Derivatives: Hedging or Speculation?

An interesting discussion on whether derivatives act as a means to hedge or a tool for speculation was partly left incomplete due to lack of time and hence I am taking this discussion forward here. The argument that hedging for many companies is a speculative medium though they try to portray it as a means to hedge their risk exposure is true if looked at from one school of thought. Take for example a company that has invested in bonds with a fixed interest feature. Now if the company enters into a derivatives contact to trade on interest earnings then one might arguably say that the company has no Price Risk or risk from Fair Market Value and hence is indulging in reckless risk exposure.

But there is another school of thought to this. Hedging is done to cancel out unwanted risk or pass it on to others so as to reduce the overall risk exposure. Now, whether one considers a derivative exposure as hedging or speculation depends on how one defines risk. Many analysts consider “Loss of Profit” as risk and hence advocate derivatives exposure to reduce Loss of Profit. Though it might seem that it is fueling speculation and I agree that it does to some extent, the objective with which one enters into derivatives exposure is not enough to decide whether it’s hedging or speculation. Rather it is how you define risk and what you consider as risk for yourself.