Speculation, in a financial context, is making an investment that increases the overall risk in a portfolio. The opposite of speculation is hedging, which is making investments that decrease the overall risk in a portfolio. The reason the context of a portfolio is important can be illustrated by example: investing in futures contracts to buy oil is generally considered to be risky and speculative; however, if your portfolio predominantly contains airlines, investing in oil contracts could very well reduce or hedge your risk. (Note that airlines frequently invest in oil futures and hedge their own oil risk, so in the absence of inside information, making such investments could indeed be speculative.)

Investment is the assumption of the risk of loss, in return for the uncertain possibility of a reward. Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives, or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculation represents one of three market roles in Western financial markets, distinct from hedging and arbitrage.

Speculation areas

Popular convention, and especially satire, sometimes portray speculators comically as speculating in pork bellies (for which there is an active commercial market — as well as a futures market in which real speculators coexist alongside the dominant commercial hedgers active there) and often as "losing their shirts" or making a fortune on small market changes. While speculation does exist in many relatively small commercial markets (as measured by aggregate market value) such as cattle, hogs, pork bellies, orange juice, and lumber, just as it does in the massively more important global markets such as foreign exchange and petroleum, for most such markets, large and small, such risk-transfer instruments as futures contracts and other derivatives are available both to commercial as well as to speculative interests to establish a large position with only a small deposit of capital (i.e., with substantial leverage). That leverage subjects the one without a counterbalancing commercial position (i.e., the speculator) to the risk of an enormous loss in proportion to one's capital on deposit, in return for the sometimes speculative opportunity for an equally enormous reward in response to a fairly small move in the underlying market.

Type of speculators

By some definitions, most long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are not primarily motivated by eventually selling at a good profit. Some dedicated speculators are distinguished by shorter holding times, the use of leverage, by being willing to take short positions as well as long positions (in markets where the distinction can be reasonably made). A degree of speculation exists in a wide range of financial decisions, from the purchase of a house to a bet on a horse; this is what modern market economists call "ubiquitous speculation."

In Security Analysis, Benjamin Graham gave a definition of speculation in relation to investment: "An investment operation is one which, upon thorough analysis, promises safety of principal and a satisfactory return. Operations not meeting these requirements are speculative."

The economic benefits of speculation

The well known speculator Victor Niederhoffer, in "The Speculator as Hero 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 for others to offset risk, including those who may be classified as hedgers and arbitrageurs.

If a certain market - for example, pork bellies - had no speculators, then only producers (hog farmers) and consumers (butchers, etc.) would participate in that market. 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 wants to either buy or sell pork bellies would be forced to accept an illiquid market and market prices that have a large bid-ask spread or might even find it difficult to find a co-party to buy or sell to. A speculator (e.g. a pork dealer) may exploit the difference in the spread and, in competition with other speculators, reduce the spread, thus creating a more efficient market.

Some side effects

Auctions are a method of squeezing out speculators from a transaction, but they may have their own perverse effects; see 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. This mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread.

Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. For example, speculative purchasing can push prices above their true value (real value - adjusted for inflation) simply because the speculative purchasing artificially increases the demand. Speculative selling can also have the opposite effect, causing prices to artificially decrease below their true value in a similar fashion. In various situations, price rises due to speculative purchasing cause further speculative purchasing in the hope that the price will continue to rise. This creates a positive feedback loop in which prices rise dramatically above the underlying value or worth of the items. This is known as an economic bubble. Such a period of increasing speculative purchasing is typically followed by one of speculative selling in which the price falls significantly, in extreme cases this may lead to crashes.

It is a controversial point whether the presence of speculators increases or decreases the 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 at times.

Etymology

The Etymology of the word is as follows; from O.Fr. speculation, from L.L. speculationem (nom. speculatio) "contemplation, observation," from L. speculatus, pp. of speculari "observe," from specere "to look at, view". Speculator in the financial sense is first recorded 1778. Speculate is a 1599 back-formation.

What is significant to note is the change from a passive to an active form of use. Specifically from a strict observer to one who contemplates what they observe then further to one who contemplates and acts on what they observe.

With these changes, the word as now commonly used, describes one who observes an object, event, or situation and takes some form of action with regard to the observed, all the while aware they may not know all the facts or factors regarding or affecting that which they observe. E.g. the financial speculator, one who understands and accepts he may not know all the facts or risks involved with a venture, yet chooses to invest his capital in the venture for the possibility of receiving greater capital in return.

Problems caused by financial speculation

Some blame financial speculation as the main cause of various economic crises around the world.

Regulating Speculation

The Tobin tax is a tax design to reduce short-term currency speculation.

In May 2008, German leaders have planned to propose a worldwide ban on oil trading by speculators, blaming the 2008 oil price rises on manipulation by hedge funds.

Books

• Sobel, Robert (2000). The Money Manias: The Eras of Great Speculation in America, 1770-1970. Beard Books.
• Gunther, Max (1992). The Zurich Axioms. Souvenir Press.
• Niederhoffer, Victor (2005). Practical Speculation. Wiley.

References

See also

• Adventurer
• Behavioral finance
• Carbon credits
• Equity investment
• Fictitious capital
• Financial markets
• Day trading
• George Soros
• Jesse Lauriston Livermore
• Gambling
• Seasonal traders
• Short selling
• Speculative Attack
• Stock market bubble
• Stock trader
• Tobin tax
• Tulip mania

External links

• Congress Plans to Tighten Rules on Energy Speculation