ECONOMIC BENEFITS OF SPECULATION

Global financial markets are driven primarily by two factors: demand and supply, which ultimately determine price levels and direction. Demand and supply are further driven by several factors one of which is speculation. Other factors include the activities of hedgers, arbitragers and investors.

Hedgers seek to offset pre-existing risk, arbitragers seek to take advantage of financial instrument price differences across different market segments, while investors seek to profit through long term ownership of financial instruments or assets. Speculation involves trading in financial assets such as stocks, commodities and foreign currencies in the hope of gain, albeit with the risk of loss. Speculators discount underlying gains in financial assets such as interest, capital gains and dividends and focus largely on changes in market value of the financial assets as a result of price movements.

A speculator has only one goal – profit. Given that he seeks to take advantage of arbitrage opportunities in the financial system, speculators often find themselves at cross purposes with regulators and the real sector. In the process of seeking to benefit from temporary structural imbalances in markets, speculators are often accused of destroying economic value usually because their activities often aggravate an existing, unwanted situation. Career speculators analyse past and present fundamentals in an attempt to establish trends. Based on these trends, they establish a view on market expectation and take a position based on their expectation.

Their exposures maybe as a result of buying, selling or short selling any particular trade-able asset with the aim of reversing (squaring) the exposure at future profitable levels. Other speculators (scavengers) simply observe structural imbalances within the financial system and seek to benefit from the imbalances usually to the overall detriment of the economy and often against the wish of financial regulators. Despite being seen as undesirable, activities of speculators actually do have some beneficial impact on the economy. Perhaps the most important advantage of speculation to the economy is the liquidity it brings to markets.

Real demand and supply may not always be available and cannot sufficiently keep markets active at all times. Since market efficiency is measured in terms of effective pricing mechanism, size and depth, the activities of speculators become relevant in buoying markets towards the desired levels of efficiency as they provide “artificial” demand when “real demand” is not available and “artificial” supply when “real supply” is not available. The risk they take (funded by their capital) is against the expectation that real demand and supply will help push prices to equilibrium. It is a speculator’s ability to accurately guess where the equilibrium price levels set in that ultimately gives him his reward.

Speculators further enhance market efficiency through their presence in the markets by making it easy for asset holders and exposed parties to measure risk by price discovery. A market without speculators would only be active periodically, i.e. when a real buyer and a real seller exist simultaneously. The price at which their trade is struck would then be recorded as the reference rate. However, with speculators in the market, trade volumes are high and frequent thus making it easy to record series of reference prices for asset valuation and risk evaluation purposes.

Finally, commodity speculators willing to buy products up front (via derivatives) actually indirectly boost the production of that product by creating up-front demand. This triggers production with its attendant desirable effects on the overall economy.

By Olawale Hamed