Dear SAP Banking Community members.
Some weeks ago the BBC make a funny interview to a stock trader, generating worldwide controversy.
http://www.youtube.com/watch?v=aC19fEqR5bA&feature=player_embedded
With the interview as an example, politicians and economists have been blaming speculators as the ultimate responsible of the coming recession.
In my opinion, speculation is just an economic activity, which plays a critical role in the Capitalist System, or more exactly, used to play.
Simplifying, a speculator buys assets in places or times (with futures, options and forward contracts) where/when they’re cheap and sells them when/where they’re expensive. He’s increasing the price when/where the asset is cheap (by increasing demand) and reducing it when/where is expensive (by increasing offering).
On the other hand, by increasing the price of the asset when is cheap the speculator is also increasing the incentives of economic agents for producing the asset which will have a positive effect reducing the price in the future. From this perspective speculators are collaborating in spreading information in the system and allocating resources.
Additionally, speculation increases liquidity in the Financial Markets; without speculators for every seller the market needs a counterpart at the same time/place. For example, if I want to sell a house in Toronto, I will need a buyer in the same place, at the same time and with the right budget. Obviously in a world like this, the number of trades will be much more limited than in a world where an speculator would buy the house now for selling to a third party in the future.
If speculation is so positive, why speculators have so bad reputation?
First, we must remember that speculators with bad reputation in crisis times; are honored investors in booming economies.
But also, the market making activity described above is less efficient than it looks like.
Let’s look to the activity of the Hedge Funds; speculating with the price of Gold (any other asset would be also valid).
Theoretically, hedge funds buy gold now because they expect future inflation and consequently higher prices of gold in the future, but reality is more complex than that.
Hedge-funds make massive use of debt to finance their investment/speculation activities.
This has two side-effects.
- On one side, in a recession or non-growing market like nowadays, the volume of trades is minimal and the influence of the Hedge Funds on the price of the assets is much higher than it would be in growing market, consequently there’s no balance of information amongst economic agents (a root cause for an inefficient market).
- On the other hand, the high level of debt of the Hedge Funds comes with very high level of Credit Risk which is translated in Market risk and multiplying the volatility of the market.
For instance, the hedge fund financing gold acquisition with debt is very sensitive to an increase of interest rates which will end in liquidity problems for the fund. At this time the hedge fund would sell gold making fall its price. The credit risk of the Fund has been translated in market risk of the gold. Again, a very inefficient way of building a market.
Speculation is useful in a booming economy as it plays a necessary role of resources allocation, but it’s inefficient in the kind of Financial System we’re moving to.
Capital and Liquidity are very expensive resources and they’re going to be more and more expensive in the oncoming future. Efficient Capital and Liquidity management is going to be critical, I’m not so sure that hedge-funds and traditional speculation activities can play that role.
Looking forward to read your comments.
Kindest Regards.
Ferran.
Some weeks ago the BBC make a funny interview to a stock trader, generating worldwide controversy.
http://www.youtube.com/watch?v=aC19fEqR5bA&feature=player_embedded
With the interview as an example, politicians and economists have been blaming speculators as the ultimate responsible of the coming recession.
In my opinion, speculation is just an economic activity, which plays a critical role in the Capitalist System, or more exactly, used to play.
Simplifying, a speculator buys assets in places or times (with futures, options and forward contracts) where/when they’re cheap and sells them when/where they’re expensive. He’s increasing the price when/where the asset is cheap (by increasing demand) and reducing it when/where is expensive (by increasing offering).
On the other hand, by increasing the price of the asset when is cheap the speculator is also increasing the incentives of economic agents for producing the asset which will have a positive effect reducing the price in the future. From this perspective speculators are collaborating in spreading information in the system and allocating resources.
Additionally, speculation increases liquidity in the Financial Markets; without speculators for every seller the market needs a counterpart at the same time/place. For example, if I want to sell a house in Toronto, I will need a buyer in the same place, at the same time and with the right budget. Obviously in a world like this, the number of trades will be much more limited than in a world where an speculator would buy the house now for selling to a third party in the future.
If speculation is so positive, why speculators have so bad reputation?
First, we must remember that speculators with bad reputation in crisis times; are honored investors in booming economies.
But also, the market making activity described above is less efficient than it looks like.
Let’s look to the activity of the Hedge Funds; speculating with the price of Gold (any other asset would be also valid).
Theoretically, hedge funds buy gold now because they expect future inflation and consequently higher prices of gold in the future, but reality is more complex than that.
Hedge-funds make massive use of debt to finance their investment/speculation activities.
This has two side-effects.
- On one side, in a recession or non-growing market like nowadays, the volume of trades is minimal and the influence of the Hedge Funds on the price of the assets is much higher than it would be in growing market, consequently there’s no balance of information amongst economic agents (a root cause for an inefficient market).
- On the other hand, the high level of debt of the Hedge Funds comes with very high level of Credit Risk which is translated in Market risk and multiplying the volatility of the market.
For instance, the hedge fund financing gold acquisition with debt is very sensitive to an increase of interest rates which will end in liquidity problems for the fund. At this time the hedge fund would sell gold making fall its price. The credit risk of the Fund has been translated in market risk of the gold. Again, a very inefficient way of building a market.
Speculation is useful in a booming economy as it plays a necessary role of resources allocation, but it’s inefficient in the kind of Financial System we’re moving to.
Capital and Liquidity are very expensive resources and they’re going to be more and more expensive in the oncoming future. Efficient Capital and Liquidity management is going to be critical, I’m not so sure that hedge-funds and traditional speculation activities can play that role.
Looking forward to read your comments.
Kindest Regards.
Ferran.
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