Explain the difference between hedging and speculation.

Difference between Hedging and Speculation Hedging: Hedging refers to combining transactions so as to try to achieve a position of reduced risk. The primary objective of hedging is to mitigate potential losses from adverse price movements in an asset or liability. It involves taking an offsetting position in a related security or financial instrument. There are many specific financial vehicles to accomplish this, including forward contracts, swaps, options, many types of over-the-counter and derivative products, and perhaps most popularly futures contracts. Hedgers typically have an existing exposure to a risk (e.g., a company expecting to receive foreign currency in the future) and use derivatives to protect themselves from unfavorable price changes. The goal is risk reduction, not profit maximization from price movements. Speculation: Speculation involves the deployment of funds with the primary objective of profiting from anticipated price movements. It is not backed by a conscious analysis of pros and cons in the sense of risk mitigation. Mostly, it is a spur-of-the-moment activity that is typically impelled by unconfirmed information and rumors, though it can also be based on thorough analysis. Speculative deployment of funds is generally prevalent in the secondary equity market and other financial markets. What attracts people to speculation is the hope of a rate of return that is abnormally higher than the prevailing market rates. Speculators intentionally take on risk in the hope of making significant profits. They do not have an underlying exposure they are trying to protect. The balancing of risk and return nevertheless operates in speculative activity also, and as such, the risk element in speculation is very high. In essence, hedging is about managing and reducing existing risk, while speculation is about taking on risk to profit from market movements.