Speculation

What It Is: Speculation is a method of short-term investing whereby traders essentially bet on the direction an asset's price will move. How It Works/Example: Technically, anyone who buys or shorts a security with the expectation of a favorable price change is aspeculator. For example, if a speculator believes XYZ Company stock is overpriced, they may short the stock, wait for the price to fall, and make a profit. It's possible to speculate on virtually every security, though speculation is especially concentrated in the commodities, futures, and derivatives markets. But to really understand speculation, one must understand how it differs from hedging. Let's consider an example: let's assume part of your investment portfolio includes shares of Company XYZ, which manufactures autos. Because the auto industry is cyclical, Company XYZ shares will probably decline if the economy starts to deteriorate. If you want to protect this investment -- that is, you want to hedge your investment -- one way to do that is to buy defensive stocks. You may choose "noncyclicals," or companies that sell basic necessities like toothpaste or toilet paper. During economic slumps, these stocks tend to hold or increase their value, which could offset the loss in value of the XYZ shares. A speculator wouldn't follow this strategy. If a speculator purchased food-company stocks, he would do so because he simply believes the stock is going to increase. Speculation can increase short-term volatility (and thus, risk). It can inflate prices and lead to bubbles, as was the case in the 2005-2006 real estate market in the United States. Speculators who were betting that home prices would continue to increase purchased houses (often using leverage) intending to "flip" them for a profit. This increased the demand for housing, which raised prices further, eventually taking them beyond the "true value" of the real estate in many markets. The frenzied selling that ensued is typical for speculative markets. Why It Matters: Some people may see speculators as dangerous gamblers, but speculators actually provide muchneeded liquidity to markets and are thus a vital component of market efficiency. Without them, many commodities markets, for example, would virtually grind to a halt because the only participants would be farmers and food companies. With fewer participants in a market, bid-ask spreads would widen and it would be much harder for buyers and sellers to find each other. The resulting illiquidity would dramatically increase the risk in that market.

Hedge (finance)
A hedge is an investment position intended to offset potential losses/gains that may be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses/gains suffered by an individual or an organization. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps,options, many types of over-the-counter and derivative products, and futures contracts. Public futures markets were established in the 19th century[1] to allow transparent, standardized, and efficient hedging of agricultural commodity prices; they have since expanded to include futures contracts for hedging the values of energy, precious metals, foreign currency, and interest rate fluctuations.
Contents

1 Etymology 2 Examples

o o o o

2.1 Agricultural commodity price hedging 2.2 Hedging a stock price 2.3 Hedging Employee Stock Options 2.4 Hedging fuel consumption

3 Types of hedging

3.1 Hedging strategies

3.1.1 Financial derivatives such as call and put options

4 Natural hedges 5 Categories of hedgeable risk 6 Hedging equity and equity futures

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6.1 Futures hedging 6.2 Contract for difference

7 Related concepts 8 See also

8.1 Accountant views

9 References 10 External links

[edit]Etymology

Hedging is the practice of taking a position in one market to offset and balance against the risk adopted by assuming a position in a contrary or opposing market or investment. The word hedge is from Old English hecg, originally any fence, living or artificial. The use of the word as a verb in the sense of "dodge, evade" is first recorded in the 1590s; that of insure oneself against loss, as in a bet, is from 1670s. [2]

[edit]Examples [edit]Agricultural

commodity price hedging

A typical hedger might be a commercial farmer. The market values of wheat and other crops fluctuate constantly as supply and demand for them vary, with occasional large moves in either direction. Based on current prices and forecast levels at harvest time, the farmer might decide that planting wheat is a good idea one season, but the forecast prices are only that forecasts. Once the farmer plants wheat, he is committed to it for an entire growing season. If the actual price of wheat rises greatly between planting and harvest, the farmer stands to make a lot of unexpected money, but if the actual price drops by harvest time, he could be ruined. If at planting time the farmer sells a number of wheat futures contracts equivalent to his anticipated crop size, he effectively locks in the price of wheat at that time: the contract is an agreement to deliver a certain number of bushels of wheat to a specified place on a certain date in the future for a certain fixed price. The farmer has hedged his exposure to wheat prices; he no longer cares whether the current price rises or falls, because he is guaranteed a price by the contract. He no longer needs to worry about being ruined by a low wheat price at harvest time, but he also gives up the chance at making extra money from a high wheat price at harvest times.

[edit]Hedging

a stock price

A stock trader believes that the stock price of Company A will rise over the next month, due to the company's new and efficient method of producing widgets. He wants to buy Company A shares to profit from their expected price increase. But Company A is part of the highly volatile widget industry. If the trader simply bought the shares based on his belief that the Company A shares were underpriced, the trade would be a speculation. Since the trader is interested in the company, rather than the industry, he wants to hedge out the industry risk by short selling an equal value (number of shares price) of the shares of Company A's direct competitor, Company B. The first day the trader's portfolio is:

Long 1,000 shares of Company A at $1 each Short 500 shares of Company B at $2 each

(Notice that the trader has sold short the same value of shares)

If the trader was able to short sell an asset whose price had a mathematically defined relation with Company A's stock price (for example a put option on Company A shares), the trade might be essentially riskless. In this case, the risk would be limited to the put option's premium. On the second day, a favorable news story about the widgets industry is published and the value of all widgets stock goes up. Company A, however, because it is a stronger company, increases by 10%, while Company B increases by just 5%:

Long 1,000 shares of Company A at $1.10 each: $100 gain Short 500 shares of Company B at $2.10 each: $50 loss

(In a short position, the investor loses money when the price goes up.) The trader might regret the hedge on day two, since it reduced the profits on the Company A position. But on the third day, an unfavorable news story is published about the health effects of widgets, and all widgets stocks crash: 50% is wiped off the value of the widgets industry in the course of a few hours. Nevertheless, since Company A is the better company, it suffers less than Company B: Value of long position (Company A):

Day 1: $1,000 Day 2: $1,100 Day 3: $550 => ($1,000 $550) = $450 loss

Value of short position (Company B):

Day 1: $1,000 Day 2: $1,050 Day 3: $525 => ($1,000 $525) = $475 profit

Without the hedge, the trader would have lost $450 (or $900 if the trader took the $1,000 he has used in short selling Company B's shares to buy Company A's shares as well). But the hedge the short sale of Company B gives a profit of $475, for a net profit of $25 during a dramatic market collapse.

[edit]Hedging

Employee Stock Options

Employee Stock Options are securities issued by the company generally to executives and employees. These securities are more volatile than stock and should encourage the holders to manage those positions with a view to reducing that risk. There is only one efficient way to manage the risk of holding employee stock options and that is by use of sales of exchange traded calls and to a lesser degree by buying puts. Companies discourage hedging versus ESOs but have no prohibitions in their contracts.

[edit]Hedging

fuel consumption

Main article: Fuel hedging Airlines use futures contracts and derivatives to hedge their exposure to the price of jet fuel. They know that they must purchase jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. By using crude oil futures contracts to hedge their fuel requirements (and engaging in similar but more complex derivatives transactions), Southwest Airlines was able to save a large amount of money when buying fuel as compared to rival airlines when fuel prices in the U.S. rose dramatically after the 2003 Iraq war and Hurricane Katrina.

[edit]Types

of hedging

Hedging can be used in many different ways including foreign exchange trading The stock example above is a "classic" sort of hedge, known in the industry as a pairs trade due to the trading on a pair of related securities. As investors became more sophisticated, along with the mathematical tools used to calculate values (known as models), the types of hedges have increased greatly.

[edit]Hedging

strategies

Examples of hedging include:

Forward exchange contract for currencies Currency future contracts Money Market Operations for currencies Forward Exchange Contract for interest Money Market Operations for interest Future contracts for interest

This is a list of hedging strategies, grouped by category.

[edit]Financial derivatives such as call and put options

Risk reversal: Simultaneously buying a call option and selling a put option. This has the effect of simulating being long on a stock or commodity position.

Delta neutral: This is a market neutral position that allows a portfolio to maintain a positive cash flow by dynamically re-hedging to maintain a market neutral position. This is also a type ofmarket neutral strategy.

[edit]Natural

hedges

Many hedges do not involve exotic financial instruments or derivatives such as the married put. A natural hedge is an investment that reduces the undesired risk by matching cash flows (i.e. revenues and expenses). For example, an exporter to the United States faces a risk of changes in the value of the U.S. dollar and chooses to open a production facility in that market to match its expected sales revenue to its cost structure. Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure. Similarly, an oil producer may expect to receive its revenues in U.S. dollars, but faces costs in a different currency; it would be applying a natural hedge if it agreed to, for example, pay bonuses to employees in U.S. dollars. One common means of hedging against risk is the purchase of insurance to protect against financial loss due to accidental property damage or loss, personal injury, or loss of life.

[edit]Categories

of hedgeable risk

There are varying types of risk that can be protected against with a hedge. Those types of risks include:

Commodity risk: the risk that arises from potential movements in the value of commodity contracts, which include agricultural products, metals, and energy products.[3]

Credit risk: the risk that money owing will not be paid by an obligor. Since credit risk is the natural business of banks, but an unwanted risk for commercial traders, an early market developed between banks and traders that involved selling obligations at a discounted rate.

Currency risk (also known as Foreign Exchange Risk hedging) is used both by financial investors to deflect the risks they encounter when investing abroad and by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.

Interest rate risk: the risk that the relative value of an interest-bearing liability, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed-income instruments or interest rate swaps.

Equity risk: the risk that one's investments will depreciate because of stock market dynamics causing one to lose money.

Volatility risk: is the threat that an exchange rate movement poses to an investor's portfolio in a foreign currency.

Volumetric risk: the risk that a customer demands more or less of a product than expected.

[edit]Hedging

equity and equity futures

Equity in a portfolio can be hedged by taking an opposite position in futures. To protect your stock picking against systematic market risk, futures are shorted when equity is purchased, or long futures when stock is shorted. One way to hedge is the market neutral approach. In this approach, an equivalent dollar amount in the stock trade is taken in futures for example, by buying 10,000 GBP worth of Vodafone and shorting 10,000 worth of FTSE futures. Another way to hedge is the beta neutral. Beta is the historical correlation between a stock and an index. If the beta of a Vodafone stock is 2, then for a 10,000 GBP long position in Vodafone an investor would hedge with a 20,000 GBP equivalent short position in the FTSE futures (the index in which Vodafone trades). Futures contracts and forward contracts are means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the 19th century, but over the last fifty years a large global market developed in products to hedge financial market risk.

[edit]Futures

hedging

Investors who primarily trade in futures may hedge their futures against synthetic futures. A synthetic in this case is a synthetic future comprising a call and a put position. Long synthetic futures means long call and short put at the same expiry price. To hedge against a long futures trade a short position in synthetics can be established, and vice versa. Stack hedging is a strategy which involves buying various futures contracts that are concentrated in nearby delivery months to increase the liquidity position. It is generally used by investors to ensure the surety of their earnings for a longer period of time.

[edit]Contract

for difference

Main article: Contract for difference A contract for difference (CFD) is a two-way hedge or swap contract that allows the seller and purchaser to fix the price of a volatile commodity. Consider a deal between an electricity producer and an electricity retailer, both of whom trade through an electricity market pool. If the producer and the retailer agree to a strike price of $50 per MWh, for 1 MWh in a trading period, and if the actual pool price is $70, then the producer gets $70 from the pool but has to rebate $20 (the "difference" between the strike price and the pool price) to the retailer. Conversely, the retailer pays the difference to the producer if the pool price is lower than the agreed upon contractual strike price. In effect, the pool volatility is nullified and the parties pay and receive $50 per MWh. However, the party who pays the difference is "out of the money" because without the hedge they would have received the benefit of the pool price.

The disadvantages of a joint stock company are as follows: 1. Legal formalities The company requires too many legal formalities to form, operate and close. It is time consuming and expensive. Several legal documents are required to form a public company. They are Memorandum of Association, Articles of Association, Certificate of Commencement and Prospectus for issue of shares. 2. Lack of secrecy A company cannot keep secrecy about its operation. Public company is required to publish annual report and audited financial statements for public information. Lack of secrecy is a disadvantage for company because competitors can take undue advantage from such information. 3. Delayed decisions Decision making is delayed in a company. The professional managers manage the company in a bureaucratic way. The board of directors meet at various intervals to make decisions. Shareholders meet in Annual General Meet to make major decisions. Company meetings require prior notice as per law. They cannot be arranged all of a sudden. This may lead to loss of business opportunities. 4. Lack of motivation There is separation of ownership and management in a company. The shareholders own the company. But they have little involvement in the management of the company. The directors manage the company. But they lack motivation and incentive for better management. There is no link between efforts and reward for motivation. The salaried executives lack personal interest in the company. 5. Speculation The shares of a company are subject to speculation. The directors have access to inside information. They can manipulate such information to speculate in shares. A few individual can get control over company by holding majority shares. Unhealthy speculation in shares is a disadvantage of a company. 6. Conflict of interest A company has many interest groups. They can be shareholders, employees, suppliers, creditors, government and community. Their interests vary. The conflict in their interests can badly affect the performance of the company. Corrupt management can exploit shareholders. Interdepartmental conflicts can be harmful.

7. Neglect of minority All decisions in a company are made by majority vote. The promoters are in majority groups. The minority groups are not represented in the board of directors. The interests of minority are neglected by majority groups. 8. Government control A company is subject to government regulations and control. It has to fulfill various legal formalities. It has to file various reports and statements to the government. This requires a lot of time, efforts and financial resources.Excessive government control is a demerit for a company.