company B (the plastic construction factory). Oil for them is the basic raw material for the production of plastic and so they want, as much as they can, to have a fixed oil cost in order to plan their expenses. They have already agreed to buy 10,000 barrels from company A after one month but the director of the factory believes, due to various factors, that its price after one month will be at $95/barrel (they have already agreed to buy it at $105). How company B can counterbalance such an event? In other words, how can the factory reduce the effective cost of the 10,000 barrels by taking advantage falling oil prices? They can short sell 10 oil contracts at $105/barrel and last trading day after one month.
If the spot price of oil after one month is at $95/barrel then company B will have profited $10/barrel from the contracts and the effective price that it will buy the 10,000 barrels from company A is $95/barrel (they will buy at $105 minus $10 profit, equals effectively to $95/barrel).
What would have happened if the price of oil after one month had risen to $110 instead of falling to $95? Then company B would have a loss of $5/barrel from the short position in the contracts which would effectively have augmented the purchase cost of oil from company A by $5/barrel.
Notice also that hedging using futures incorporates basis risk due to the fact that spot prices are not changing in tandem with contracts prices, the further from the delivery date a contract is.
Conclusively, hedging is not without risk but it might be useful in order for a company to counterweight unanticipated market shifts.