Auditing or accounting for hedging/derivatives is whole another story, but here's the concept of hedging.
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Let's say you enter into a contract to deliver wheat to a real customer 3 months later from now at $10/bushel.
In 3 months, the market can fluctuate, right? The risk here is market going up and you missing out on that much profit.
In order to “hedge” this risk, you go into the future market and go the opposite direction of your real contract.
In this example, you “SOLD” wheat in real life.
In the futures market, you “BUY” corresponding futures in the commodity you are trading.
Now let's say 3 months later, the market did go up and you can sell wheat @ $15/bushel.
You are missing out on that extra $5/bushel, right?
Thankfully we hedged this risk. In future market, because your position is “long” or “buy”, the futures value would've appreciated.
The gain on futures and loss in real life cancel each other. In perfect hedge, you wouldn't make any money nor lose any money. Does that make sense?
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It would work the same way if you agreed to “BUY” wheat @ $10/bushel in 3 months from now.
You “SELL” in futures market and 3 months passes and now the price of wheat if $5/bushel.
Although you are losing money in real life, because now you can buy wheat @ $5/bushel, but you agreed to buy them @ $10/bushel already.
Your position in futures market, however, is “SELL” or “SHORT”, you can close out that position by buying future contracts at $5/bushel, so you make profit there.
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Long story short – in order to hedge, you go the opposite direction of real life contracts in futures.
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