Speculating and Hedging: The Fundamental Differences

Demetri Papacostas and Francesco Tonin

The previous chapter delved into how speculators and PMs are perceived by the market, and the most common approaches they use to differentiate the way they make money. In this second chapter on speculators, we examine the difference between hedging and speculating, and take a deeper dive into relative value trades. We then raise the bar and look at how a PM would speculate across many currencies at the same time – what criteria would be used to judge performance and what would be the most efficient way to allocate capital. Finally, we present a cookbook of different speculative FX option structures that can fit any market view. However, we don’t examine those in detail like we did for corporate hedgers, as that would require another book.

 

HOW IS SPECULATING DIFFERENT FROM HEDGING?

What is the difference between trading by corporations and trading by speculators? The first fundamental difference is that hedging is a problem with a solution. The hedger expresses an objective, which could be to reduce the volatility of earnings year-on-year, or maybe to defend a budget rate. Whatever the objective, it is very narrowly defined and its solution can sometimes be expressed by a