In our previous article, while we are talking about forward and futures contract we came across the terms hedging and speculation. People commonly juxtapose these two terms, as they are in the way connected with the unanticipated price movements. The basic difference between hedging and speculation is that the former is seen as a means to reduce risk, whereas the latter involves intentionally taking the risk to make profits. Take a read of this article carefully, to know how these two terms differ.
Content: Hedging Vs Speculation
|Basis for Comparison||Hedging||Speculation|
|Meaning||The act of preventing an investment against unforeseen price changes is known as hedging.||Speculation is a process in which the investor involves in a trading of financial asset of significant risk, in the hope of getting profits.|
|What is it?||A means to control price risk.||It relies on the risk factor, in expectation of getting returns.|
|Involves||Protection against price changes.||Incurring risk to make profits from price changes.|
|Operators are||Risk averse||Risk lovers|
Definition of Hedging
By the term hedging, we mean a technique of managing price risk. It is used to minimise or eliminate the probability of substantial loss or profits due to movements in the price of the underlying asset (i.e. A commodity or financial instrument), suffered by an investor. This is possible only by holding contrary positions in two different markets to counterbalance the risk of loss. Therefore, if there is a loss/gain in the cash position because of the price fluctuations, it can be offset by the movements in the prices of a futures position.
Definition of Speculation
The term speculation refers to the process of buying and selling of an asset incorporating considerable risk, in the hope of generating good returns from an anticipated change in the price level.
In an attempt to make huge profits, speculators look for an opportunity where they can take advantage of fluctuations in the price of the financial asset. The asset can be stocks, bonds, commodities, currencies, derivatives and other tradable items. They do not trade in any investments randomly rather they take calculated and analysed risk. The risk may result in bearing the loss of initial outlay in a futures contract or it may turn into rewards.
Key Differences Between Hedging and Speculation
The difference between hedging and speculation can be drawn clearly on following grounds:
- Hedging is the act of preventing an investment against unforeseen price changes. The process in which the speculators trade in an underlying asset of high-risk element, in order to earn profits is known as speculation.
- Hedging is a means to control or eliminate risk. Conversely, speculation depends on risk, in the hope of making good returns.
- Hedging offers protection against undesired price fluctuations. On the other hand, Speculation involves incurring risk to generate profits from price changes.
- Hedgers are risk averse, who secure their investment through hedging. Speculators are risk lovers, who take risks deliberately and play a critical role in providing liquidity in the market.
In simple terms, hedging means to protect, so as in the case of a futures contract. It means to secure the investment from the unforeseen fall in prices in the near future. It prevents the investor from incurring risk but also minimises the chances of potential gains.
In speculation, the speculators, always look for an opportunity, where the chances of gains are relatively high, along with a significant amount of risk of losing the initial outlay. They play an extremely important role in stabilising the financial market in a way that when a normal investor avoids engaging in a riskier financial transaction, speculators go for it. Thus, they help in maintaining liquidity in the economy.