Hedgers vs. Speculators: two parties involved in the risk management process

Depending on their prior risk exposures, participants in the derivatives market can be classified into hedgers and speculators.

• A hedger trades futures to reduce some pre-existing risk exposure.
  • Prior to the transaction, the hedger does have risk exposure.
  • After the transaction, the hedger reduces risk exposure.
  • At the time of entering into hedging transactions, the hedger knows the benefit (reduced risk).
  • Hedgers are often producers or users of a given commodity.

• A speculator takes a view of the market, and accepts the market's risk in pursuit of profit.
  • Prior to the transaction, the speculator has no risk exposure.
  • After the transaction, the speculator has increased risk exposure.
  • The profits/losses of a speculative transaction are not known immediately.

Issuers, investors and financial intermediaries use derivatives to change exposure to an underlying to meet their financial obligations.

Issuers typically use derivatives to offset or hedge market-based underlying exposures that impact their assets, liabilities and earnings (hedge accounting).

Examples: FX forward to hedge forecasted sales, and commodity future to hedge inventory.

Issuers use derivatives to minimize income statement and cash flow volatility (cash flow hedges).

Examples: interest rate swap to a fixed rate for floating-rate debt, and currency forward.

Investors use derivatives to modify investment portfolio cash flows, replicate investment strategy returns in cash markets, and/or create exposures unavailable to cash market participants. For example, when investing overseas they use FX hedges to minimize the volatility of return due to currency fluctuations.