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What is The Difference Between Hedging and Speculation Research Team | Posted On Wednesday, April 15,2009, 05:21 PM

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What is The Difference Between Hedging and Speculation



Hedging involves mainly taking an offsetting position in a derivative in order to regulate balance any gains and losses to the underlying asset. Hedging attempts to get rid of the instability associated with the price of an asset by taking offsetting positions divergent to what the investor currently has. The main principle of speculation, alternatively, is to profit from betting on the direction in which an asset will be moving.

Hedgers diminish their risk by taking an opposite position in the market to what they are frustrating to hedge. The ultimate situation in hedging would be to cause one effect to abandon out another. For instance, suppose that a company specializes in producing jewelry and it has a major contract due in six months, for which gold is one of the company's most important inputs. The company is worried about the instability of the gold market and believes that gold prices may increase significantly in the near future. Consecutively to guard itself from this uncertainty, the company could buy a six-month futures contract in gold. This technique, if gold experiences a 10% price boost, the futures contract will lock in a price that will offset this gain. Although hedgers are sheltered from any losses, they are also controlled from any gains. Depending on a company's policies and the type of business it runs, it may prefer to hedge against certain business operations to reduce fluctuations in its profit and defend itself from any downside risk.

Speculators make bets or guesses on where they think the market is headed. For instance, if a speculator believes that a stock is high-priced, he or she may short sell the stock and wait for the price of the stock to decline, at which position he or she will buy back the stock and receive a profit. Speculators are vulnerable to both the downside and upside of the market; consequently, speculation can be enormously risky.

On the whole, hedgers are seen as risk averse and speculators are characteristically seen as risk lovers. Hedgers try to decrease the risks associated with uncertainty, while speculators bet against the actions of the market to try to profit from fluctuations in the price of securities

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