Sunday, March 18, 2012

Speculation: Good or Bad?

Speculation is a topic that provides a variety of responses and reactions from various individuals. Some folks want to ban it, some folks defend the activity. Many activists are seeking to ban the activity, and are pushing politicians to pass legislation to eliminate this practice.  I believe speculation plays a vital role in the free market.  Here is a quote from the famous economist Ludwig von Mises regarding speculation:

 “Speculation is the link that binds isolated economic action to the economic activity of society as a whole. “

Speculation provides a mitigation of volatility while providing liquidity to the market place; and it does not create increases in demand of the underlying asset.  It should not be banned; in fact, banning this practice will increase the volatility in the marketplace, making the banning of this practice very dangerous.

 A Speculator assumes the risk of the volatility of future prices and brings them into the present.  In other words, he assumes the risk of the rapid price changes in the marketplace, thus making the volatility, well quite frankly, less volatile for the producer.   Many people assume speculation is like gambling.  As Economist Dr. Thomas Sowell writes:

“Speculation is often misunderstood as being the same as gambling, when in fact it is the opposite of gambling. What gambling involves, whether in games of chance or in actions like playing Russian roulette, is creating a risk that would otherwise not exist, in order either to profit or to exhibit one’s skill or lack of fear.  What economic speculation involves is coping with in inherent risk in such a way as to minimize it and to leave it to be borne by whoever is best to equipped to hear it.”

For the most part, speculators are mitigating the risk—the risk of price fluctuations.   They serve as a form of “insurance” for the marketplace.  For example, a farmer that is growing a particular commodity may be unsure of how his crop will turn out.  His prices of his crop are determined not just based on the availability of his crops, but a worldwide inventory.  If there is a situation that causes shrinkage of the worldwide inventory, the farmer’s prices will be impacted.  This may place the farmer in a precarious financial situation. To mitigate this situation, he will enter into a contract with a speculator. That speculator will assume the risk of the uncertainty of the price fluctuation. This agreement allows the famer to move forward in working his operation; the speculator has provided an offer to purchase a finite quantity of the farmer’s crop at a set price in the future. Of course, the speculator will never take issue or inventory of that particular good or crop.

Let us assume that the farmer was in an environment where speculators were banned. What would be the consequences of this action? Reviewing the scenario, the farmer would still be uncertain of future prices and how the future prices would turn out. So, he is placing his operation’s resources at risk in the event that prices are not able to satisfy his cost to produce a crop. If he guesses wrong, he loses money, maybe his operation.  Transferring this risk to a speculator actually protects his operation and its finite resources.  This scenario can be used in any sort of speculative transaction.

What about the claims that the speculators are raking in all this cash, and operating with surreptitious motives? This claim does not tell the entire story. Most trades do not make money. Obviously, they earn money as a whole; otherwise they would do something else.  They must have the ability to predict for each contract the proper price on the contract. If the contract prices do not meet the actual price projected by the farmer, the speculator can and will lose money. Since the risk is being passed from the farmer to the speculator, they absorb more of the risk. This makes this type of enterprise with a potential high reward, and very high risk. 

Lastly, there is no evidence that speculation drives up the market price. The Hunt brothers in the 1970s attempted to corner the silver commodities market. They lost billions within a matter of days or weeks.  Here is a quote from Economist Darryl Duffie of the Hoover Institute:

 “The market for silver was temporarily cornered in 1979-80, when Nelson Bunker Hunt and his brother William Herbert Hunt held silver derivatives representing approximately half of annual global silver production. In the end, the Hunt brothers were unable to maintain a corner. As they sold, silver prices fell, causing them calamitous losses “

The FTC did an investigation [,] where they found no correlation between speculators and gas prices.

In closing, speculation is a needed function in the marketplace. Removal of this activity would be extremely hazardous.  Speculators provide a method of handling risk in the marketplace. It is a means to provide producers a way to transfer the risk of uncertainty of prices, so producers can focus on what they are well equipped to do: Produce. 

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