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.

The Price of Speculation

I have always believed that speculation is the reason the concept of modern markets is in existence. Speculation is a zero sum game. Someone pays the price for it and someone else pockets the profit. Crude is a classic example of how speculation can drive a commodity to more than 4.5 times its utility value. The following graph shows the Price of Speculation for Crude from May 2008 to November 2008. 

In august this year, the Price of Speculation for Crude was 3 times the utility price of Crude as on 8th December, 2008 ($ 39.74) and with time, this has come down to as low as $10.10, i.e. 1/3rd of the utility price.

In fact the Average Price of Speculation for Crude has been $60.92 for the period which means that we have been paying twice as much for Crude, just based on speculation. Interesting.....

Noise Traders

Three years back I came across the concept of stock markets and trading shares on a stock exchange. The way the markets worked and the fancy sounding jargon baffled me. What fascinates me about the markets is the fact that, traders know that the markets are inefficient and ill informed and that is precisely the reason why they enter the markets. In my quest to try and understand the markets better (or so I assumed), I read a lot and a particular theory on Efficient Market Hypothesis caught my attention.

It states that the markets work because of Noise Traders who are traders who do not have any specific information about a security. These traders add liquidity to the market while keeping the valuations undistorted. A well informed trader will never enter a market which is starved of noise traders because it would be impossible to profit from such a market. A volatile market means that the chances a day trade not being turned into a delivery are very high. Moreover, it’s easy to infect the market with conditioned news with the presence of noise traders. So amongst the illiterates the one who can spell "I" is the king.

But like any theory, the experts in the field of Behavioral Finance are divided in their opinion about noise traders. Many say that these noise traders affect the markets ability of arbitrage to a large extent. What I personally feel is that the noise traders are not so much so affected by conditioned news from a well informed trader, as much by their belief of an internal market inside their heads.

My Vow – Speculate “I Do”

We live with the belief that technology has made life and decision making so much easier for us. In the context of investments, today we have complex sounding jargon and pretty looking graphs & charts that are spurred out by a Rs 5 lakh software.
Johnathan Myers quite aptly calls this cocoon phenomenon as “Psychonomics”.

Honestly, the fact is that most investors are making the same mistakes they were making 10 years back. The only difference is that these mistakes are more expensive, more in number and faster now because they are done on a Rs 40000 computer on a DSL connection.

Why do I say so and based on what facts? Before I answer this, ask yourself “If I buy a stock, won’t I visualize it going up?” I am not saying that all investors do it, but a majority do. A big chunk of investors today are young debutants without any knowledge or experience in the markets and with a lot of cash in their kitty. Another chunk is speculators who visualize the Sensex hitting 22,000 and staying there (As much as 7 out of 10 investors/traders speculate).

Visualize it like a person idolizing Shah Rukh Khan or Dr. Kalam and wanting to be like them. A stern fan of Al Gore will always defend him no matter what you say to try and convince him otherwise. That’s where biases, beliefs and attitudes come in.

Psychonomics as an approach emphasizes the relationship between investors, unique internal characteristics (the internal market in their heads) and the pressures and reinforcing effects of the external financial markets. It acknowledges the fact that emotions do guide our decisions no matter how practical we want to be. The single minded analytical approach required to minimize risk and maximize gains comes only with time and experience. This is the reason young Fund Managers are more adventurous with Midcap stocks as compared to the wiser and older ones.

The theory doesn’t tell me something I already don’t know, just gives me a new perspective to look at it. And I know for sure that as long as cars run on fuel, the typical Indian Investor will always speculate. After all, it helps him believe and be peaceful – Temporarily.