Hedging

One main use of Derivatives is as a tool for transferring/reducing risk on a commodity/item. Say you are a manufacturer who uses Rice as the ingredient in your product. You would not want the price or availability of Rice to affect your production in any way. You can decide to enter into a contract with a Rice farmer to buy a specified quantity of Rice in a future date say after 3 months at a specified price. Here you are hedging to reduce your risk of availability. The farmer would also be avoiding a risk of lack of prospective buyers. By entering into agreement with you, he has reduced that risk and he has a buyer who would be buying his product on the agreed date at the agreed price. Of course there are some external factors that may cause the agreement to become null. For e.g., if due to a flood all his crops are destroyed, you cannot expect the farmer to honour the agreement. Similarly if you go bankrupt the farmer would have to find a new buyer for his products. So Derivatives can act as a tool to mitigate risk but it cannot help us avoid it altogether. Also this risk reduction will happen only between the two parties who are entering into the agreement. Any other manufacturer may end up without rice supplies or any other farmer may end up without buyers.