Thursday, March 11, 2010

Speculators: The Devil You Know

Whenever something related to finances or money goes against what a group wants, it is speculators who are blamed. Consider the following recent statements: "Unprincipled speculators are making billions every day by betting on a Greek default," the Greek Prime Minister said Monday.
The economy is a mess, and there’s been a lot of finger pointing as to who caused the problem. Greed, lenders, speculators, the list goes on and on.

I received a note from U.S. Airways in my inbox today asking me to contact my Congressman to stop those evil speculators from causing oil prices to rise.
Dear U.S. Airways customer,
Several weeks ago, we wrote to you about skyrocketing oil prices and the impact that those prices are having on your quality of life. We urged you to get involved, learn more about the problem and to contact your members of Congress.

On Tuesday news arrived that the CFTC (a government agency that regulates commodity trading) is putting out a report blaming speculators for the big rise in gas prices that occurred a year ago, and the volatility in oil prices since.

Bill O'Reilly, who attacked speculators and `big oil' for playing a `rigged game' to rip off working Americans. O'Reilly endorsed proposals to virtually ban oil speculation (take that, free markets!), and Senator Joe Lieberman has proposed to ban futures trading by institutional investors. The "Stop Excessive Speculation Act," introduced by Democrats in Congress was designed to introduce various new restrictions on oil trading. And yesterday CFTC Chair Gary Gensler has called for new limits on speculative trading.

Why are speculators so reviled? What do they actually do? Consider the following two questions.
“How many of you are in favor of conservation?” and “How many of you are in favor of speculators?”
Most people see conservation as a noble activity that prevents people from squandering resources now to insure that adequate quantities will be available in the future. Most also see speculation as the greedy hoarding of valuable resources now in order to gouge those who will need those resources later. Is there a difference? Speculators are conservationists. Speculators decide that the price will be higher in the future and they attempt to profit on this potential movement by purchasing the item now so they can sell it back later at a higher price. This reduces the supply of the item now, thus raising the price now, so less is produced and consumed now. And, it increases supply in the future. What this does for the future is to increase the supplies in the future. This is Conservation.

\Whenever something related to finances or money goes against what a group wants, it is speculators who are blamed. Consider the following recent statements: "Unprincipled speculators are making billions every day by betting on a Greek default," the Greek Prime Minister said Monday.
The economy is a mess, and there’s been a lot of finger pointing as to who caused the problem. Greed, lenders, speculators, the list goes on and on.

But many people argue that Speculation is “Disruptive”? A simple Google search on speculation is bad yielded the following: “There are two ways in which speculators can create damage through speed, and through excess. Speculators will tend to move rapidly -- if someone gets in ahead of them, they will lose potential profit. However, the speed (or volatility) which speculators bring to the financial markets can make it difficult for policy makers and central banks to react. Speculation, therefore, may not give policy makers a fair chance to correct the fundamental problem that the speculators are exploiting.” What? Speculation is bad because it speeds the allocation of resources to where they are most highly valued and doesn’t enable policy makers a “fair” chance to intervene? This seems like a very silly argument.

Another silly argument is the following? Speculators may take things to excess. If a market moves in a clear direction (for fundamental reasons), speculators may seek to push the market beyond its fundamental fair value, with the aim of squeezing out a little more profit from the trade. This can create overshooting (either a bubble or a collapse) in asset prices. Overshooting? If speculators cause overshooting, then the speculators are losing money. Speculators make money only if they conserve wisely—buying resources (holding them off the market) when they are less valuable and selling them (making them available) when they are more valuable. If speculators don’t conserve enough, they pass up profitable opportunities to buy low and sell high, and if they conserve too much they lose money by buying high and selling low. The speculator who consistently makes mistakes is soon relieved of the money necessary to continue speculating.

For example, at the first indication that next year’s Brazilian coffee crop will be devastated by a frost, speculators will immediately purchase raw coffee beans to store them until next year. Consumers will still see plenty of ground coffee in the stores, but suddenly the prices will be higher. What consumers don’t see is that coffee prices will be lower next year than they otherwise would have been because they are higher today, and that their reduced consumption today will be more than compensated by their greater consumption later.

All right, so speculation on commodities may actually help the allocation of resources, but surely speculation on economies is bad. Suppose investors thought an economy like Iceland was weak (large current account deficit, high inflation and external debt). Then speculators would sell the currency, in anticipation of its fall. This speculation would cause the currency to fall. Is this bad? It is nothing more than speeding up the process of the currency decline. If Iceland had been trying to maintain its exchange rate with the pound or the dollar but its currency was overvalued, speculators would see a profit opportunity by shorting the Iceland currency. It is simply the market functioning.

The latest calamity to arise because of speculators is the Greece situation. Speculators are purchasing credit default swaps on the Greek bonds. Credit-default swaps function like insurance against a bond default. If a borrower defaults, the CDS holder is paid by the seller of the protection. A CDS is a contract under which one side pays an annual fee to buy protection against default, while the seller promises to cover losses in the event of a default. They are in effect an insurance policy against defaults of bonds and other debt. The buyer gets a payoff if the underlying bond goes into default.

Traders don't need to own the bonds to buy the protection. Instead, they can use the contracts to make "naked bets" on a bond's direction. So, as financial problems mounted for Greece and other euro-zone countries in recent months, prices of swaps insuring against debt default by those nations soared, drawing attention to the troubles and raising questions about whether speculation was worsening them.‪ The increased demand for CDS raises the price of the CDS and thus raises the cost to Greece or the other countries to borrow. The interest rate on Greek debt goes up. This is shown in the following illustration taken from the Wall Street Journal March 3, 2010, section A. In the top part of the illustration is the typical purchase of a CDS by an investor on a bond the investor holds. In the bottom part of the illustration is the “naked” transaction where the investor (read speculator) is purchasing a CDS but does not own a bond.

Greece's ailing state finances are increasingly attracting speculators. The hedge funds are operating very aggressively in the market. The funds have been dealing in the credit default swaps (CDS) on a large scale. In the case of Greece, the dealers in CDS are betting that the Greek government won't be able to repay its debts and that the price of CDS will therefore rise. This drives up the cost of Greek debt (raises their interest cost) and makes it more expensive for Greece to borrow to make cover its government deficit.

If Greece is bailed out it, the CDS won’t pay off. However, speculators are taking precautions against a bailout by purchasing Greek bonds in the futures market. Then if Greece is bailed out, the price of the bonds will rise as interest rates fall. Of course, if Greece is bailed out, there will be a domino effect in which other indebted states will also have to be bailed out. That will cost all euro countries - including the relatively stability-oriented ones such as Germany - a lot of money,"
Athens blames financial speculation for worsening the country’s problems and wants the G20 to discuss curbs. International momentum is building for stricter oversight of derivatives trading, as a top U.S. regulator recommended new limits on credit-default swaps and European leaders pushed for a ban on speculative bets against government debt following recent financial turmoil in Greece. In the U.S., Commodity Futures Trading Commission Chairman Gary Gensler in a speech Tuesday offered his most-specific criticisms yet of credit-default swaps. German Chancellor Angela Merkel said Tuesday that her government is backing an initiative to curb the credit-default swaps market, together with France, Greece and Luxembourg, and she suggested Europe would forge ahead on its own even if the U.S. didn't go along. José Manuel Barroso, president of the European Commission, the European Union's executive arm, said the commission would examine closely the possibility of banning outright "purely speculative" trading of the swaps.

Why would the governments want to ban the use of CDS? Because of the pressure the speculators put on Greece and the EU. There is no cheap solution so long as CDS can be purchased. The thinking is that should the CDS be banned, then Greece could be bailed out without as much fear of a domino effect on other economies. But CDS is not the only way the speculators can ensure resources are allocated to their highest valued uses. If CDS are banned, other financial instruments will arise to take their place.

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