Hedging and speculation are two terms that a conservative investor and trader almost always know. However, these two terms are very different from each other. Now let us understand the difference between hedging and speculation.
Now, let's give an example of how it also works in the currency market. Let's say there is a small company which has rendered services abroad and are likely to receive payments 3 months down the line.
Now, they are not sure what the price of the dollar would be against the rupee three months down the line. If the rupee is at 64 against the dollar and three months down the line when the payment is made if it is 63, the currency conversion may cost the company. You can hedge your risk by selling dollars in the futures segment of the currency market in advance to hedge your risk.
What is speculation?
Speculation is nothing but engaging in a positional trade in markets to make money. Speculation is a very aggressive behavior with the primary aim of making money. While speculation means a risky behavior, hedging is taking no risks at all. The actions are completely contrary to each other.
Speculation will result in huge profits or losses depending on your trade. Speculation could largely be on the back of some roumors, information or event based transaction.
Now, let's give an example of speculation.
Say you bought one lot of the Nifty (25 shares) with the belief that the Reserve Bank of India would cut interest rates. Now, let's assume that you bought the same at 8300 hoping that interest rates would be cut by the RBI and the Nifty would rally to 8400 points and you would make money. This can be considered as speculative ahead of a key event.
If the RBI does not cut interest rates and the Nifty falls be prepared to bear losses. On the other hand should the RBI cut rate and the Nifty rally be prepared for huge gains.
So, this can largely be considered as speculation.
Speculation and hedging can be considered as two activities or transactions that are totally contrary to each other. The former is for those with a key desire to make quick money, the latter is for those who are risk averse.