Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Wednesday, May 12, 2010

Duffie in Defense of Speculation

Darrell Duffie explains here why speculation is not a four-letter word (In case you do not subscribe to the WSJ, I reproduce the article below).

It's a nice and easy read. But I couldn't help notice that he does not exactly define the term for us (nor, for that matter, do those who wish to pass laws to prohibit the practice).

He seems to identify "speculators" as relatively risk-tolerant agents. These type of agents provide a social good by their willingness to absorb risk, giving the rest of peace of mind.

Of course, their willingness to absorb risk is not necessarily the same thing as their ability to absorb risk. If things turn out very poorly, the rest of us will be asked to absorb the risk. So maybe these "speculators" aren't quite as risk tolerant as they are made out to be (since they have no risk to bear when things turn out badly).

Hmmm...how to define these terms? Perhaps we need some sort of Devil's Dictionary (by Ambrose Bierce, in case you haven't read this--it is brilliant). OK, I propose to hold a contest. Please submit your preferred (cynical) definition of either "speculator" or "speculation." Here's mine:

Speculation (n): The risk-taking behavior of other people.

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By DARRELL DUFFIE
George Soros, Washington Democratic Sen. Maria Cantwell and others are proposing to curb speculative trading and even outlaw it in credit default swap (CDS) markets. Their proposals appear to be based on a misconception of speculation and could harm financial markets.
Speculators earn a profit by absorbing risk that others don't want. Without speculators, investors would find it difficult to quickly hedge or sell their positions.
Speculators also provide us with information about the fundamental values of investments. When the fundamentals appear favorable, they buy. Otherwise, they sell. If their forecasts are correct, they profit. This causes prices to more accurately forecast an investment's value, spreading useful information. For example, the clearest evidence that Greece has a serious debt problem was the run-up of the price for buying CDS protection against the country's default.
Is this sort of speculation wrong? I have not heard why.
Those who call for stamping out speculation may be confused between speculation and market manipulation. Manipulation occurs when investors "attack'' a financial market in order to profit by changing the value of an investment. Profitable speculation occurs when investors accurately forecast an investment's fundamental strength or weakness.
An example of manipulation is an attack on a currency with a fixed exchange rate in an attempt to cause a devaluation of that currency. Mr. Soros allegedly attacked the British pound in 1992 and the Malaysian ringgit in 1997. An attack on the equity or CDS of a bank could create fears of insolvency, leading to a bank run and allowing the manipulator to profit from his attack.
In the week of Lehman Brothers' bankruptcy in September 2008, John Mack, then CEO of Morgan Stanley, suggested that the difficulties facing his firm stemmed from such an attack. But firms complaining of unfounded short-selling often had real problems beforehand.
A market manipulator can also attempt to profit by "cornering" a market. This is done by holding such a large fraction of the supply of an asset that anyone who wants to buy that asset is at the mercy of the corner holder when negotiating a price.
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.
Market manipulation for profit is not easily done. If the fundamentals of supply and demand suggest that the value of something is $100, then a manipulator must buy at prices above $100 in order to drive the price up or to accumulate a monopolistic position. He then owns an asset that on paper could be worth more than what he paid for it. However, he must sell his asset in order to cash in on his profit. This spurs the price of that asset to fall, as the Hunt brothers learned.
Simply driving up the price, as speculators are alleged to have done in the oil market in 2008, is not enough. To make a profit, a manipulator needs to obtain monopolistic control of the supply. Given the size of the oil market, that seems implausible, absent a major and sustained conspiracy.
In the United States, trade with an intent to manipulate financial markets is generally illegal. Regulators should keep anti-manipulation laws up to date and aggressively monitor potential violators.
Speculation is not necessarily harmless. If a large speculator does not have enough capital to cover potential losses, he could destabilize financial markets if his position collapses. The Over-the-Counter Derivatives Markets Act, which could come up for a vote in the Senate soon, will hopefully reduce such risks.
It would be better for our economy to enforce anti-manipulation laws, and require that speculators have enough capital to cover their risks, than to attempt to squash speculation.
Mr. Duffie is a professor of finance at Stanford University's Graduate School of Business.

14 comments:

  1. David,

    Prof. Duffie makes an excellent case for the benefits of speculators. Without question, speculators provide critical liquidity to markets and they wouldn't function without such liquidity.

    I'm not sure I can submit a cynical definition of a speculator. In derivative markets, it's actually pretty easy to define speculators and speculation. Anyone who takes a position in a derivative that does not simultaneously have an economic interest in the underlying asset is a speculator. Anyone else is a hedger.

    Ben Graham (Security Analysis, 1934) defined speculators in contrast to investors. His simple delimiter was investment horizon, or holding period. Graham wrote that anyone who bought a security with the intent to sell it soon is a speculator, and anyone with a "buy and hold" position is an investor. By this definition, short sellers are all speculators. Also, his definition doesn't transmit too well to derivative markets.

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  2. A person seeking to profit from asset price fluctuations.

    I don't think risk tolerance has anything to do with it, most people are speculators and don't even realize it. I think anybody who buys a house knowing they only plan to live in it for a few years is a speculator.

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  3. Prof J:

    Can you give me an example of "taking a position in a derivative that does not simultaneously have an economic interest in the underlying asset"? (Or maybe a couple of examples...thanks).

    Pointbite:

    Your definition will not make it into my Devil's Dictionary--please try again! But I agree with you that we are all speculators (consistent with my own brilliant definition...lol).

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  4. David,

    I think I will proceed first by counterexample. An airline faces multiple sources of risk, but a big one is volatility in the cost of aviation fuel. Thus, airlines manage said risk by engaging in futures contracts on the long side.

    I can't think of any airlines that would want the short side of the futures contract. However, a trader that doesn't otherwise need aviation fuel for his business might take the view that the price per unit of aviation fuel will be lower in the future than what is currently implied by futures prices. So, that trader would be willing to take the short side of the contract but would not otherwise have an economic interest in aviation fuel.

    Since there is a clearinghouse for standardized futures contracts, the airline doesn't care who ultimately has the short side of the contract because they just deal with the clearinghouse.

    Another example would be precious metals contracts. One can speculate on the future price of gold without either being a gold miner or refiner, or jeweler or anything like that.

    In short: if your only exposure to the asset price risk is through the derivative, then you are a speculator.

    Note that there are some groovy contracts that exist where one could always claim to have an "economic interest." For example, the labor force contracts that allow one to take a view on monthly unemployment rates. Or the new real estate futures: everyone is going to buy a house! Whether you want to or not, the government will see to it you get put in a house....

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  5. I drive a car. I want to insure against the prospect of higher future gas prices. So I buy my future gas now at a set price. Who do I buy this futures contract from?

    One possibility is the gas station itself. So the gas station insures me against the prospect of higher future gas prices. Is this act of providing insurance defined as speculation? Perhaps not, because the gas station has "an underlying interest in gas" -- whatever this means (it owns gas?).

    Another possibility is that some third party comes forth to insure me. An insurance company with no underlying interest in gas. But again, I ask, why is this provision of insurance labelled as an act of "speculation?"

    I am hedging, but the one willing to hedge me is a speculator...is this it? (I am confused).

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  6. The gas station has an economic interest external to the derivative contract. First, it must purchase the gas it sells retail (if not vertically integrated). Second, it bears potential sales fluctuations based on the gas price. So it bears price risk independent of the use of the derivative. The need for hedging, though, depends on the nature of competition in the industry, i.e. can the firm pass on price volatility to its customers?

    The insurer is the more intriguing issue here. In fact, the insurer is a kind of speculator, but not all speculators are created equal. First, if the insurer seeks to neutralize all its open positions (balance long v. short with equivalent exposures) then it would be risk-free, and make money on bid-ask spreads.

    If the insurer just takes one side of the transaction and doesn't go ahead and offset the exposure, then the insurer would seek to earn profit due to future price fluctuations - either decreases if on the short side, or increases if on the long side.

    There is no doubt that practically this is a very messy business. The financial services industry provides all the derivative contracts, but often they are like the insurer in your above example. Industrial firms want to manage risk, but because of search costs and other transaction costs, such firms can't really find another industrial to take the other side of the contract. Hence, the requirement for counterparties from the financial services industry. Can you imagine price behavior and volatility without risk management? Yikes....

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  7. Excellent and timely post. I do not see any fundamental difference between so-called investing and speculation. Talked to a professional on-line gambler a while back and was surprised at how similar his risk management study was to that of seasoned stock investors.

    The adjective speculative might offer some insights. More speculative investments are generally riskier or characterized by more immutable uncertainty. They require more time and effort to manage. They generally require a much more sophisticated and detailed risk management strategy in order to be successful.

    Risk management know-how likely predicts where folks end up on numerous controversial economic, financial and environmental debates. It is particularly difficult for lay people when you have numerous lettered (natural) scientists expounding on studies and issues where they clearly do not understand the underlying statistical models.

    Economists are hardly blame free. How many empirical studies are published these days with sufficient diagnostics testing? Less than 5%? How many times do you read an empirical study and conclude: "Great idea but I bet the data and model do not support the hypotheses."?

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  8. Hey...c'mon people...the contest...remember the contest! I don't want to make myself the winner! :)

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  9. Speculator: Someone who makes a lot of money in a way I later disapprove of because I didn't think of it first.

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  10. Well done, Prof J! This will be tough to beat...but let's see if any other good ones emerge.

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  11. OK, here's one from Chris Waller (who is too lazy to post himself):

    Speculator: The party on the opposite side your losing bet.

    Not bad.

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  12. Speculator: Individuals that save the risks from damaged financial environments and hold them in captivity until they grow larger and healthier. The goal is to set them free at a later date. See Risk-free.

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  13. Speculation (academics): Information mechanism

    Speculation (everyone else): Shitheads

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