It’s not always as clear as the rising Sun, when trying to clarify to which side do we belong to.
With regards to my audience here “VC PM’s, Start Up Founders, CFO’s and Management”
You Are All Hedgers in that respect.
In coming paragraphs, I will try to simplify things and hopefully will give you readers better understanding.
Forward Contracts are mainly used by hedgers, speculators and arbitrators, which plays a pivotal role in the market. In this context, people often mixing the terms hedging and speculation as they are in the way connected with the unanticipated price movement, but they different in a number of aspects.
Hedging is performed by the hedgers to protect themselves against the risk or say to reduce the risk of the changes in the price of the underlying asset (commodity, currency, rates, etc.)
Speculator is on the contrary putting on risk in order to earn profit from the changes in the difference between future price and current spot price, as they bet on the difference.
Hence, the risk is taken intentionally to gain profits.
Definition of Hedging
By the term hedging, we mean a tool of managing price risk. It is used to minimize or eliminate the probability of substantial loss or profits due to movements in the price of an underlying asset (currency, stock, commodity…) by the hedger. This is possible only by holding contrary positions in two different markets to counterbalance the risk of loss. Therefore, if there is a loss/gain in the cash position because of the price fluctuation, it can be offset by the movements in the prices of forward positions.
Definition of Speculation
The term speculation refers to the process of buying and selling of an asset incorporating considerable risk, in hope of generating good returns from the movement in the price level.
In an attempt to make profits, speculators look for an opportunity where they can take advantage of the fluctuations in the price of a financial asset. The asset can be stock, bond, currencies, derivatives and other tradable assets. The risk may result in bearing the loss of initial outlay in the forward contracts or may turn into rewards.
In simple terms, hedging means to protect, so as in the case of forward contract. It means to secure the investment from unforeseen fall in price in the near future. It prevents the investor (hedger) from incurring risk but also minimizes the chances of potential gains.
In speculation, the speculators, always look for an opportunity, where the chances of gains are relatively high, along with the significant amount of risk of losing the initial capital. They play an extremely important rolein stabilizing the financial markets in away that when a normal investor avoids engaging in a riskier financial transaction, speculators go for it. Thus, they help in maintaining liquidity in the markets.
With relation to our Start-Up Nation, most businesses raise their funds in USD (or other hard currency) and in most cases their expenses mostly in local currency “ILS”. That is a very simple case where the company is a Hedger and realizing their status will help the treasury properly manage their currency exposure.
Next article, I will describe variety of hedging tools in a simple fashion way in order to open your mind to the world of derivatives and their application to your world.
This article was written by Aharon Nanov, Founder & Active Partner @ Altshuler Shaham Financial Services.
Aharon has close to 20 years of experience in local and International Markets. His last role as head of CEEMEA in the FX Rates and Credit trading division at Barclays Capital.
Aharon is also Managing Partner at Yasoor Hedge Fund (Part of AS Hedge Fund Division).
Contact him at: email@example.com