Question

Discuss and evaluate the statement: “Hedging and speculation go hand in hand in the derivatives market.”

Answer 1

Hedging is the act of risk management. Different types of market participants use derivatives to hedge their risk. Sellers of a product, buyers of a product, portfolio managers, individual investors, etc. are just a few examples of market participants that use derivatives to hedge their risk.

Speculation is the act of attempting to profit from a change in security prices. There are several types of speculators including short-term, long term, commodity, equity, bonds etc.

Every derivative transaction has two sides - the long and the short positions (buyer and seller). The same transaction can be a hedging transaction for the buyer/seller, while it could be a speculative transaction for the other party.

Thus, both types of market participants (hedgers and speculators) - as well as others such as arbitrageurs - are important for a well-functioning derivative market. Having different types of market participants improves liquidity and adds depth to the market.

Therefore, it is correct to say that hedging and speculation go hand in hand in the derivatives market.