The Difference Between Hedging and Speculating

Derivatives are the preeminent tool for laying off or taking on risk. Because of this dual purpose, the general public (and even some finance professionals) confuses their risky – and risk-averse – role.

Speculation is rightfully compared to making a bet. It may be an “educated” bet because the speculator is forecasting rather than simply gambling. The speculator does not have underlying risk that is being offset. Rather, s/he is taking a “naked” position. The position is the whole show.

Hedging differs from speculating in that a change in the value of the hedge position offsets an underlying risk. The position gains value when the hedged item loses value. When the position loses value, the hedged item gains. The net position of the hedger is neutral.

The speculator, however, is always adding risk.

Risk Management Approaches Vary

A risk management framework is more than just reports and algorithms. It has to make sense for a company’s unique business and risk portfolio, so that risk can be managed optimally.

For example, if a company is positioned to lose money when commodity prices rise, then an unhedged position is more risky than a hedged position. By doing nothing, the company is making a bet that commodity prices won’t rise.  But the company may be taking on more risk by doing nothing more than employing a thoughtful hedging strategy, even if it uses derivatives. The company may be exposed to changes in interest rates, energy costs, commodity prices (agricultural or industrial), or foreign currency rates of exchange. Therefore the “doing nothing” approach is the risky course of action – or non-action, as it were.

This simple example may not match your company’s position, but it might prepare you to think differently.

A thoughtful framework for risk management can help identify and quantify exposures, assess alternative solutions, manage, and report. Contact Grayline to learn more.

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