Future Business Leaders of America (FBLA) Agribusiness Practice Test

What role does hedging play in future contracts?

1. It restricts market access

2. It protects against potential price losses

3. It increases transaction costs

4. It eliminates price risks completely

The correct answer is: It protects against potential price losses

Hedging plays a crucial role in future contracts by protecting investors and businesses from potential price losses in the underlying asset. In various markets, such as commodities or financial instruments, prices can fluctuate significantly due to various factors, including supply and demand dynamics, geopolitical events, and economic indicators. By engaging in hedging strategies, traders and businesses can lock in prices for future transactions, which provides a level of certainty and mitigates the risk of adverse price movements. For example, a farmer may use futures contracts to lock in a price for their produce ahead of the harvest. This ensures that regardless of how market prices change, they can sell their product at a predetermined price, thereby safeguarding their income against unforeseen drops in market prices. Similarly, companies that rely on commodities can hedge against price increases that could affect their operating costs, thereby stabilizing their financial performance. The other options do not accurately reflect the primary function of hedging. Restricting market access would involve additional barriers rather than protective mechanisms. While hedging may lead to transaction costs due to the buying and selling of contracts, this is not its primary purpose. Lastly, while hedging significantly reduces price risk, it does not eliminate it entirely. There are always residual risks and uncertainties in the markets,