Simple Example

Its actually quite easy.  Imagine if you are trying to buy a book from Barnes & Noble, but they tell you that the book is not in stock, and that they can order if for you.  You agree.  You have just bought a forward contract with the book seller.  Meaning that you have agreed to give them money in the future in exchange for their "deliverable instrument", ie the book.  The book store that is selling the book has just sold you a forward contract, meaning that they are obligated to give you the book in the future when you bring them (the agreeed upon amount of) money.  You have agreed upon a price, and locked in that "contract" for a future delivery.  No cash changes hands until the final date when the product is delivered. 

*  Book buyer:  bought a futures contract (LONG)-- buys the book (asset) in the future at a set price....must deliver money in the future. Note:  if the market price of the book goes up, then the book buyer would be happy that they locked in the lower price (this contract would be more valuable).

Types of hedges:

1.  Long - benefit if market price of asset goes up (like a "call option")

2.  Short - benefit if market price of asset goes down (like a "put option")

                      Forward     Type        when to use                                example

Book seller:       sells       short        if your hurt by price decrease     selling inventory

Book buyer:       buys       long        if your hurt by price increase       if purchasing for resale (and have fixed sales price)

applications:

• hedging
• forward contracts
• futures contracts
• derivatives