Hedging can achieve the purpose of transferring price risk, mainly based on the following principles:
(1) The futures price trend of the same commodity is basically consistent with the spot price trend.
For a specific commodity, the fluctuation of spot price and futures price is influenced and restricted by the same economic factor, so generally speaking, the trend of these two prices is the same, rising and falling together. Hedging is to use this price linkage relationship between two markets to achieve the result of losing money in one market and making profits in the other.
(2) As the expiration date of the futures contract approaches, the futures price tends to be consistent with the spot price.
In an effectively competitive market, when futures contracts expire, futures prices and spot prices will tend to be consistent. If there is inconsistency, it will lead to arbitrage trading, thus narrowing the price difference between the two.
When China's agricultural futures contract expires, all physical goods must be delivered. When the delivery is near, if the futures price is higher than the spot price (regardless of the delivery cost for the time being), someone will buy grain at a low price in the spot market, sell it in the futures market and deliver it, and get risk-free income, that is, arbitrage trading between the futures market and the spot market. On the other hand, if the futures price is lower than the spot price, someone will buy the grain for delivery in the futures market, and then sell it at a high price in the spot market, and also get stable income. Arbitrage trading will make the futures price and spot price tend to be consistent when the futures contract expires. Considering the distribution cost and transportation conditions, the two will not be exactly the same, but they will generally be very close.