PROJECT ON:SPECULATION AS A RISK

GROUP MEMBERS 1. PAYAL JOSHI 2. PRATIKSHA PAKHARE 3. AARTI SONI

ROLL NO 19 32 48

ACKNOWLEDGEMENT
With great pleasure and a deep sense of gratitude I hereby acknowledge everyone who provided me with their help, assistance and sustained support without which, even if I have had done this work, it would not have been as it has turned out to be. Their enlightened feedbacks and directions can be sensed as the project moves on.

I am sincerely thankful to my project guide, Prof. Oberoi Sir, who provided me With all the theoretical and practical inputs for my project. Without her thoughtful support this project would not have been completed.

Last but not the least, I thank everybody, who helped directly or indirectly in completing the project that will go a long way in my career, the project is really knowledgeable & memorable one.

INDEX
1. 2. 3. 4. 5. 6. 7. 8. 9. Introduction of speculation Kinds of Speculators Investment V/S Speculation The Economic benefits of speculation The Economic Dis-advantage of speculation Speculation Fundamentals Excessive Speculation The Speculator as a risk taker Speculation,Hedging & Arbitrage Speculative limits

10. Conclusion Biblography

1. Introduction of speculation:In finance, speculation is a financial action that does not promise safety of the initial investment along with the return on the principal sum. Speculation typically involves the lending of money for the purchase of assets, equity or debt but in a manner that has not been given thorough analysis or is deemed to have low margin of safety or a significant risk of the loss of the principal investment. The term, "speculation," which is formally defined as above in Grahamand Dodd's 1934 text, Security Analysis, contrasts with the term "investment," which is a financial operation that, upon thorough analysis, promises safety of principal and a satisfactory return. In a financial context, the terms "speculation" and "investment" are actually quite specific. For instance, although the word "investment" is commonly used to mean any act of placing money in a financial vehicle with the intent of producing returns over a period of time, most ventured moneyincluding funds placed in the world's stock marketsis technically not investment, but speculation. Speculators may rely on an asset appreciating in price due to any of a number of factors that cannot be well enough understood by the speculator to make an investment-quality decision. Some such factors are shifting consumer tastes, fluctuating economic conditions, buyers' changing perceptions of the worth of a stock security, economic factors associated with market timing, the factors associated with solely chart-based analysis, and the many influences over the short-term movement of securities. There are also some financial vehicles that are, by definition, speculation. For instance, trading commodity futures contracts, such as for oil and gold, is, by definition, speculation. Short selling is also, by definition, speculative. Financial speculation can involve the trade (buying, holding, selling) and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate,derivatives, or any valuable financial instrument to attempt to profit from fluctuations in its price irrespective of its underlying value.

Kinds of Speculators:Four kinds of speculators operate in the Indian Stock Exchange. They are known as bull, bear, stag and lame duck.

1. Broker :Broker is a person who transact business in securities on behalf of his clients and receives commission for his services. He deals between the jobbers and members our side the house. He is an experienced agent of the public. 2. Bull :He is a speculator who purchases various types of shares. He purchases to sell them on higher prices in future. He may sell the shares and securities before coming in possession. If the price falls then he suffers a loss.

3. Bear :He is always in a position to dispose of securities which he does not possess. He makes profit on each transaction. He sells the various securities for the objective of taking advantages of an expected fall in prices. 4. Lame Duck :When bear fails to meet his obligations he struggles to meet finance like the Lame Duck. This may happen when he has been concerned. Generally a bear agrees to dispose off certain shares on specific date. But sometimes he fails to deliver due to non availability of shares in the market. If the other party refuses to postpone the delivery them lame duck suffers heavy losses.

5. Stag:A stag is that type of speculator who treads his path very carefully. He applies for shares in new companies and expects to sell them at a premium if he gets an allotment. He selects those companies whose shares are most in demand and are likely to carry a premium. He sells the shares before being called to pay the allotment money. A stag does not indulge in purchase and sale of shares in the market like a bull and a bear. A Lame Duck is nothing but a stressed bear. When a bear finds it difficult to complete his promise he is labeled as a lame duck. 6.Jobber:Jobber is a professional speculator who has a complete information regarding the particular shares he deals. He transacts the shares of profit. He conducts the securities in his own name. He is the member of the stock exchange and he deals only with the members.

2. Investment vs. speculation

Identifying speculation can be best done by distinguishing it from investment. According to Ben Graham in Intelligent Investor, the prototypical defensive investor is "...one interested chiefly in safety plus freedom from bother." He admits, however, that "...some speculation is necessary and unavoidable, for in many common-stock situations, there are substantial possibilities of both profit and loss, and the risks therein must be assumed by someone." Many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only the rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit. Speculating is the assumption of risk in anticipation of gain but recognizing a higher than average possibility of loss. The term speculation implies that a business or investment risk can be analyzed and measured, and its distinction from the term Investment is one of degree of risk. It differs from gambling, which is based on random outcomes. There is nothing in the act of speculating or investing that suggests holding times have anything to do with the difference in the degree of risk separating speculation from investing.

3. The economic benefits of speculation 3.1. Sustainable consumption level:Speculation usually involves more risks than investment. The 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.

3.2. Market efficiency:If a certain marketfor example, pork bellieshad 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. Some schools of thought argue that this creates an efficient market. But it is also true that, as more and more speculators participate in a market, real

demand and supply can become diminishing small compared to supply and demand which is a result of speculation and thus prices become distorted and bubbles appear.

3.3. Bearing risks

Speculators also sometimes perform a very important risk bearing role that is beneficial to society. For example, a farmer might be considering planting corn on some unused farmland. Alas, he might not want to do so because he is concerned that the price might fall too far by harvest time. By selling his crop in advance at a fixed price to a speculator, the farmer can hedge the price risk and is now willing to plant the corn. Thus, speculators can actually increase production through their willingness to take on risk.

3.4. Finding environmental and other risks:Hedge funds that do fundamental analysis "are far more likely than other investors to try to identify a firms off-balance-sheet exposures", including "environmental or social liabilities present in a market or company but not explicitly accounted for in traditional numeric valuation or mainstream investor analysis", and hence make the prices better reflect the true quality of operation of the firms.

3.5. Shorting:Shorting may act as a canary in a coal mine to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.

4. The economic speculation:4. 1. Winner's Curse:-

disadvantages

of

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.

4.2. Economic Bubbles:Speculation can also cause prices to deviate from their intrinsic value if speculators trade on misinformation, or if they are just plain wrong. 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. In 1936 John Maynard Keynes wrote: "Speculators may do no harm as bubbles on a steady stream of enterprise. But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. (1936:159)" Mr Keynes himself enjoyed speculation to the fullest, running an early precursor of a hedge fund. As the Bursar of the Cambridge University King's College, he managed two investment funds, one of which, called Chest Fund, invested not only in the then 'emerging' market US stocks, but also periodically included commodity futures and foreign currencies, albeit to a smaller extent (see Chua and Woodward, 1983) . His fund achieved positive returns in almost every year, averaging 13% p.a., even during the Great Depression, thanks to very modern investment strategies, which included inter-market diversification (i.e., invested not only in stocks but

also commodities and currencies) as well as shorting, i.e., selling borrowed stocks or futures to make money on falling prices, which Keynes advocated among the principles of successful investment in his 1933 report ("a balanced investment position [...] and if possible, opposed risks.")

4.3. Volatility:According to Ziemba and Ziemba (2007), Keynes risk-taking reached 'cowboy' proportions, i.e. 80% of the maximum rationally justifiable levels (of the so called Kelly criterion), with overall return volatility approximately three times higher than the stock market index benchmark. Such levels of volatility, responsible for his spectacular investment performance, would be achievable today only through the most aggressive instruments (such as 3:1 leveraged exchange-traded funds). He chose modern speculation techniques practiced today by hedge funds, which are quite different from the simple buy-and-hold long-term investing. 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.

5. Speculation fundamentals:The futures contract is the fundamental building block from which other speculative instruments are built. The contract obligates parties to buy or sell a specified quantity of a commodity at a specified price at an agreed date in the near future, usually one to three months from the contract date for agricultural commodities. An options contract does not oblige the parties and costs less to execute but provides less price protection. Futures and options contracts enable those who buy and sell commodities to manage short-term price risks and to discover the price at which those contracts settle as the due date for fulfilling the contract approaches. According to UNCTAD, futures contracts and other commodity derivatives are not capable of mitigating the causes of commodity price volatility, such as failure to manage structural oversupply of commodities. Failure to regulate commodity derivatives adequately has not only contributed to huge increases in food import bills and food insecurity, but also to making futures and options contracts unavailable or too expensive for many farmers and some agribusinesses to use to manage price risk. In the U.S., futures contracts were useful and affordable as long as futures prices and cash (spot) market prices converged as the date for the contracts execution approached. Futures prices helped commodities traders to set a benchmark price in the cash market. With convergence came some degree of contract predictability needed to calculate when to buy or sell. Similarly, option contracts, in which buyers have the right but not the obligation to buy or sell a commodity at a specified price at a specified time, relied on price convergence to provide some contract predictability. As prices have become more volatile and convergence less predictable since 2006, the futures market has lost its price discovery and risk management functions for many market participants. According to the FAO, as of March 2008, volatility in wheat prices reached 60 percent beyond what could be explained by supply and demand factors. Non-commercial commodities speculation was a factor, though not the only one, that impeded price convergence and induced extreme market volatility, testified the National Grain and Feed Association (NGFA) to Congress. However, the NGFA and other groups cautioned against over-

regulating the commodities markets, lest there be too little capital in the market to enable commercial speculators to hedge their risks with futures contracts.

6. Excessive Speculation:There is a difference of opinion about how much speculation in agricultural commodities has increased food prices beyond what can be accounted for by traditional market fundamentals and energy-related factors. A U.S. academic review of two dozen studies on causes of the price increases stated in July, Based on existing research, it is impossible to say whether prices levels have been influenced by speculative activity. Another study from the University of Illinois concludes, There is no pervasive evidence that current speculative levels, even after accounting for index trader positions, are in excess of those recorded historically for agricultural futures markets. However, these conclusions do not take into account the OTC trades of privatized risk management that dominate commodities speculation. Their analysis is limited by the quantity and quality of CFTC reported data upon which they rely. The preliminary data suggest a correlation between volume of commodity index fund activity and price. For example, the December 31, 2007 snapshot shows $8 billion invested in Chicago Board of Trade (CBOT) index corn contracts at an average price of $4.56 a bushel. By June 30, 2008 the amount invested in CBOT index corn is $13 billion at $7.25 a bushel. On June 30, index fund corn contracts were 18 percent of the value of all CBOT futures and options corn contracts. Though 18 percent of the exchange value of trades might not seem to dominate the corn futures market, if the CFTC could mandate the reporting of the private OTC trades that include index funds, it would be very surprising if OTC trades were shown not to greatly affect agricultural futures and options prices. Furthermore, if economists, who historically have ignored the market power of dominant traders in commodities, were to apply a market power analysis to futures and options trading, the economic case for regulation would be made.

7. The Speculator As A Risk-Taker:1. Every enterpriser is to some extent specializing as a risk-taker. This familiar idea may be taken as a starting point in discussing speculation. In its broadest sense speculation means to look into things, to examine attentively, study deeply, contemplate, meditate. In a business sense the speculator is one who studies carefully the conditions and the chances of a change of prices; hence arises the thought that speculation is connected with chance. The enterpriser can estimate these chances better than most men. He stands on a hilltop sweeping the horizon, and can see farther than the workingman can. He relieves the other agents of part of the risk, and he insures both laborer and capitalist against future fluctuations of prices. Some of the profits of successful enterprise in countries where no system of regular insurance has grown up, and in certain lines here where no insurance is possible, are speculative gains of this sort. Offsetting them, however, in large measure, are the speculative losses, by which in many cases the investment has been swept away altogether. The cautious business man tries to reduce chance as much as possible by insurance, and to confine his thought and worry to the parts of the productive process where his ability counts in the result. The wise have found out that it is better to shift the risk to some specialist who can take it better than they. For a man who has his thought and effort concentrated on running a flourmill, it is foolish to take the risks of fire, of loss in shipment, of a rise in the price of grain needed to fill outstanding orders - it is as foolish as it would be for him to make his own machinery. Insurance being the economical way to cover risk, the reckless will, in the long run, be eliminated from the ranks of enterprisers. An element of speculation in all business. 2. In some lines the risk of marketing and carrying large stocks becomes highly specialized, so that ordinary enterprisers shift it to a small group of risk-takers. In buying and selling large quantities of produce there is required the closest and most exclusive attention of a small group of men. The marketing of some staple products requires the most minute acquaintance with world conditions. To foretell the price of wheat one must know the rainfall in India, the condition of the crop in Argentina, must be in

touch as nearly as possible with every unit of supply that will come into the market. Such knowledge is sought by the great produce speculators in the central markets. If all means of communication - telegraph, cables, mails are open to all, competition among these speculators becomes intense, and the result is the extremest efficiency. Their survival depends on the development of acute insight into market conditions. It is the testimony of expert witnesses and of writers in the report of the Industrial Commission that the margin at which farm produce is sold has fallen greatly in the last few years. These products are marketed along the lines of the least resistance, that is, of the greatest economy. The function of the commercial specialists is to foresee the markets, and to ship to the best place, at the right time, in the right quantities. If a product shipped to Liverpool will, by the time it arrives there, be worth more in Hamburg, there is a loss. Such difficult decisions can be made best by a small group of men selected by competition. When handling actual products they perform a real economic service. Specialization of risk taking. Produce speculators as insurers. 3. Even some mere speculators on the produce markets may and do at times perform a productive service as risk-takers. Many of the speculators in staples, wheat, corn, wool, rarely handle the material things, the real products. They make it their business to study the world conditions, to foresee prices, and in a sense to bet upon them. Regular merchants buy and sell fictitious products of these men. When a miller buys ten thousand bushels of wheat that will remain in the mill three months before they are marketed as actual flour, he at the same time sells that number of bushels to a speculator for future delivery; or selling flour for future delivery the miller buys a future in wheat. In either case he cancels the chance of loss or gain, giving up the chance of profit in the rise of wheat in exchange for protection from the loss of the product on his hands. To him this is legitimate insurance, for he is striving not to create an artificial risk, but like the medieval ship-owners, to neutralize one that is inseparable from the ordinary conditions of his business. One may ask, How, if the miller in the long run benefits, can the speculator gain? He does not intend to perform this service for nothing. Yet as the sales in the whole market equal the purchases, some say that there can be

no profits to the speculator. There are unsuccessful speculators and at any rate their losses go to the successful as a sort of gambling profit. Speculators do not dine entirely on "lambs"; they are anthropophagous. But, further, the sales to legitimate purchasers should net a gain to the abler speculator. In proportion as his estimates are correct, there will remain a regular slight margin of profit to him. If he agrees to sell wheat at eighty-five cents to be delivered in three months, he expects it to be a little less at that time. In the long run the ablest speculator probably buys at a little less and sells at a little more than the price really proves to be. This means that the merchants in the long run pay something for protection against changes in prices, just as they pay something for insurance. And yet this is the cheapest way to eliminate risk, and a man engaged on a large scale in milling is, it is said, at a disadvantage if he neglects this method of marginal buying. Source of legitimate speculators' gain. 4. The buying of margins by the "lambs" is simple betting, and much manipulation of the market is dishonest. What has just been described is the more legitimate phase of marginal buying, not its darker aspect. One who, having no special opportunities to know the market, buys or sells wheat, or other commodities or securities, on margin, is called a lamb. He is simply betting. He has no unusual skill; he cannot foresee the result. The commission paid to brokers "loads the dice" slightly; the opportunities of the larger dealer of anticipating information load the dice heavily against the lambs. Secret combinations and all kinds of false rumors cause fluctuations large enough to use up the margins of the small speculator. At times a number of powerful dealers unite to cause an artificially high or low price, a situation called "a corner." But this is little other than gambling between betters. The general public gains and loses little if any by these operations, except in the evil effects they entail socially. Ignorant and dishonest speculation. The promoter's service to the owners.

8. Speculation, Hedging, and Arbitrage:Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a fixed profit at the time of the transactions, although the life of the assets and, hence, the consummation of the profit may be delayed until some future date. The key element in the definition is that the amount of profit be determined with certainty. It specifically excludes transactions which guarantee a minimum rate of return but which also offer an option for increased profits. Hedging is the simultaneous purchase and sale of two assets in the expectation of a gain from different subsequent movements in the price of those assets. Usually the two assets are equivalent in all respects except maturity. Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the price of that asset.

8.1. Arbitrage:Arbitrage can occur in a number of ways. For example, a wholesale egg merchant in Chicago may find that eggs are being quoted in New York at a price that exceeds the Chicago price by more than the costs of transportation between New York and Chicago. He can then buy eggs in Chicago, simultaneously sell them for delivery in New York next week, and ship the eggs for an assured profit. The key consideration is that the instant the transactions are completed, the profit is assured, even though delivery may not take place until later. Similarly, a foreign exchange arbitrageur may be able to buy British pounds sterling in New York for $2.80 and sell them on the Swiss market for $2.8010. Since, in this case, there are no shipping costs, the entire difference, except for minor transaction costs, is profit. In the pursuit of these profits, arbitrageurs tend to force prices in all markets toward equality. The arbitrageurs transactions tend to raise prices in the cheap market and depress prices in the expensive one. Because of transaction costs and transportation costs, literal equality will not be achieved. But neglecting the former costs, completely effective arbitrage

would eliminate the incentive to shop among markets. To the extent that arbitrageurs, through specialization, can seek out market imperfections more efficiently than other market participants can, they will increase social welfare. Because arbitrage profits are riskless, they are hard to get. Since most obvious opportunities are quickly eliminated by the activity itself, most actual arbitrage activity involves more complicated operations than are suggested by the above examples. The foreign exchange arbitrageur is more likely to use his dollars to buy German marks, use those marks to buy pounds, and sell those pounds for dollars (Grubel 1963). Such profits as do exist are a recompense for the detailed attention and time invested in seeking out those opportunities. Many operations customarily designated as arbitrage are not arbitrage at all. For example, if the egg merchant in the previous example had purchased eggs in Chicago at a price lower than in New York, but lower by less than costs of transport, in the hope that Chicago prices would go to a par with New York, he would not be engaging in bona fide arbitrage because the profit is not assured.

8.2. Hedging:An understanding of hedging requires an understanding of the elements of the theory of asset holding. Individuals will hold inventories of assets only in the expectation of increases in the value of those assets by at least enough to cover the costs of carrying the assets. In the case of financial assets, these carrying costs are largely the costs of the money tied up. In the case of physical inventories, there will also be costs of storage and spoilage or deterioration. Set against these costs will be certain benefits from the inventory: for merchants, for example, the inventory may be the means to increased sales or commissions. The net costs of carrying inventory may be positive or negative, but in economic equilibrium the marginal cost of a unit of inventory must be equal to the expected price appreciation of that unit of inventory (Working 1933; Brennan 1958). This introduces an asymmetry into the behavior of expected changes in prices of storable assets. At no time can the expected price one period from now be greater than the current price by more than the marginal cost of storage for that period. Once the difference becomes equal to the costs of storage, an increase in expected future price will

increase todays price as well. On the other hand, there is no similar lower limit on the extent of expected price decreases: if prices are expected to fall, current prices will be depressed by a reduction in the amount of inventories held until the marginal value of those inventories is equal to the expected price decline. But while inventories can be accumulated indefinitely, they can be reduced only to zero. When inventories are increased, the holder exposes himself to increased capital risk from fluctuations in the price of the goods being held. If the merchant is a risk averter, increasing his inventory increases his subjective costs of storage. To reduce that risk, he may hedge by selling for future delivery at some fixed price some or all of the inventory he owns. By doing so, he passes the risk to the speculator who buys the futures contracts. Traditionally, this reduction in risk is supposed to be the primary advantage of hedging. To illustrate this argument, assume that a Chicago wheat merchant purchases 1,000,000 bushels of No. 2 soft red winter wheat in July at $1.45 a bushel for his inventory. He is now exposed to the risk of changes in the value of his inventory due to fluctuations in the price of his wheat: he is speculating on the price of wheat. If he prefers, however, he may sell futures contracts on the Chicago Board of Trade, promising delivery of 1,000,000 bushels of No. 2 soft red winter wheat any time in December at the price currently quoted for December futures, say, $1.52. If he does so, he is clearly hedging, as we have defined it, since his wealth is now affected only by relative movements in the prices of the wheat and of the futures contracts. Conventional usage stresses the fact that by waiting until December and delivering his wheat on the futures contracts, the merchant is assured of a seven-cent gain on each and every bushel of wheat he owns. (Note that since he must pay storage costs on the wheat from July to December, this is not necessarily a profitable transaction.) This traditional view likens hedging to an arbitrage in which the merchant has eliminated his risk by passing it on to the speculator who purchases the futures contract. This transaction, however, is not genuine arbitrage, nor is it typical of hedging at all. To be sure, the price of actual wheat will gain by seven cents relative to Chicago December futures if the wheat is held until December. It is possible, however, that some temporary shortage in supplies (due either to a spurt in demand or to a natural catastrophe) might occur, so that in October the price of wheat might rise to $1.52 or higher without a concomitant rise in the December futures. In such an event, the

merchant would make a profit by selling the wheat and buying back the futures contract in October, since he would experience the same or a greater relative movement in prices while paying storage charges for a shorter period of time. In addition, by selling the wheat he would earn a commission which he would not get if he delivered the wheat on the futures contract. In other words, his hedge is really an option to benefit from a certain minimum relative price movement, but with freedom to take a larger gain if the opportunity arises. In view of this, the premium of the December futures contract price over the actual wheat price in July is rarely enough to cover the actual costs of storing wheat from July to December. If the premium were usually that large, any amateur could earn a riskless profit, since hedging would result in zero profits at worst and positive profits whenever random events made it possible. As a result, hedging rarely takes the form of the textbook example. In the usual case, hedging is undertaken in the hope or expectation that the gain on the hedge transaction will be greater than the current difference between the price of the futures contract and the price of the corresponding physical commodity. This may arise as in the illustration above or in a number of other ways. For example, the hedger may feel that wheat in Indianapolis is cheap relative to Chicago wheat and will rise by more, relative to the Chicago futures contract, than will Chicago wheat. Note that the Indianapolis wheat is not deliverable on the Chicago futures contract without incurring the cost of shipment to Chicago, and so the prospect of actual delivery is even more remote than in the earlier case. Similarly, the wheat hedged might be No. 1 white wheat at Toledodifferent both in grade and in location from the Chicago futures contract. Notice that, in financial terminology, the merchant has bought a callable asset and has sold an asset (bought a liability) with a maturity of five months. This is just the reverse of the bank that accepts (buys) a demand deposit (a call liability) and invests the funds in (buys) a five-month loan or Treasury security. The merchant buys shortlived assets and long-lived liabilities; the bank buys long-lived assets and short-lived liabilities. In both cases hedger and bank alike can (and do) benefit from appropriate changes in the relative prices of the assets they hold. Their position is much safer than outright holding of either the asset or the liability alone, but it retains some risk and some hope of gain in each case (Cootner 1963).

This is true even though in practice bank demand deposits are rather longlived assets (Samuelson 1945). These examples are known as short hedges, because the futures contracts are sold short first and bought back, or delivered against, later. Another form of hedge, the long hedge, arises when, for example, a merchant is asked in March, at a time when he has no wheat on hand, to deliver wheat to a flour mill at a fixed price of $2.00 in May. The merchant has the option of buying the wheat in March and holding it until May, or, if he feels that the current price difference between March and May wheat is too small, of buying May wheat futures. In the latter case, he would wait until May, take delivery of wheat on the futures contract, and in turn deliver the wheat to the flour mill (an unlikely procedure). Or he could hold the futures contract as protection until a lot of wheat of suitable price and quality becomes available, say in April, and then liquidate the contract. The transactions involving the initial purchase of futures and later selling the futures or taking delivery are called long hedgesprotection against price rises. Although transactions involving futures constitute most of what we call hedges, futures markets are not a prerequisite to hedging. One might buy shares of one textile company while selling those of another if one had feelings about the relative prosperity of the former but little assurance about the over-all prospects of the industry. Regardless of whether merchants hedge to eliminate risk or to anticipate movements of relative prices, the hedge generally has less risk associated with it than does holding of either of the two assets constituting the hedge: the variance in value of the hedge is less than that of the assets themselves. When a merchant hedges, however, he need not reduce his risk exposure, since the lower risk per unit of inventory can be offset by holding a larger total volume of inventory. Since a larger level of inventories permits an individual merchant to increase his profitable sales opportunities, he has an incentive to hedge in order to increase inventories. Thus, even if the expected gain from holding a bushel of wheat outright is greater than the expected gain from holding a bushel of wheat hedged, the merchant may prefer to hedge in order to be able to finance a larger inventory holding. A common figure used in trade circles is that banks will permit a merchant to finance three to five times as much hedged inventory as unhedged.

Thus, the merchant may assume the same total risk in hedged contracts as he would have if he had held a smaller volume unhedged. In doing so, he exercises his opinion that he is better able to predict relative price movements than changes in the absolute level of prices and has increased the rate of return associated with the risk by specializing in the area in which he has a comparative advantage. Hedging provides the economic rationale for the speculator. When the merchant hedges to reduce his personal risk, he does not change the total risk faced in the market. The risk of price fluctuation is merely transferred from the merchant to the futures speculator. The speculator accepts that risk voluntarily, in expectation of making money from the futures price changes.

8.3. Speculators:As a group actually to earn a profit requires that merchants be willing to sell for future delivery at prices lower than those they expect in the future. One reason why they might do so is that by hedging, they eliminate risk; and the difference between the price at which they sell and the price they expect in the future is the risk premiumsomewhat analogous to the premium one pays for insurance (over and above the actuarial value of the risk). Speculators, like insurance companies, would not furnish their services without being paid the premium. In this view, the speculator receives what the merchant is willing to pay for his services. Whether the speculator actually makes money or whether he is willing to accept the risk for the love of the gamble has been a matter of some controversy. The weight of the evidence now is that speculators do make money (Cootner I960; Houthakker 1957), although some writers disagree (see Telser in Cootner 1960). If speculators do make money, futures prices must rise over the period that they own futures, and fall during the period that they are short futures. Since hedgers are usually short and speculators usually long, Keynes (1930) argued that futures prices will normally rise over the lifetime of each contract. More recently, Cootner (1960) has shown that in agricultural commodities, hedgers are frequently long (and speculators are short) in the period prior to harvest when inventories are low. In cases where that pattern usually obtains, if speculators are to profit, futures prices must fall

prior to harvest and rise thereafter. In short, payment of risk premiums would imply a seasonal pattern for futures prices. In the view of hedging presented here, however, the individual merchant, by hedging and paying the risk premium, gets the opportunity to increase his merchandising profits by an equal or greater amount. While this is true for every merchant individually, it can be true for the market as a whole only if speculation (1) increases the average price to the consumer or (2) reduces the costs of merchandising. The evidence on this point is that (1) is not true but that (2) is likely to be true, although it has not been proved (Working 1953).

The social value of speculation:In a world characterized by uncertainty, speculation is essential to the allocation of economic resources over time. There is no question of whether or not speculation should be permitted; the only economic issue is who will perform the service most effectively. The sometimes-heard charge of overspeculation is incorrectly framed: The issue is not one of amount but, rather, whether it is done well or poorly. The role of speculation is to allocate resources among periods. If one expects, as did Joseph and the Pharaoh in the Old Testament, seven lean years to follow the seven fat, economic theory tells us that social welfare can be increased by refraining from some present consumption and storing the unconsumed goods until the lean years are upon us, so long as the price expected in the lean years is greater than todays price by at least the costs of storage (including capital costs). If the future is certain (Samuelson 1957), there is no need for speculation, but with uncertainty, whoever carries the inventories is exposed to the risk that the expected lean years will not materialize. Unless that risk is taken, resources will be used wastefully today and unnecessary hardship will be induced tomorrow, relative to intertemporal distribution under certainty. Although the issue is stated in terms of grain, it is formally identical with the problem of financing fixed capital investment. The terminology of capital markets is less precise, but the suppliers of capital for investment projects play a similar role in determining whether resources should be nonconsumed today so as to permit greater production of goods in the future.

In futures markets, the influence of the speculator is easier to see. If the speculator anticipates higher prices in the future, he buys futures contracts, tending to force up their price. As indicated in our hedging example, this gives a larger prospective profit to the hedger for carrying inventory and causes him to increase his holdings. Thus, if speculators as a group make correct judgments, their self-interest results in correct intertemporal decisions. Several studies of commodity markets before and after futures trading have been undertaken. All suggest that prices are more stable with futures trading than without: that prices do not fall as low or rise as high after the introduction of futures trading (e.g., Working 1960). This implies that futures traders tend to buy at low prices and sell at high ones, i.e., that they profit. Despite this evidence, periods of very low prices or very high prices still are often blamed on speculators, and futures trading has been regulated or prohibited on many occasions. Interestingly enough, however, because it works very well, futures trading has sometimes been banned when, for political or social motives, interference with the economic mechanism is desired. Abolition of foreign exchange futures markets frequently accompanies foreign exchange controls, and some regulation of bond speculation was introduced in the United States in the 1960s because the speculation interfered with the operation of monetary policy intended to destabilize bond prices (Cootner 1964). Even among those who recognize that futures markets may reduce the range of price variation, there are some who believe that speculative activity may cause prices to move more frequently between the narrower boundaries. According to this view, alternate waves of buying and selling may cause excessive fluctuations: price changes over successive periods would be positively correlated. On the other hand, in a perfect market, future price changes would be completely independent of past history. The price at the end of the previous day would discount all factors of importance known at that timea price change would result only from new information. To a very close approximation, if we correct for the seasonality of risk premiums, speculative markets seem to be perfect (Cootner I960; 1964; Working 1934).

9. SPECULATIVE LIMITS:

To protect futures markets from excessive speculation that can cause unreasonable or unwarranted price fluctuations, the Commodity Exchange Act (CEA) authorizes the Commission to impose limits on the size of speculative positions in futures markets. Core Principle 5, of Section 5(d) of the CEA, requires designated contract markets to adopt speculative position limits or position accountability for speculators, where necessary and appropriate, to reduce the potential threat of market manipulation or congestion, especially during trading in the delivery month. There are three basic elements to the regulatory framework for speculative position limits. They are: the size (or levels) of the limits themselves; the exemptions from the limits (for example, hedged positions); and the policy on aggregating accounts for purposes of applying the limits.

9.1. SPECULATIVE POSITION LIMITS:Section 4a(a) of the CEA, 7 USC 6a(a), specifically holds that excessive speculation in a commodity traded for future delivery may cause "sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity." Section 4a(a) provides that, for the purpose of diminishing, eliminating, or preventing such problems, the Commission may impose limits on the amount of speculative trading that may be done or speculative positions that may be held in contracts for future delivery. Most physical delivery and many financial futures and option contracts are subject to speculative position limits. For several markets (corn, oats, wheat, soybeans, soybean oil, soybean meal, and cotton), the limits are determined by the Commission and set out in Federal regulations (CFTC Regulation 150.2, 17 CFR 150.2). For other markets, the limits are determined by the exchanges. The Commission has adopted Acceptable Practices for the establishment of

exchange-set limits (Appendix B to Part 38 of the CFTCs regulations). Violations of exchange-set limits are subject to exchange disciplinary action. Violations of exchange speculative limit rules approved by the Commission are subject to enforcement action by the Commission. Speculative limits in physical delivery markets are generally set at a more strict level during the spot month (the month when the futures contract matures and becomes deliverable). Stricter limits in the spot month are important because that is when physical delivery may be required and, therefore; may be more vulnerable to price fluctuation caused by abnormally large positions or disorderly trading practices. The Commissions Acceptable Practices under Core Principle 5 specifies that spot month levels for physical delivery markets should be based upon an analysis of deliverable supplies and the history of spot month liquidations. For cash-settled markets, spot month position limits should be set at a level no greater than necessary to minimize the potential for manipulation or distortion of the contract and the underlying commodity price. In general, position limits are not needed for markets where the threat of market manipulation is non-existent or very low. Thus, speculative position limits are not necessary for contracts on major foreign currencies and other financial commodities that have highly liquid and deep underlying cash markets. A contract market may impose for position accountability provisions in lieu of position limits for contracts on financial instruments, intangible commodities, or certain tangible commodities, which have large open interest, high daily trading volumes, and liquid cash markets.

9.2. EXEMPTIONS:The Commission and exchanges grant exemptions to their position limits for bona fide hedging, as defined inCFTC Regulation 1.3(z), 17 CFR 1.3(z). A hedge is a derivative transaction or position that represents a substitute for transactions or positions to be taken at a later time in a physical marketing channel.

Hedges must reduce risk for a commercial enterprise and must arise from a change in the value of the hedger's (current or anticipated) assets or liabilities. For example, a short hedge includes sales for future delivery (short futures positions) that do not exceed its physical exposure in the commodity in terms of inventory, fixed-price purchases and anticipated production over the next 12 months. A long hedge includes purchases of future delivery (long futures positions) that do not exceed its physical exposure in the commodity in terms of the hedger's fixed-price sales and 12 months' unfilled anticipated requirements for processing or manufacturing. There are a number of technical provisions with regard to the eligibility for hedge exemptions. For example, the treatment of cross hedging and exemptions under special circumstances are reviewed by the Commission on a case-by-case basis. CFTC Regulation 1.3(z) requires that "no transactions or position will be classified as bona fide hedging...unless their purpose is to offset price risks incidental to commercial cash or spot operations and such positions are established and liquidated in an orderly manner in accordance with sound commercial practices. " The exchanges may also grant exemptions for spreads, straddles, arbitrage positions, or other positions consistent with the purposes of position limit rules. The Commissions Acceptable Practices state that exchanges should establish a program for traders to apply for these exemptions. If the exemption is granted, an exemption level is set at an amount higher than the applicable speculative limit so as not to give a limitless hedge exemption. Exchanges sometimes disallow hedge exemptions or place severe restrictions on exemptions during the last several days of trading in a delivery month. The Commission periodically reviews how each exchange grants exemptions, how it monitors compliance with its limits, and what types of regulatory action (warnings, fines, trading suspensions, etc.) the exchange takes once a violation of a position limit or exemption is detected. In the several markets with Federal limits, hedgers must file a report with the Commission if their futures/option positions exceed speculative position limits. 17 CFR Part 19. The report must be filed monthly or in response to a request by the Commission. The report

shows traders positions in the cash market, and it is used to check whether or not the trader has a sufficient cash position to justify any futures/option position in excess of the speculative position limits.

9.3. AGGREGATION REQUIREMENTS:In order to achieve the intended effect of the speculative position limits, the Commission and the exchanges treat multiple positions subject to common ownership or control as if they were a single trader. Accounts are considered to be under a common ownership if there is a 10 percent or greater financial interest. The rules are applied in a manner calculated to aggregate related accounts. For example, each participant with a 10 percent or greater interest in a partnership account must aggregate the entire position of the partnershipnot just the participants fractional sharetogether with each position they may hold separately from the partnership. Likewise, a pool comprised of many traders is allowed only to hold positions as if it were a single trader. The Commission also treats accounts that are not otherwise related, but are acting pursuant to an express or implied agreement, as a single aggregated position for purposes of applying the limits. Narrow exceptions to the aggregation rules exist for limited partners and pool participants that have no knowledge of, or control over, the positions of the pool. Also exempted are commodity pool operators or commodity trading advisors with commonly-owned but independentlycontrolled market positions. Entities claiming this exemption are required, upon call by the Commission, to provide information supporting their claim that the account controllers for these positions are acting completely independently of each other.

BIBLOGRAPHY:www.google .com www.wikipedia.com www.investopedia.com www.encylopedia.com www.cftc.gov.com www.pennystockpickalert.com

Conclusion:Speculation is the foundation of a well functioning capital market, which produces market efficiency. Speculation needs to involve neither counterparty risk nor criminal activities like market manipulation and insider trading. Our assessement of speculation should not be clouded by our wellfounded hostility towards those evils The objective of this analysis is to determine the exchange rates between the U.S. dollar and three other currencies, the euro, the pound, and the yen. Lately, the U.S. dollar is loosing value with respect the other three major currencies of the world and we want to see if this depreciation depends on economic fundamentals (lower real return in the U.S. and higher risk) or it is just speculation from individuals or countries, which hold large amounts of foreign assets denominated in different currencies. The preliminary conclusion is, here, that, due to high risk (wars and political conflicts) and low returns many speculators have invested in euros, pounds, and yens instead in dollars denominated assets. Historically, the U.S. has frozen the foreign assets inside the U.S. when a conflict arises. The L-T smoothing of these returns shows that they are growing, so the demand for U.S. investment will increase and the U.S. is expected to appreciate in the future. Investors know this and speculators take advantage of this knowledge. Also, by constructing a portfolio of four different assets, we can maximize the utility function of a speculator by maximizing his return and minimizing his risk. From these real returns, we can conclude if the currency will appreciate or not. High expected real return on assets denominated in euros means that euro is expected to appreciate. The preliminary tests show that economic fundamentals have less effect on exchange rates, lately; then, exchange rates depend mostly on speculation, due to the expected risk and return. The paper needs some more date from all the countries involved and more statistical and portfolio analysis to give better results. This paper theoretically analyzed the error of .financial innovation on portfolio risks in a standard mean-variance setting in which both the speculation and risk sharing forces are present. In this framework, I have de.ned the average variance of traders. net worths as a natural measure of portfolio risks. I have also decomposed the average variance into two components: the uninsurable variance, de.ned as the variance that would

obtain if there were no belief disagreements, and the speculative variance, de.ned as the residual amount of variance that results from speculative trades based on belief disagreements. My main result characterized the eect of .nancial innovation on both components of the average variance. Financial innovation always reduces the uninsurable variance through the traditional channels of diversification and the efficient transfer of risks. However, .nancial innovation also always increases the speculative variance, through two distinct economic channels. First, new assets generate new disagreements. Second, new assets amplify traders.speculation on existing disagreements. The second channel stems from an important economic force, the hedgemore/bet-more eect: Traders use new assets to hedge their bets on existing assets (i.e., to take purer bets), which enables them to take larger bets. In view of this eect (and the second channel), my main result shows that new assets increase the speculative variance even if traders completely agree about their payos. I have also analyzed endogenous .nancial innovation by considering a pro.t seeking market maker who introduces the new assets for which it subsequently serves as the intermediary. The market maker.s pro.ts are proportional to traders. perceived surplus from trading the new assets. Consequently, traders.speculative motive for trade as well as their risk sharing motive for trade creates innovation incentives for the market maker. In particular, the endogenous set of assets depends on the size and the nature of belief disagreements, in addition to the risk sharing possibilities emphasized by the previous literature. A natural question is how large belief disagreements should be to make these results practically relevant. I considered a calibration of the model in the context of the national income markets for G7 countries analyzed by Athanasoulis and Shiller (2001). For reasonable levels 37

of belief disagreements, the assets proposed by Athanasoulis and Shiller (2001) would increase the consumption risks of individuals in G7 countries. This is because income risks constitute a relatively small fraction of income in G7 countries. Moreover, income risks are correlated across the G7 countries. Hence, even if these risks were perfectly diversi.ed, the reduction in the standard deviation of consumption is a relatively small fraction of income. In contrast, for reasonable levels of the coe cient of relative risk aversion and belief disagreements, individuals are willing to bet a larger fraction of their incomes in their pursuit of speculative gains. I have also shown that the endogenous asset design is typically very dierent than in Athanasoulis and Shiller (2001) because new assets are directed towards increasing the opportunities for speculation rather than risk sharing. A number of avenues for future research are opened by this paper. The .rst open question concerns the policy implications of the results. This paper characterized the positive eects of belief disagreements on portfolio risks and .nancial innovation, but it has been quiet about the normative aspects. This is because the equilibrium in this paper is Pareto e cient despite the fact that trade in new securities may increase the average variance of traders.net worths. In view of belief disagreements, each trader perceives a large expected payo from her speculative portfolio that justi.es the additional risks that she is taking. Despite the Pareto e ciency of equilibrium, it is important to analyze policy implications for at least two reasons. First, while this paper illustrates the results in a standard mean-variance framework without externalities, the main mechanisms apply also in richer environments that may feature externalities. For

example, if the traders are .nancial intermediaries that do not fully internalize the social costs of their losses (or bankruptcies), then an increase in speculation may lead to a Pareto ine ciency. I develop a model along these lines in a companion paper. Second, the notion of Pareto e ciency with heterogeneous priors is somewhat unsatisfactory. This is because while all traders perceive a large expected return, at most one of these expectations can be correct.14 The analysis of the appropriate welfare notion in these settings is a fascinating topic which I leave for future work. A second avenue of new research concerns the evolution of belief disagreements. This paper analyzed .nancial innovation in a model in which traders.beliefs are exogenously .xed. In a companion paper, I consider .nancial innovation in a model in which traders.beliefs evolve over time. The novel feature of this dynamic setting is that traders learn from past observations of asset payos. Under appropriate assumptions, traders.belief disagreements on a given set of new assets disappear in the long run. Thus, in these environments, there is a tension between the short run and the long run eects of new assets on portfolio risks. The resolution of this tension has important implications for the optimal regulation of .nancial innovation, which I leave for future research.