Speculation is often seen in pejorative terms, although it is widely recognized in trading and academic circles as providing a useful economic function. In the commodity markets, for example, which are often characterized by output uncertainty and (hence) price volatility, an optimal market equilibrium is achieved when participants can exchange risk through the process of speculation (Courchane and Nickerson, 1986). In this sense, speculators are often seen as the counter-parties to hedge traders who wish to offload an exposure to risk. Marshall’s view was that speculation was only marginally distinguishable from gambling. However, in a more refined distinction, Floersch (Vice Chairman, Chicago Board Options Exchange, in Strong, 1994) sees gamblers as creating risk where none exists, and speculators as accepting an existing risk. In this sense, hedgers offer a market for risk which speculators accept at a price. The speculators’ unique skill is in their ability to judge whether the risk is worth taking at a particular price and, in so doing, they will try to ascertain and learn from information that others do not have (Froot et al. , 1992).
Speculation is not restricted to financial markets. Agricultural products, gold, and other precious metals are the subject of speculative trading. In this sphere, gold is often seen as fundamentally a speculative venture since trade rs mostly do not take delivery but can trade in gold certificates, gold futures, and futures options. However, the important risk hedging function is still evident since gold is often a safe refuge in times of political or economic uncertainty.
Many of the controversies surrounding speculation relate to the association of speculators with destabilized markets and huge financial losses, particularly in recent times with respect to currency markets and also in the use of derivative securities. While financial losses can be a natural consequence of taking a position in a security, the question of a destabilized market is a subject of debate. Traditionally, speculation is seen as an activity that assists in moving prices to equilibrium (Friedman, 1953) and , as such, cannot be the cause of market destabilization. Critics of speculation would argue that the use of derivative securities, for which there might be a huge open interest relative to the supply of the deliverable commodity, is indicative of how such assets might be destabilizing by giving rise to price runs unrelated to the scarcity of the underlying commodity . Moreover, the ease at which a substantial position can be created through the use of leve rage can give rise to a resulting price dynamic against which the market, itself, cannot fight. While the desired role of speculation is not disputed, the pertinent question – which will help determine its impact – is whether speculation results from a rational/fundamentals-based realignment or is a response to noise trading whereby apparently random events can give rise to destabilizing trading responses. The often observed coexistence of speculation and instability has led to considerable theoretical work in an attempt to identify and quantify possible linkages between the two and a number of different markets have been investigated.
Speculative activity in foreign exchange is often a two-edged sword. On the one hand, speculation within the context of an underlying stable economic policy can create a framework within which long-term fundamentals prevail as the principal driving forces in currency movements. Speculators then look to longer-term horizons and this has been seen as a mechanism by which currency volatility can be reduced. On the other hand, Krugman and Miller (1992), argue that stop-loss orders made by speculators can undermine the stability of a currency if a currency target zone, such as the ERM, is not seen as effective. Badly misjudged target zones can create speculative runs on the expectation that a currency will be forced to leave a target zone (as in the departure of sterling from the ERM in 1992).
In principle, trading in derivatives markets (on currencies, bonds, stocks, and stock indices) cannot be destabilizing because – if the pricing of these securities is correct – options and futures of all types only serve to make easier the taking of positions which enable the exchange of risk. In general, derivative assets can only present a picture of a situation that already exists, but in an easier-to-trade manner . In particular, futures trading, for example, is largely perceived to perform the role of price discovery and thereby enable the process of risk transfer. However, speculators in futures are often criticized for not trading on the basis of fundamentals (Maddala and Yoo, 1991), thereby creating excessive volatility and raising the risk premiums faced by hedgers when it is their economic role to reduce premiums thereby allowing the easier transacting of risk. The issue is an empirical one. In measuring average levels of speculation with average volatility, Edwards and Ma (1992), report no correlation, whereas some degree of association should be present for there to be a relationship.
On a global scale, the crash of 1987 revealed a situation in which an extremely destabilized market was associated with hedging/speculation and derivatives trading. Program trading and portfolio insurance have been accused of destabilizing the market and these subjects are covered elsewhere.
