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  • Differences between hedging and speculation

     
     
    Hedging is often confused with speculation. In both cases operators are concerned with unforeseen price changes. They make buying and selling decisions based on their expectations of how the market will move in the future. However, where hedging is essentially a means to avoid or reduce price risk, speculation relies on the risk element. For instance, it would be irrational to carry out a selling hedge if the market were absolutely certain to rise. In the absence of absolute certainty about future market movements, hedging offers an element of protection against price risk, whereas speculation involves deliberately taking a risk on price movements, up or down, in the hope of obtaining a profit.

    One of the principles of speculation involves the opportunity for gain that the investor achieves by agreeing to accept some of the risk passed off by the hedger. In other words, the hedger gives up some opportunity in exchange for reduced risk. The speculator on the other hand acquires opportunity in exchange for taking on risk.

    Buyers and sellers of coffee who aim to minimize their price risks in the physical market assume opposite positions, or risks, in the futures market. At any moment there will be a number of buying and a number of selling hedge operations. However, it is unlikely that demand for hedges against buying risks will exactly balance demand for hedges against selling risks. The resulting surplus of buying and selling risks that has not been covered by the usual hedgers is taken up by speculators.

    To absorb the vast amounts of futures entering the coffee exchanges, numerous speculators willing to buy one or two lots are required. Likewise, considerable purchasing pressure occurs when traders or roasters hedge to cover their future needs. Prices would increase unless speculators were willing to step in as sellers.

    If producers who wish to hedge could always find counterparts who also wished to do so, there would be no need for speculators. However, this situation is unlikely to occur regularly, partly because the periods in which producers carry out hedging operations normally do not coincide with the periods in which consumers try to hedge. The speculator provides the link between these two different periods and interests.
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