Speculation

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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.

Commodity marketable item produced to satisfy wants or needs

In economics, a commodity is an economic good or service that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.

Real estate is "property consisting of land and the buildings on it, along with its natural resources such as crops, minerals or water; immovable property of this nature; an interest vested in this (also) an item of real property, buildings or housing in general. Also: the business of real estate; the profession of buying, selling, or renting land, buildings, or housing." It is a legal term used in jurisdictions whose legal system is derived from English common law, such as India, England, Wales, Northern Ireland, United States, Canada, Pakistan, Australia, and New Zealand.

Market value or OMV is the price at which an asset would trade in a competitive auction setting. Market value is often used interchangeably with open market value, fair value or fair market value, although these terms have distinct definitions in different standards, and may or may not differ in some circumstances.

Contents

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.

Technical analysis security analysis methodology

In finance, technical analysis is an analysis methodology for forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the same tools of technical analysis, which, being an aspect of active management, stands in contradiction to much of modern portfolio theory. The efficacy of both technical and fundamental analysis is disputed by the efficient-market hypothesis which states that stock market prices are essentially unpredictable.

Stock financial instrument

The stock of a corporation is all of the shares into which ownership of the corporation is divided. In American English, the shares are commonly known as "stocks". A single share of the stock represents fractional ownership of the corporation in proportion to the total number of shares. This typically entitles the stockholder to that fraction of the company's earnings, proceeds from liquidation of assets, or voting power, often dividing these up in proportion to the amount of money each stockholder has invested. Not all stock is necessarily equal, as certain classes of stock may be issued for example without voting rights, with enhanced voting rights, or with a certain priority to receive profits or liquidation proceeds before or after other classes of shareholders.

Bond (finance) instrument of indebtedness

In finance, a bond is an instrument of indebtedness of the bond issuer to the holders. The most common types of bonds include municipal bonds and corporate bonds.

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.

Hedge (finance)

A hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.

In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices at which the unit is traded. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For example, an arbitrage opportunity is present when there is the opportunity to instantaneously buy something for a low price and sell it for a higher price.

In economics, fungibility is the property of a good or a commodity whose individual units are essentially interchangeable, and each of its parts is indistinguishable from another part.

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]

<i>The Intelligent Investor</i> 1949 book by Benjamin Graham

The Intelligent Investor by Benjamin Graham, first published in 1949, is a widely acclaimed book on value investing.

Economic benefits

Sustainable consumption level

Speculation usually involves more risks than investment. Philippine-stock-market-board.jpg
Speculation usually involves more risks than investment.

Nicholas Kaldor [6] 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", [7] 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. [8] 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. [8]

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. [9]

Shorting

Shorting may act as a "canary in a coal mine" to stop unsustainable practices earlier and thus reduce damages and forming market bubbles. [9]

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. [10] A bubble occurs when the price for an asset exceeds its intrinsic value by a significant margin, [11] although not all bubbles occur due to speculation. [12] 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. [13] The growth of the bubble is followed by a precipitous collapse fueled by the same phenomenon. [11] [14] Speculative bubbles are essentially social epidemics whose contagion is mediated by the structure of the market. [14] Some economists link asset price movements within a bubble to fundamental economic factors such as cash flows and discount rates. [15]

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)" [16] 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". [17]

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 speculation 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. States often enact such financial regulation in response to a crisis. Note for example the Bubble Act 1720, which the British government passed at the height of the South Sea Bubble to try to stop speculation in such schemes. It remained in place for over a hundred years until repealed in 1825. The Glass–Steagall Act passed in 1933 during the Great Depression in the United States provides another example; 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.

The Soviet Union regarded speculation (Russian : спекуляция) as a criminal offence and punished speculators accordingly with fines, imprisonment, confiscation and/or corrective labor.

Food security

Some nations have moved to limit foreign ownership of cropland to ensure that food is available for local consumption, while others have leased food land abroad despite receiving aid from the World Food Programme. [18]

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 achieving independence in 1947, India in the 1950s 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 in 1953, 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. [19] The restrictions were not lifted until the 1980s.

Regulations

In the United States of America, following passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, 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". [20] The proposed position limits would apply to 28 physical commodities traded in various exchanges across the US. [21]

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. [22]

Proposals

Proposals made in the past to try to limit speculation - but never enacted - included:

Books

See also

Related Research Articles

Derivative (finance) Operation in calculus

In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the "underlying". Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation or getting access to otherwise hard-to-trade assets or markets. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the New York Stock Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges. Derivatives are one of the three main categories of financial instruments, the other two being stocks and debt. The oldest example of a derivative in history, attested to by Aristotle, is thought to be a contract transaction of olives, entered into by ancient Greek philosopher Thales, who made a profit in the exchange. Bucket shops, outlawed a century ago, are a more recent historical example.

Commodity market physical or virtual transactions of buying and selling involving raw or primary commodities

A commodity market is a market that trades in the primary economic sector rather than manufactured products, such as cocoa, fruit and sugar. Hard commodities are mined, such as gold and oil. Investors access about 50 major commodity markets worldwide with purely financial transactions increasingly outnumbering physical trades in which goods are delivered. Futures contracts are the oldest way of investing in commodities. Futures are secured by physical assets. Commodity markets can include physical trading and derivatives trading using spot prices, forwards, futures, and options on futures. Farmers have used a simple form of derivative trading in the commodity market for centuries for price risk management.

Contango

Contango, also sometimes called forwardation, is a situation where the futures price of a commodity is higher than the anticipated spot price at maturity of the contract. In a contango situation, arbitrageurs/speculators, are "willing to pay more [now] for a commodity [to be received] at some point in the future than the actual expected price of the commodity [at that future point]. This may be due to people's desire to pay a premium to have the commodity in the future rather than paying the costs of storage and carry costs of buying the commodity today." On the other side of the trade, hedgers are happy to sell futures contracts and accept the higher-than-expected returns. A contango market is also known as a normal market, or carrying-cost market.

Futures contract standardized legal agreement to buy or sell something (usually a commodity or financial instrument) at a predetermined price (“forward price”) at a specified time (“delivery date”) in the future

In finance, a futures contract is a standardized forward contract, a legal agreement to buy or sell something at a predetermined price at a specified time in the future, between parties not known to each other. The asset transacted is usually a commodity or financial instrument. The predetermined price the parties agree to buy and sell the asset for is known as the forward price. The specified time in the future—which is when delivery and payment occur—is known as the delivery date. Because it is a function of an underlying asset, a futures contract is a derivative product.

Forward contract non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed upon today

In finance, a forward contract or simply a forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on at the time of conclusion of the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

Futures exchange Central financial exchange where people can trade standardized futures contracts

A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of contracts fall into the category of derivatives. A counterpart to the futures market is the spots market, where trades will occur immediately after a transaction agreement has been made, rather than at a predetermined time in the future. Futures instruments are priced according to the movement of the underlying asset. The aforementioned category is named "derivatives" because the value of these instruments are derived from another asset class.

Commodity Futures Trading Commission government agency

The U.S. Commodity Futures Trading Commission (CFTC) is an independent agency of the US government created in 1974, that regulates futures and option markets.

The foreign exchange market is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the Credit market.

Stock trader a person or company involved in trading equity securities (share stock in companies)

A stock trader or equity trader or share trader is a person or company involved in trading equity securities. Stock traders may be an agent, hedger, arbitrageur, speculator, stockbroker. Such equity trading in large publicly traded companies may be through a stock exchange. Stock shares in smaller public companies may be bought and sold in over-the-counter (OTC) markets.

Foreign exchange fraud is any trading scheme used to defraud traders by convincing them that they can expect to gain a high profit by trading in the foreign exchange market. Currency trading became a common form of fraud in early 2008, according to Michael Dunn of the U.S. Commodity Futures Trading Commission.

Nadex Nadex

Nadex, formerly known as HedgeStreet, is US-based retail-focused online binary options exchange. It offers retail trading of binary options and spreads on the most heavily traded forex, commodities and stock indices markets.

Foreign exchange risk is a financial risk that exists when a financial transaction is denominated in a currency other than the domestic currency of the company. The exchange risk arises when there is a risk of significant appreciation of the domestic currency in relation to the denominated currency before the date when the transaction is completed.

The following outline is provided as an overview of and topical guide to finance:

A commodity broker is a firm or an individual who executes orders to buy or sell commodity contracts on behalf of the clients and charges them a commission. A firm or individual who trades for his own account is called a trader. Commodity contracts include futures, options, and similar financial derivatives. Clients who trade commodity contracts are either hedgers using the derivatives markets to manage risk, or speculators who are willing to assume that risk from hedgers in hopes of a profit.

Amaranth Advisors LLC was an American multi-strategy hedge fund founded by Nicholas Maounis and headquartered in Greenwich, Connecticut. During its peak, the firm had up to $9 billion in assets under management before collapsing in September 2006, after losing in excess of $5 billion on natural gas futures. The firm's failure was one of the largest known trading losses and hedge fund collapses in history.

A foreign exchange derivative is a financial derivative whose payoff depends on the foreign exchange rate(s) of two currencies. These instruments are commonly used for currency speculation and arbitrage or for hedging foreign exchange risk.

A Commodity trading advisor (CTA) is US financial regulatory term for an individual or organization who is retained by a fund or individual client to provide advice and services related to trading in futures contracts, commodity options and/or swaps. They are responsible for the trading within managed futures accounts. The definition of CTA may also apply to investment advisors for hedge funds and private funds including mutual funds and exchange-traded funds in certain cases. CTAs are generally regulated by the United States federal government through registration with the Commodity Futures Trading Commission (CFTC) and membership of the National Futures Association (NFA).

A managed futures account (MFA) or managed futures fund (MFF) is a type of alternative investment in the US in which trading in the futures markets is managed by another person or entity, rather than the fund's owner. Managed futures accounts include, but are not limited to, commodity pools. These funds are operated by commodity trading advisors (CTAs) or commodity pool operators (CPOs), who are generally regulated in the United States by the Commodity Futures Trading Commission and the National Futures Association. As of June 2016, the assets under management held by managed futures accounts totaled $340 billion.

Sharia and securities trading Muslim view on trading

The Islamic banking and finance movement that developed in the late 20th century as part of the revival of Islamic identity sought to create an alternative to conventional banking that complied with sharia (Islamic) law. Following sharia it banned from its practices riba (usury) – which it defined as any interest paid on all loans of money – and involvement in haram (forbidden) goods or services such as pork or alcohol. It also forbids gambling (maisir) and excessive risk.

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. Nicholas Kaldor, 1960. Essays on Economic Stability and Growth. Illinois: The Free Press of Glencoe.
  7. Victor Niederhoffer, The Wall Street Journal, 10 February 1989 Daily Speculations
  8. 1 2 http://chicagofed.org/digital_assets/publications/understanding_derivatives/understanding_derivatives_chapter_1_derivatives_overview.pdf
  9. 1 2 Unlikely heroes - Can hedge funds save the world? One pundit thinks so, The Economist, 16 February 2010
  10. Teeter, Preston; Sandberg, Jorgen (2017). "Cracking the enigma of asset bubbles with narratives". Strategic Organization. 15 (1): 91–99. doi:10.1177/1476127016629880.
  11. 1 2 Hollander, Barbara Gottfried (2011). Booms, Bubbles, & Busts (The Global Marketplace). Heinemann Library. pp. 40–41. ISBN   1432954776.
  12. 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."
  13. Rosser, J. Barkley (2000). From Catastrophe to Chaos: A General Theory of Economic Discontinuities: Mathematics, Microeconomics, Macroeconomics, and Finance. p. 107.
  14. 1 2 Shiller, Robert J. (23 July 2012). "Bubbles without Markets" . Retrieved 29 August 2012.
  15. 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.
  16. 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.
  17. Chua, J. H. and R. S. Woodward (1983). "The Investment Wizardry of J.M. Keynes". 39. Financial Analysts Journal: 35–37. JSTOR   4478643.Cite journal requires |journal= (help)
  18. Compare: Valente, Marcela. "Curbing foreign ownership of farmland." IPS, 22 May 2011. "The governments of Argentina, Brazil and Uruguay are drafting laws to curb acquisition by foreigners of extensive tracts of their fertile agricultural land. [...] China, Egypt, Japan, South Korea, Saudi Arabia, India, Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates are all buying or leasing fertile land in other countries where food is not always abundant, the Grain report says.
    The study says Cambodia, which receives aid from the World Food Programme, has leased rice fields to Qatar and Kuwait, while Uganda has granted concessions on its wheat and maize fields to Egypt, and interested parties from Saudi Arabia and the United Arab Emirates are making approaches to the Philippines."
  19. Frida Youssef (October 2000). "Integrated report on Commodity Exchanges And Forward Market Commission (FMC)". FMC.
  20. "Speculative Limits". U.S. Commodity Futures Trading Commission. Retrieved 21 August 2012.
  21. "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.
  22. David Cho and Binyamin Appelbaum (22 January 2010). "Obama's 'Volcker Rule' shifts power away from Geithner". The Washington Post . Retrieved 13 February 2010.
  23. 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