How does a derivative security work as a hedging device?
Financial managers can use a derivative security to hedge the asset to which the derivative is connected by creating an opposite exposure to the asset. For example, a food processor could buy futures on the agricultural products it will be purchasing in the next few months. If the cost of the products rises the food processor will have to pay more for them, but the futures contracts will increase in value as well offsetting the extra cost and providing the additional money required. The asset and the derivative position are perfectly negatively correlated in this strategy: any change in value of the asset will be offset by an opposite change in value of the derivative security. In the ideal hedge, the opposite exposure is for the same amount of money as the asset itself, however, since derivative instruments come in fixed sizes for example $10,000 units it is often difficult to construct an opposite position of precisely the needed amount.