Managing your portfolio risk through speculation and hedging

Before we look into hedgers and speculators, let's read a little into what is risk and future contracts and why do we need future contracts in the first place. Starting from risk, investment risk is the chance that in future the profits or returns will be smaller (or no return at all) than expected. Investment risk arises from uncertainty, and because uncertainty is always there, risk cannot be separated from any form of investment.

Coming to the futures contracts, they are the agreements between two parties to buy or sell some commodity in the future at current rates (or the price decided at the time of contract). In this case the seller minimizes the risk of a cut down in prices by foregoing some potential gains, while buyer assumes the risk expecting larger yields.

Hedging:
In portfolio management hedging is regularly used to secure the investors from some negative events in the future. In a simple futures contract, where A agrees to deliver some commodity to B after eight months at current prices, A is making sure that if the price for that particular asset goes down, he/she will remain indifferent to that slump. Note that A is also missing out on some potential profits that he may get in case the prices rise instead of going down, but he/she has secured himself from a loss in case of a negative event (i.e. adverse inflation).

Hedging is used to reduce risk, but any reduction in risk means a reduction in expected profits and in the end it comes down to investor's intuition that whether they want to go for “more-profits” or “less-risk”? Normally the investors who are in doubt (scared of market fluctuations) will go for hedging, just to make sure in case of some unfavorable occurence; the loss will be minimum (or no loss in case of perfect hedging).

Speculation:
Where the hedgers are minimizing the risk, someone is needed to absorb that risk (obviously in expectations of large returns). In simple words speculators are investors, ready to assume high risk while expecting high returns. Though speculators are quite similar to normal investor, and speculation process is almost the same as investment, there are some minor differences. Speculation is short term, high-risk and high-return form of investment, where normal investments are mostly for longer periods of time. Speculators are quite vulnerable to the risk, that’s why speculative investment is not suitable for less experienced investors or the beginners.