Hedging as 'Speculation on the Basis'

Holbrook Working has described hedging as "speculation on the basis" and has argued that traders engage in hedging because they believe they can do better from hedging than from not hedging, in contrast to the Keynes-Hicks-Kaldor view that hedging is an activity undertaken to shift risk to other traders. In this paper, we derive necessary and sufficient conditions for hedging ("speculation on the basis") to be preferred by all risk averse traders to speculating on the cash market. When the futures market is in fact a forward market, then short hedging is p referred to not hedging by all risk averse traders if and only if there is a contango on the market. In the case of a "true" futures market, it is shown that short hedging is preferred to an unhedged position by all risk averse traders if and only if the "Houthakker effect" is sufficiently strong. These results are derived for the "all or nothing" case of comparisons between an unhedged and a completely hedged position.