Would you agree with the statement that speculators are a necessary and vital component of the financial marketplace? Comment

ANSWER

Financial market is an organizational framework within which financial instruments can be bought and sold. It exists to provide facilities for the purchase and sale of financial instruments.

Financial markets include long-term capital market, short-term money market, foreign exchange market, international capital market and derivatives market.

Speculators are most important components of financial markets along with hedgers and arbitrager.

A speculator is one who takes risks in the hope of making a profit, usually by trying to forecast future prices and betting his money that he is correct. If a speculator expects the price of gold to be higher in a year than it is now, he can buy gold and wait. If he is right, he will make a profit on his action, while if he is wrong, he will lose.

The speculator is widely regarded as someone who contributes nothing positive to the economy because he produces nothing. However, by buying when prices are low and selling when they are high, the successful speculator transfers goods from low-valued uses to high-valued ones, which is a useful task. He also smoothes price fluctuations because his purchases increases prices when they are low, and his sales when prices are high helps keep prices from going even higher.

Without speculators, a futures market could not function properly. The benefits that speculators provide others are not part of their intentions, an example of the unintended consequences in which economists delight. A person involved in speculation is not engaged in arbitrage, he is not a middleman, nor is he an entrepreneur. Arbitrage is buying in a market where prices are low and simultaneously selling in a market in which they are high. There is no risk involved in pure arbitrage. Arbitrage tends to equalize prices in various markets.

Speculators purchase a naked futures position , hoping the market will go in the direction you predict. For example a futures trader would be speculating if they bought “long” crude oil futures at $72, hoping to cash out at some point above that price. As you can see, a speculator would earn money if they choose the right direction of the market, using either a buy (“long“) or sell (“short“) position to profit. Typically, speculators are stuck to their computer screens analyzing the futures markets, waiting for the latest price break or news release. Once it happens, the trader jumps on the opportunity, positioning themselves accordingly. Even though the high yields may sound great, the fact is, there can also be higher risk. With even the best traders in the world, the leverage in futures make speculation a double-edged sword.

Speculators plays very important role in foreign exchange marker, according to Keith pilbeam speculators are engage in forward exchange market because they believe that the future spot rates corresponding to date of the quoted forward exchange rate will be different from quoted forward exchange rate, it is not possible to determine the farward exchange rate without inter action of speculators with traders and hedgers because one of the conditions that must hold in farward exchange market is that for every farward purchase there must be farward sale of currency so that the net demand for currency sum to zero ,it means sum net demand of hedgers, speculators and arbitrager must be zero.

Speculators are at work in both spot and forward exchange markets if they thought that the current spot rate is overvalued they may sell spot so that the currency depreciates, and if interest rate do not change then the both spot and forward rates depreciate. Similarly if speculators feel that the currency is overvalued farward then they will sell forward and both the forward and spot exchange quotations will depreciate therefore arbitrage ties the spot and forward exchange market quotations together on the other hand speculation and hedging may be thought of as determining the level of the spot and farward exchange quotations./p>

According to Marc levinson speculators are most important figure of foreign exchange market along with three other players which are exporters and importers , Investors and Government, speculators buy and sell the currency solely to profit from anticipated changes in exchange rates , without engaging in other sorts of business dealing for which foreign currency is essential. Currency speculation is often combined with speculation in short- term financial instruments, such as treasury bills . The biggest speculators include leading banks and investment banks, almost all of which engage in proprietary trading using their own money, as well as hedge funds and investment funds.

On the one hand, speculators can restore prices to equilibrium in market place; on the other hand, they increase volatility in the market place. One example of this is the roles speculators play in foreign exchange market. Private speculation can be stabilizing in that it is in the interests of speculators to move the exchange rate to its fundamental economic value. Speculators will attempt to buy the currency at a low value and sell it at a high value and in so doing reduce the gap between the low and high values. Since destabilizing speculation involves losses, there is every reason to suppose that private speculators will move the exchange rate towards its fundamental equilibrium value.

The ways speculation can be destabilizing which produce the ‘wrong' exchange rate include both ‘irrational' speculation and uncertainty. One example of ‘irrational' speculation is that foreign exchange market can be too risk-averse. There might be unjustified reluctance to move out of a strong currency and to hold a weak currency. Excessive risk-aversion unjustified by the fundamentals implies inefficiency of market and implies that part of the risk premium required is unjustified by the fundamentals. Another case of irrational speculation is the ‘bandwagon effect'. There is too much self-generated speculation detached from the fundamentals, ‘speculation feeding upon speculation' rather than the fundamentals.

The above two scenario presuppose speculators do not use all the information efficiently. In fact, even rational speculators can produce the ‘wrong' exchange rate. These explanations are all based upon the concept of exchange rate uncertainty. Speculators might not know the correct exchange rate model, and as such using a seriously defective model. There is also the ‘Peso problem'. Even if the speculators' model of the underlying fundamentals is correct, their perceptions about the future can prove to be seriously wrong. Another reason for rational speculation producing the wrong rate is known as ‘rational bubble'. It exists when holders of a currency realize that it is overvalued but they are nevertheless willing to hold it since they believe the appreciation will continue for a while longer and that there is only limited risk of a serious depreciation during a given holding period. Such speculation both prolongs an exchange overvaluation and aggravates the macroeconomic costs associated with it.

Speculators are derivative securities market participants who do not hold the underlying assets. A speculator does not buy futures contracts because he expects to purchase a commodity later. A speculator buys futures contracts merely because he believes that the price of the commodity will increase beyond the current price. If this happens the speculator makes money, without ever needing to buy the actual asset. The drawback is that should the futures price of the commodity fall, the speculator will lose money, again without ever actually having owned the asset. Needless to say, speculation is extremely risky and scrupulous brokers will only handle these transactions for sophisticated clients who thoroughly understand the risks involved.
Speculation in options is similar; traders who believe a security is increasing in price would buy calls, and those who believe it is falling would buy puts. There are a number of complicated strategies, given fancy names such as the "butterfly spread," the "straddle," etc., but they all serve the same purpose. Namely, to design a payoff structure such that the speculator makes money when the asset price moves in the proper direction. Should the asset fail to move in the desired direction, the option premiums paid are lost without the receipt of any physical goods?

It has long been debated among economists whether speculators are good for the market. Although some people still argue that speculation can be destabilizing, most agree that speculators are necessary participants in the market who help provide liquidity that hedgers need to trade more.The presence of speculators in the market place ensures that the futures price approximately equals the expected future spot price. A divergence between the futures price and the expected future spot price creates attractive speculative opportunities. In response, profit-seeking speculators will trade as long as the futures price is sufficiently far away from the expected future spot price.

Conclusion

Speculation is a calculated business risk with the expectation of profit through the exploitation of price volatility. Professional speculators are essential in providing liquidity and efficiency to financial markets. They help allocate economic resources to their best uses through the art of buying and selling financial assets and, by their volume of trade, provide liquidity to the markets. This allows firms to hedge away risk and helps to lower the cost of capital, thereby facilitating economic growth and improving the capital formation process. It is the speculator who warns investors of weaknesses in markets and provides financial discipline throughout the world by forcing financial law and order through pricing. Perhaps the most positive impact speculators have on the capital formation process is the ability to place checks on governmental policy through the buying and selling of currencies and bonds, thus preventing inflationary excesses. Speculation does not come without dangers.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/financial-marketplace.php


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