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From Wikipedia, the free encyclopedia

Speculation is the purchase of an asset (a commodity, goods, or real estate) with the hope that it will become more valuable in the near future. In finance, speculation is also the practice of engaging in risky financial transactions in an attempt to profit from short term fluctuations in the market value of a tradable financial instrument—rather than attempting to profit from the underlying financial attributes embodied in the instrument such as capital gains, dividends, or interest.

Many speculators pay little attention to the fundamental value of a security and instead focus purely on price movements. Speculation can in principle involve any tradable good or financial instrument. Speculators are particularly common in the markets for stocks, bonds, commodity futures, currencies, fine art, collectibles, real estate, and derivatives.

Speculators play one of four primary roles in financial markets, along with hedgers, who engage in transactions to offset some other pre-existing risk, arbitrageurs who seek to profit from situations where fungible instruments trade at different prices in different market segments, and investors who seek profit through long-term ownership of an instrument's underlying attributes.

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Transcription

- [Tyler] Today, we're going to be looking at speculation. Speculation and speculators are often considered to be morally dubious. Speculation is associated with gambling, and gambling is morally dubious. When a speculator gets rich people wonder, "What has this person really done for the social good? What have they really produced of true value?" What we're going to show is that using a basic model of speculation, speculation can be quite a useful part of the market process. So let's take a look. Speculation is actually very similar to an example we've already talked about. Remember our example, when oil prices are low on the west coast, and high on the east coast, this gives entrepreneurs an incentive to buy low and sell high to move oil from the west, where it has low value, and bring it to the east, where it has higher value. Speculators do the same thing, but instead of moving resources through space geographically, they are moving them through time. For example, suppose you believe that oil prices will be higher in a year due to, for example, a very destructive war. You might think there will be such a war in the Middle East, and that's going to push up oil prices in the next year. You can make a profit by buying oil now when the price is low, storing that oil, and then selling it next year when the price is high. Buy low, sell high. That's speculation - the attempt to profit from future price changes. Is this a bad thing? What we're going to show is that speculation tends to smooth prices over time and to increase welfare. Why does it increase welfare? Exactly for the same reasons that moving oil from the west coast to the east coast increases welfare. You're taking oil from where it has low value and moving it through time to where it has higher value. You're increasing value and increasing welfare. Let's take a look at that with our model. Here's two markets: today's market and the future market for oil. Let's look at what happens without speculation. Here's our demand, here's our supply. I've just drawn a vertical supply curve for simplicity. So production today is high, that means today's price is low. If there's a destructive war in the Middle East, then production in the future will be lower and price in the future will be higher. That's what happens without speculation. Now let's consider what happens with speculation. Remember, we begin with a situation where the price today is low and speculators expect that the price tomorrow because of this war will be high. What do speculators want to do? They want to buy low and sell high. They want to buy today and sell in the future. If speculators buy today, they're going to take some of the current production, take that production and put it into storage. They'll take it off the market and store it. The supply curve to the market is this supply curve. This then gives us consumption, which is equal to production minus what the suppliers put into storage. Notice that with speculation, the price today goes up because the speculators have taken some of that supply off the market. What happens in the future? In the future when the price is high, the speculator’s going to want to take what they have out of storage and sell it in the market. The supply curve in the future becomes equal to production plus what is being pulled out of the inventory. Production is low in the future because of disruption due to, let's say again this destructive war, but consumption will be higher than production in the future because suppliers are taking some of the inventory out and selling it into the market. Notice that in the future, the speculators are pushing the price down. What about welfare? This is slightly Tricky, but if we just follow our rules, let's look at consumer surplus, which is what is going to matter here with the vertical supply curve. It's simpler that way. Well, consumer surplus, what's going to happen? There's a loss in value today when speculators take oil off the market. That oil is not consumed, those units are not consumed, and because they're not consumed there is a resulting loss in value. However, notice what the speculators are doing. In the next period there's a gain in value. The consumption would have been here but because of the speculation, because the good comes out of inventory, consumption is now higher. The value of that consumption is equal to this green area. Since the green area is bigger than the red area, speculation increases welfare. It also stabilizes the price over time. The price today goes up, but the price in the future goes down. We get a more stable price. Again what's the basic point here? What's the basic idea? It's that what speculators do is they take resources from where they have lower value and they move them through time to where they have higher value. That's a very useful thing to have happened. That increases welfare, that makes the speculators money, but because of the invisible hand, in the right circumstances the incentives lead the speculators to do the right thing, thereby increasing value for society as a whole. Here is one more important point. In order to speculate in a market like the market for oil, you don't actually have to have a storage tank where you're going to store your oil. You can do it another way - that's through the future's market. Futures are contracts to buy or sell specified quantities of a commodity or a financial instrument at a specified time in the future, at a price that is agreed upon today. So how would this work? Suppose that Tyler thinks the price of oil will be greater than $50 per barrel in 12 months from now. But Alex thinks the price of oil will be lower than $50 in 12 months. Tyler agrees to buy from Alex 1,000 barrels of oil 12 months from now at a price of say, $50 per barrel. It's a futures contract. Let's see what happens after 12 months pass. Suppose that 12 months from now, the price of oil on the market is $82. That we call the spot price. That means Tyler was right, the price of oil went up, and by a lot. So what do they do then? Tyler has two options. He can accept the oil from Alex, pay $50,000 to Alex, and then turn around and sell the oil for $82,000, netting Tyler $32,000. But Alex doesn't have any oil. Tyler also doesn't really want to take the delivery of the oil and then turn around and have to sell all that oil. That can be a big pain. Instead, Tyler and Alex come to an agreement, perhaps through a clearing house. Alex gives $32,000 to Tyler and they close the contract out in cash. Notice that either way, Tyler nets $32,000 and Alex is out $32,000. The second method is usually more convenient. Neither Tyler nor Alex actually have to deal in the oil. They only have to deal in the cash value of the futures contract. In fact, futures contracts are usually settled in cash, rather than through physical delivery. What this means is that through the futures market, anybody can speculate in oil. Now we're not suggesting you actually do this - it's one way to lose a lot of money very quickly. But the point is, you don't have to accept or deliver oil to speculate in the oil market. That's a good thing because there are many people who may know lots of things about conditions in the Middle East or about the oil market who don’t themselves have the facilities to store or deliver oil. The better speculators can predict the future, the more money they can make. When they make their predictions, they change the prices in futures markets. Prices in futures markets often have information built into them which tells you something about the future. Think, for example, about the Florida orange juice crop. What determines whether the crop is really going to be a bumper crop, in which case the price of orange juice will be low, or whether the crop is going to be a small crop, in which case the price will be high? Very often it's the weather that matters. This led one economist, Richard Roll, to look at the weather forecasts of the National Weather Service and to see whether orange juice future prices could help to predict Florida weather. What he found, in fact, is that they can. There was additional information in the orange juice futures prices that allowed for improvements in the weather forecasts from the National Weather Service. Lots of information is embedded in market prices. Let's end where we began with the image problem speculators have. One of the issues is that speculators raise prices today, but lower prices in the future. Everyone sees the price increase today, but fewer people see that the future price will be lower than it would have been without the speculation. Why is society better off with speculation? Remember, the speculators are moving resources through time from lower to higher valued uses. Of course, the speculators don't always guess correctly. When they guess incorrectly, they'll be moving resources from higher valued uses to lower valued uses. We don't want that, but the speculators have got their own money on the line. They have a huge incentive to be right, and when they're wrong, they have to take big losses. Over time, bad speculators, speculators who aren't good at forecasting the market, they tend to go bankrupt. And the good or better speculators will become a larger share of the market. Let's also remember that we really want somebody to be able to predict the future. We really want people to be thinking about the future. We really want to give people an incentive to think about future events, both good and bad, and how those events will impact production and consumption decisions. Speculation markets, futures markets, they give people strong incentives to think carefully about the future. Indeed, these markets have been shown to be much better predictors of the future, much better ways of seeing into the future than our alternative institutions which rely less on incentives and rely less on markets. We'll talk about all of that more in the next lecture. Thanks. - [Announcer] If you want to test yourself, click “Practice Questions.” Or, if you're ready to move on, just click “Next Video.” Subtitles by the Amara.org community

Contents

History

With the appearance of the stock ticker machine in 1867, which removed the need for traders to be physically present on the floor of a stock exchange, stock speculation underwent a dramatic expansion through the end of the 1920s. The number of shareholders increased, perhaps, from 4.4 million in 1900 to 26 million in 1932.[1]

Speculation and investment

The view of what distinguishes investment from speculation and speculation from excessive speculation varies widely among pundits, legislators and academics. Some sources note that speculation is simply a higher risk form of investment. Others define speculation more narrowly as positions not characterized as hedging.[2] The U.S. Commodity Futures Trading Commission defines a speculator as "a trader who does not hedge, but who trades with the objective of achieving profits through the successful anticipation of price movements."[3] The agency emphasizes that speculators serve important market functions, but defines excessive speculation as harmful to the proper functioning of futures markets.[4]

According to Benjamin Graham in The Intelligent Investor, the prototypical defensive investor is "...one interested chiefly in safety plus freedom from bother." He admits, however, that "...some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." Thus, many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit.[5]

Speculation is condemned on ethical-moral grounds as creating money from money and thereby promoting the vices of avarice and gambling.[6]

There is opinion that it serves no purposes from a human and economic perspective [7]

Economic benefits

Sustainable consumption level

Speculation usually involves more risks than investment.
Speculation usually involves more risks than investment.

Nicholas Kaldor[8] has long recognized the price-stabilizing role of speculators, who tend to even out "price-fluctuations due to changes in the conditions of demand or supply," by possessing "better than average foresight." This view was later echoed by the speculator Victor Niederhoffer, in "The Speculator as Hero",[9] who describes the benefits of speculation:

Let's consider some of the principles that explain the causes of shortages and surpluses and the role of speculators. When a harvest is too small to satisfy consumption at its normal rate, speculators come in, hoping to profit from the scarcity by buying. Their purchases raise the price, thereby checking consumption so that the smaller supply will last longer. Producers encouraged by the high price further lessen the shortage by growing or importing to reduce the shortage. On the other side, when the price is higher than the speculators think the facts warrant, they sell. This reduces prices, encouraging consumption and exports and helping to reduce the surplus.

Another service provided by speculators to a market is that by risking their own capital in the hope of profit, they add liquidity to the market and make it easier or even possible for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

Market liquidity and efficiency

If any market, such as pork bellies, had no speculators, only producers (hog farmers) and consumers (butchers, etc.) would participate. With fewer players in the market, there would be a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wanted to trade pork bellies would be forced to accept this illiquid market and might trade at market prices with large bid-ask spreads or even face difficulty finding a co-party to buy or sell to.

By contrast, a commodity speculator may profit the difference in the spread and, in competition with other speculators, reduce the spread. Some schools of thought argue that speculators increase the liquidity in a market, and therefore promote an efficient market.[10] This efficiency is difficult to achieve without speculators. Speculators take information and speculate on how it affects prices, producers and consumers, who may want to hedge their risks, needing counterparties if they could find each other without markets it certainly would happen as it would be cheaper. A very beneficial by-product of speculation for the economy is price discovery.

On the other hand, as more speculators participate in a market, underlying real demand and supply can diminish compared to trading volume, and prices may become distorted.[10]

Bearing risks

Speculators perform a risk bearing role that can be beneficial to society. For example, a farmer might be considering planting corn on some unused farmland. However, he might not want to do so because he is concerned that the price might fall too far by harvest time. By selling his crop in advance at a fixed price to a speculator, he is now able to hedge the price risk and so he can plant the corn. Thus, speculators can actually increase production through their willingness to take on risk (not at the loss of profit).

Finding environmental and other risks

Speculative hedge funds that do fundamental analysis "are far more likely than other investors to try to identify a firm's off-balance-sheet exposures" including "environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis". Hence, they make the prices better reflect the true quality of operation of the firms.[11]

Shorting

Shorting may act as a "canary in a coal mine" to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.[11]

Economic disadvantages

Winner's curse

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects by the winner's curse. The winner's curse, is however, not very significant to markets with high liquidity for both buyers and sellers, as the auction for selling the product and the auction for buying the product occur simultaneously, and the two prices are separated only by a relatively small spread. That mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread.

Economic bubbles

Speculation is often associated with economic bubbles.[12] A bubble occurs when the price for an asset exceeds its intrinsic value by a significant margin,[13] although not all bubbles occur due to speculation.[14] Speculative bubbles are characterized by rapid market expansion driven by word-of-mouth feedback loops, as initial rises in asset price attract new buyers and generate further inflation.[15] The growth of the bubble is followed by a precipitous collapse fueled by the same phenomenon.[13][16] Speculative bubbles are essentially social epidemics whose contagion is mediated by the structure of the market.[16] Some economists link asset price movements within a bubble to fundamental economic factors such as cash flows and discount rates.[17]

In 1936, John Maynard Keynes wrote: "Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. (1936:159)"[18] Keynes himself enjoyed speculation to the fullest, running an early precursor of a hedge fund. As the Bursar of the Cambridge University King's College, he managed two investment funds, one of which, called Chest Fund, invested not only in the then 'emerging' market US stocks, but to a smaller extent periodically included commodity futures and foreign currencies (see Chua and Woodward, 1983). His fund was profitable almost every year, averaging 13% per year, even during the Great Depression, thanks to very modern investment strategies, which included inter-market diversification (it invested in stocks, commodities and currencies) as well as shorting (selling borrowed stocks or futures to profit from falling prices), which Keynes advocated among the principles of successful investment in his 1933 report: "a balanced investment position... and if possible, opposed risks".[19]

It is controversial whether the presence of speculators increases or decreases short-term volatility in a market. Their provision of capital and information may help stabilize prices closer to their true values. On the other hand, crowd behavior and positive feedback loops in market participants may also increase volatility.

Government responses and regulation

The economic disadvantages of speculators have resulted in a number of attempts over the years to introduce regulations and restrictions to try to limit or reduce the impact of speculators. Such financial regulation is often enacted in response to a crisis as was the case with the Bubble Act 1720, which was passed by the British government at the height of the South Sea Bubble to try to stop speculation in such schemes. It was left in place for over a hundred years until it was repealed in 1825. Another example was the Glass–Steagall Act passed in 1933 during the Great Depression in the United States; most of the Glass-Steagall provisions were repealed during the 1980s and 1990s. The Onion Futures Act bans the trading of futures contracts on onions in the United States, after speculators successfully cornered the market in the mid-1950s; it remains in effect as of 2013.

Food security

Some nations have moved to limit foreign ownership of cropland to ensure that food is available for local consumption while others have sold food land and depend on the World Food Programme.[20]

In 1935, the Indian government passed a law allowing the government partial restriction and direct control of food production (Defence of India Act, 1935). It included the ability to restrict or ban the trading in derivatives on food commodities. After independence, in the 1950s, India continued to struggle with feeding its population and the government increasingly restricted trading in food commodities. Just at the time the Forward Markets Commission was established, the government felt that derivative markets increased speculation, which led to increased food costs and price instabilities. In 1953, it finally prohibited options and futures trading altogether.[21] The restrictions were not lifted until the 1980s.

Regulations

In the US, following passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Commodity Futures Trading Commission (CFTC) has proposed regulations aimed at limiting speculation in futures markets by instituting position limits. The CFTC offers three basic elements for their regulatory framework: "the size (or levels) of the limits themselves; the exemptions from the limits (for example, hedged positions) and; the policy on aggregating accounts for purposes of applying the limits."[22] The proposed position limits apply to 28 physical commodities traded in various exchanges across the US.[23]

Another part of the Dodd-Frank Act established the Volcker Rule, which deals with speculative investments of banks that do not benefit their customers. Passed on 21 January 2010, it states that those investments played a key role in the financial crisis of 2007–2010.[24]

Proposals

A number of proposals made in the past to try to limit speculation that were never enacted:

  • The Tobin tax is a tax intended to reduce short-term currency speculation, ostensibly to stabilize foreign exchange.
  • In May 2008 German leaders planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds.[25]
  • On 3 December 2009, Representative Peter DeFazio, who blamed "reckless speculation" for the 2008 financial crisis, proposed the introduction of a financial transaction tax, which would specifically target speculators by taxing financial market securities transactions.

Books

  • Covel, Michael. The Complete Turtle Trader. HarperCollins, 2007. ISBN 9780061241703
  • Douglas, Mark. The Disciplined Trader. New York Institute of Finance, 1990. ISBN 0-13-215757-8
  • Gunther, Max The Zurich Axioms Souvenir Press (1st print 1985) ISBN 0-285-63095-4.
  • Fox, Justin. The Myth of the Rational Market. HarperCollings, 2009. ISBN 9780060598990
  • Lefèvre, Edwin. Reminiscences of a Stock Operator John Wiley & Sons Inc., 2005 (1st print 1923) ISBN 0471678767
  • Neill, Humphrey B. The Art of Contrary Thinking Caxton Press 1954.
  • Niederhoffer, Victor Practical Speculation John Wiley & Sons Inc., 2005 ISBN 0-471-67774-4
  • Sobel, Robert The Money Manias: The Eras of Great Speculation in America, 1770-1970 Beard Books 1973 ISBN 1-58798-028-2
  • Patterson, Scott The Quants, How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed it Crown Business, 2010 ISBN 9780307453372
  • Schwartz, Martin "Buzzy". Pit Bull: Lessons from Wall Street's Champion Trader HarperCollins, 2007 ISBN 9780061844638
  • Schwager, Jack D. Trading with the Market Wizards: The Complete Market Wizards Series John Wiley & Sons 2013 ISBN 9781118582978
  • Tharp, Van K. Definitive Guide to Position Sizing International Institute of Trading Mastery, 2008. ISBN 0935219099

See also

References

  1. ^ Stäheli 2013, p. 4.
  2. ^ Szado, Edward (2011). "Defining Speculation: The First Step toward a Rational Dialogue". The Journal of Alternative Investments. CAIA Association.
  3. ^ "CFTC Glossary: A guide to the language of the futures industry". cftc.gov. Commodity Futures Trading Commission. Retrieved 28 August 2012.
  4. ^ "Staff Report on Commodity Swap Dealers & Index Traders with Commission Recommendations" (PDF). U.S. Commodity Futures Trading Commission. 2008. Retrieved 27 August 2012.
  5. ^ Graham, Benjamin (1973). The Intelligent Investor. HarperCollins Books. ISBN 0-06-055566-1.
  6. ^ Investment vs. Gambling, the Gambling Culture, pp. 37-44
  7. ^ A discussion of stock market speculation by P. J. Proudhon
  8. ^ Nicholas Kaldor, 1960. Essays on Economic Stability and Growth. Illinois: The Free Press of Glencoe.
  9. ^ Victor Niederhoffer, The Wall Street Journal, 10 February 1989 Daily Speculations
  10. ^ a b http://chicagofed.org/digital_assets/publications/understanding_derivatives/understanding_derivatives_chapter_1_derivatives_overview.pdf
  11. ^ a b Unlikely heroes - Can hedge funds save the world? One pundit thinks so, The Economist, 16 February 2010
  12. ^ Teeter, Preston; Sandberg, Jorgen (2017). "Cracking the enigma of asset bubbles with narratives". Strategic Organization. 15 (1): 91–99. doi:10.1177/1476127016629880.
  13. ^ a b Hollander, Barbara Gottfried (2011). Booms, Bubbles, & Busts (The Global Marketplace). Heinemann Library. pp. 40–41. ISBN 1432954776.
  14. ^ Lei, Noussair & Plott 2001, p. 831: "In a setting in which speculation is not possible, bubbles and crashes are observed. The results suggest that the departures from fundamental values are not caused by the lack of common knowledge of rationality leading to speculation, but rather by behavior that itself exhibits elements of irrationality."
  15. ^ Rosser, J. Barkley (2000). From Catastrophe to Chaos: A General Theory of Economic Discontinuities: Mathematics, Microeconomics, Macroeconomics, and Finance. p. 107.
  16. ^ a b Shiller, Robert J. (23 July 2012). "Bubbles without Markets". Retrieved 29 August 2012.
  17. ^ Siegel, Journal (2003). "What Is an Asset Price Bubble? An Operation Definition" (PDF). European Financial Management. 9 (1): 11–24. doi:10.1111/1468-036x.00206.
  18. ^ Dr. Stephen Spratt of Intelligence Capital (September 2006). "A Sterling Solution". Stamp Out Poverty report. Stamp Out Poverty Campaign. p. 15. Retrieved 2 January 2010.
  19. ^ Chua, J. H. and R. S. Woodward (1983). "The Investment Wizardry of J.M. Keynes". 39. Financial Analysts Journal: 35–37. JSTOR 4478643.
  20. ^ Valente, Marcela. "Curbing foreign ownership of farmland." IPS, 22 May 2011.
  21. ^ Frida Youssef (October 2000). "Integrated report on Commodity Exchanges And Forward Market Commission (FMC)". FMC.
  22. ^ "Speculative Limits". U.S. Commodity Futures Trading Commission. Retrieved 21 August 2012.
  23. ^ "CFTC Approves Notice of Proposed Rulemaking Regarding Regulations on Aggregation for Position Limits for Futures and Swaps". U.S. Commodity Futures Trading Commission. Retrieved 21 August 2012.
  24. ^ David Cho and Binyamin Appelbaum (22 January 2010). "Obama's 'Volcker Rule' shifts power away from Geithner". The Washington Post. Retrieved 13 February 2010.
  25. ^ Evans-Pritchard, Ambrose (26 May 2008). "Germany in call for ban on oil speculation". The Daily Telegraph. The Daily Telegraph. Retrieved 28 May 2008.
Bibliography

External links

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