Hedging and the Futures Market
All businesses operate in an environment where prices for goods and services are subject to change without notice. An individual company has little control over price because price is set by the aggregate decisions of many individual companies, each believing that they are acting independently of one another. The same can be said for volume of sales. Aggregate volume is in the hands of overall economic activity and consumer preferences, hardly matters under the control of an individual businessman.
Price and volume of sales are the risks of the marketplace. There may be yet another dimension to market risk in the form of timing. A manufactured item, such as a tractor, has a current price, which is known by the manager of a tractor factory. The manager also knows the cost of manufacture in fairly precise terms. There is a lapse in time between acquiring the steel, the motor, and other bits and pieces to manufacture a tractor, and its delivery to a dealership. A tractor cannot be sold to a farmer until it is a finished product. The moment of its sale sets the price, and consequently, determines the profit, in manufacturing the tractor. Therefore, the manager of the tractor-making plant does not know the profit in the making of another tractor on the day that the material for the building of the tractor is acquired even though the cost of manufacture and the current price of tractors are known.
The time lag between the day that sets the cost of manufacture and the day that sets the price represents a risk. The manufacturer must bear the risk of a price decline between the time of purchase of the raw materials and component parts and the sale of the finished product. There is no way for the tractor manufacturer to cover this risk of a potential price decline once the required material for production is purchased because there is no futures market for tractors.
Many, if not most, industries do not have a futures market in order to lay off