Trading in derivatives encourage investors to speculate
According to the textbooks, financial markets should be a vehicle through which capital can be allocated to projects that are economically useful and ideally socially useful and environmentally sustainable tooto the benefit of society.
As such, they should play an essential role in our economy. They also happen to be deeply woven into our lives as consumers, as means to manage our savings, pensions and insurance.
In this multimedia dossier you can learn what financial markets are for and how they have developed in recent decades. In the second part, we look at some of the lobby myths told about financial markets and explain why Finance Watch thinks they are mistaken. Put simply, a financial market is a place where assets such as equities, bonds, currencies, derivatives The market allows for prices to be set for the risks and rewards of investing.
There are several ways to be involved:. The issuer company, government She sells securities, such as shares in a company "equity" or debt in the form of bonds, and looks for stable, long-term investors to buy them. The issuer gets to use the funding and undertakes to pay her investors trading in derivatives encourage investors to speculate return, such as a dividend on a share or interest on a bond.
The investor individual, pension or investment fund, government, company He will look for a return that he thinks provides a fair remuneration for his exposure to risks, such as the risk that the issuer gets into financial difficulties, or the risk that the security cannot be sold in the secondary market for any reason. Fund managers and other institutional investors act on behalf of the millions of ordinary people saving for their pensions, who are the real end investors.
The chain of intermediaries banks, brokers, market makers, fund managers Intermediaries help the markets to run more smoothly, although they add to investors' transaction costs. Other things being equal, more intermediation means lower returns for the end investor. On the right side of the figure, we have ultimate creditors called also ultimate savers. This group includes households with their savings and investors willing to buy assets e. On the trading in derivatives encourage investors to speculate hand side, we have ultimate borrowers e.
The financial sector includes everything that happens in-between and where financial intermediaries banks, brokers, market makers, fund managers For example, household savings can be channelled through traditional banks to investments or loans, or through financial markets to equities, bonds and other investments. IMFreproduced by Finance Watch. A well-functioning infrastructure trading in derivatives encourage investors to speculate not enough to guarantee that financial markets are effective.
The conduct of market participants also determines the value that financial markets bring to the real economy and society. That requires rules written by policymakers and regulators, and supervisors who enforce them, as well as codes of conduct and ethical commitments by market participants themselves. This video is a good introduction to financial markets, made by Tim Bennett from Money Week.
The primary objective of financial markets is to channel savings and capital to the most productive activities in the economy. In more detail, financial markets fulfil three basic economic functions related to the real economy:.
Of course, transferring risk does not eliminate it, as the financial crisis showed rather dramatically. In addition, the fact that many derivatives can be issued and traded in greater quantities that the underlying risks or assets they relate to makes them ideal tools for speculation.
This helps to explain why, especially in recent years, there have come to be far more derivatives in issue than there are underlying trading in derivatives encourage investors to speculate Vanguard Group founder John Bogle explains why he thinks today's financial markets mainly benefit rent-seeking intermediaries: What else do we do?
It's a waste of resources. Traditionally, financial markets were closely linked to the real economy, whose activities they financed. Since the mids though, this link is fading away. Deregulation of the equity, bond and derivatives markets has seen more and more capital directed towards short-term, speculative uses.
Investment and speculation are not just differentiated by time horizon. On the basis of transparent information in fair markets, investment creates a partnership between the corporation or entity being financed and the investor — linking them together in success or adversity. The value captured by the investor derives from real economy activity.
The investor and the entity being funded are winning or losing together. Speculation, on the other hand, is a zero sum game where the money earned by a speculator is lost by the other side of the transaction and vice-versa. As we understand speculation to be the extraction of profit from the buying and selling of assets, it relies on highly liquid secondary markets. This is a short Finance Watch animation to explain the link between speculation in agricultural commodity derivatives and the behaviour of prices energy, food, etc.
In drawing lessons from the crisis caused by a financial bubble, Keynes does not blame greedy, ill-intentioned individuals. He is rather pointing to a market structure that incentivises speculative behaviour over the sound allocation of capital. Without such a framework, the next crisis caused by a financial bubble is only around the corner. And, the less transparency and information there is about financial products, the more likely it is that toxic products will be sold throughout the whole financial system.
Imagine that many banks made similar investments and the riskiness of those assets changed, then the banks would all be affected at the same time, potentially causing a series of banks to default.
And it was artificially cheap, as investors assume that banks with insured deposits and a trading operation capable of dragging down other banks will not be allowed to fail.
This creates a problem for bank regulators: The rapid growth of megabanks was another factor in the financial crisis. Yet, the fact that there were so many parties to blame should not be used to deflect blame from the most responsible parties of all—the big banks. Alan Greenspan, chairman of the US Federal Reserve bank from todescribed the difficulty of controlling modern financial markets in his book, the Age of Turbulences: Regulators can still pretend to provide oversight, but trading in derivatives encourage investors to speculate capabilities are much diminished and declining.
The lack of strong financial regulation has led to financial markets starting to write things such as high frequency trading, see below we can no longer read.
Kevin Slavin gave a brilliant TED talk on this topic. How much liquidity do we really need? In financial markets, liquidity is a key concept.
In addition, investors who focus too much on liquidity, for example only buying assets that they trading in derivatives encourage investors to speculate easily sell if the market price falls, may be less interested in studying the underlying risks of an asset, its nature and even less its social and environmental objectives before buying it.
According to Keynes, the doctrine of liquidity distracts investors from their social object of allocating capital for productive use. The rise of high frequency trading HFT is another example of new techniques and strategies that can threaten market fairness, order and integrity. HFT is the use of algorithms and computers to execute ultra-fast trading strategies and has come to dominate trading in trading in derivatives encourage investors to speculate financial markets.
Institutional investors use algorithms to disguise large trades, while specialist HFT firms use their algorithms to find and exploit those trades. Have a look at our infographic on High-Frequency Trading! The financial industry lobbies hard — and with some success — to weaken legislative initiatives that might affect their interests.
This has given rise to a number of myths, some of which are promoted to scare politicians into relaxing financial market rules. It is fair to say that belief in the efficiency of markets has dominated market regulation over the past 30 years. However, as many realised during the financial crises, there is a tendency for market participants to focus on extracting the maximum short-term profit based on asset prices rather than developing a longer-term investment strategy based on future returns from the underlying asset.
On the contrary, as is well known to trading in derivatives encourage investors to speculate market professionals, market participants are also influenced by irrational human behaviours fear, greed, herd instinct etc. Market trading in derivatives encourage investors to speculate suggest that the financial sector trading in derivatives encourage investors to speculate become less efficient in recent years.
Research into the unit cost of financial intermediation roughly, the value of all financial assets divided by the GDP share of the financial sector shows that it is now more expensive to support a euro of financial assets than it was in the s, not less.
This is despite the innovations and proclaimed efficiencies of market-based financing that have emerged since then. HFT creates volume but not liquidity. HFT threatens market fairness, order and integrity. However, has this financialisation of the economy always been good for growth? The IMF said recently: However, while an overdeveloped financial sector is, in general, a burden on the economy, specific types of credit are linked with growth.
Bank lending to businesses outside the financial sector is positively linked with economic growth. It is more productive, for example, than bank lending to financial businesses or real estate. The problem is that the largest EU banks are today focussed mainly on non-lending activities, such as trading and making markets in financial assets, or on lending to less productive activities such as real estate.
In NovemberFinance Watch organised the event "What finance for what growth? The current wave of re- regulation in the US and EU should be based on a realistic understanding of how market participants make decisions and under which conditions they make those decisions. The last 30 years — and the most recent half of that period in particular — showed us that self-regulation in the markets for equities, bonds and derivatives did not always bring financial stability and benefits to society.
Regulators must address these features if they are to restore stability and fairness to financial markets, remembering always that markets should adapt to regulations, not the other way around.
Without proper regulation, bad practices can spread easily, as the subprime crisis demonstrated. Policy makers rightly wish, in a period of economic underperformance, to re-direct capital from short-term and often speculative strategies to long-term investment in the economy. For those who have benefited from short-term strategies this shift is going to hurt.
There is no point denying this. But over time, this reality will allow business models to adapt and be renewed for the benefit of all. Finance Watch is of the view that policy makers should seriously question the trading in derivatives encourage investors to speculate of financial activities that are not customer facing or that do not contribute to bringing capital to productive use.
Unfortunately the Trading in derivatives encourage investors to speculate Markets Union, a new EU-initiative, risks promoting short term growth over long-term investment. If you want to know more refer to our recently published position paper and cartoon. Change finance Change Finance: Finance makes the rules 1.
Put society back in the driving seat 2. Society is still paying for bank failures 2. Slim down mega-banks 3.
Speculation is the purchase of an asset a commoditygoodsor real estate trading in derivatives encourage investors to speculate the hope that it will become more valuable at a future date. In finance, speculation is also the practice of engaging in risky financial transactions in an attempt to profit from short term fluctuations in the market value of a tradable financial instrument —rather than attempting to profit from the underlying financial attributes embodied in the trading in derivatives encourage investors to speculate such as capital gains, dividends, or interest.
Many speculators pay little attention to the fundamental value of a security and instead focus purely on price movements. Speculation can in principle involve any tradable good or financial instrument. Speculators are particularly common in the markets for stocksbondscommodity futurescurrenciesfine artcollectiblesreal estateand derivatives.
Speculators play one of four primary roles in financial markets, along with hedgerswho engage in transactions to offset some other pre-existing risk, arbitrageurs who seek to profit from situations where fungible instruments trade at different prices in different market segments, and investors who seek profit through long-term ownership of an instrument's underlying attributes. With the appearance of the stock ticker machine inwhich removed the need for traders to be physically present on the floor of a stock exchange, stock speculation underwent a dramatic expansion through the end of the s.
The number of shareholders increased, perhaps, from 4. The view of what distinguishes investment from speculation and speculation from excessive speculation varies widely among pundits, legislators and academics. Trading in derivatives encourage investors to speculate sources note that speculation is simply a higher risk form of investment. Others define speculation more narrowly as positions not characterized as hedging. Commodity Futures Trading Commission defines a speculator as "a trader who does not hedge, but who trades with the objective of achieving profits through the successful anticipation of price movements.
Speculation is condemned on ethical-moral grounds as creating money from money and thereby promoting the vices of avarice and gambling. There is opinion that it serves no purposes from a human and economic perspective . Nicholas Kaldor  trading in derivatives encourage investors to speculate long recognized the price-stabilizing role of speculators, who tend to even out "price-fluctuations due to changes in the conditions of demand or supply," by possessing "better than average foresight.
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 or even possible for others to offset riskincluding those who may be classified as hedgers and arbitrageurs. If any market, such as pork bellieshad no speculators, only producers hog farmers and consumers butchers, etc.
With fewer players in the market, there would trading in derivatives encourage investors to speculate a larger spread between the current bid and ask price of pork bellies. Any new entrant in the market who wanted to trade pork bellies would be forced to accept this illiquid market and might trade at market prices with large bid-ask spreads or even face difficulty finding a co-party to buy or sell to. By contrast, a commodity speculator may profit the difference in the spread and, in competition with other speculators, reduce the spread.
Some schools of thought trading in derivatives encourage investors to speculate that speculators increase the liquidity in a market, and therefore promote an efficient market. Speculators take information and speculate on how it affects prices, producers and consumers, who may want to hedge their risks, needing counterparties if they could find each other without markets it certainly would happen as it would be cheaper. A very beneficial by-product of speculation for the economy is price trading in derivatives encourage investors to speculate.
On the other hand, as more speculators participate in a market, underlying real demand and supply can diminish compared to trading volume, and prices may become distorted. Speculators perform a risk bearing role that can be beneficial to society. For example, a farmer might be considering planting corn on some unused farmland. However, 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, he is now able to hedge the price risk and so he can plant the corn. Thus, speculators can actually increase production through their willingness to take on risk not at the loss of profit. Speculative hedge funds that do trading in derivatives encourage investors to speculate analysis "are far more likely than other investors to try to identify a firm's 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".
Hence, they make the prices better reflect the true quality of operation of the firms. Shorting may act as a "canary in a coal mine" to stop unsustainable practices earlier and thus reduce damages and forming market bubbles.
Auctions are a method of squeezing out speculators from a transaction, trading in derivatives encourage investors to speculate they may have their own perverse effects trading in derivatives encourage investors to speculate the 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.
That mechanism prevents the winner's curse phenomenon from causing mispricing to any degree greater than the spread. Speculation is often associated with economic bubbles. InJohn Maynard Keynes wrote: But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. 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 to a smaller extent periodically included commodity futures and foreign currencies see Chua and Woodward, It is controversial whether the presence of speculators increases or decreases 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 trading in derivatives encourage investors to speculate. The economic disadvantages of speculators have resulted in a number of attempts over the years to introduce regulations and restrictions to try to limit or reduce the impact of speculators.
Such financial regulation is often enacted in response to a crisis as was the case with the Bubble Actwhich was passed by the British government at the height of the South Sea Bubble to try to stop speculation in such schemes. It was left in place for over a hundred years until it was repealed in Another example was the Glass—Steagall Act passed in during the Great Depression in the United States ; most of the Glass-Steagall provisions were repealed during the s and s.
The Onion Futures Act bans the trading of futures contracts on onions in the United States, after speculators successfully cornered the market in the mids; it remains in effect as of [update]. Some nations have moved to limit foreign ownership of cropland to ensure that food is available for local consumption while others have sold food land and depend on the World Food Programme.
Inthe Indian government passed a law allowing the government partial restriction and direct control of food production Defence of India Act, It included the ability to restrict or ban the trading in derivatives on food commodities.
After independence, in the s, India continued to struggle with feeding its population and the government increasingly restricted trading in food commodities. Just at the time the Forward Markets Commission was established, the government felt that derivative markets increased speculation, which led to increased food costs and price instabilities. Init finally prohibited options and futures trading altogether.
The CFTC offers three basic elements for their regulatory framework: Another part of the Dodd-Frank Act established the Volcker Rulewhich deals with speculative investments of banks that do not benefit their customers. Passed on 21 Januaryit states that those investments played a key role in the financial crisis of — From Wikipedia, the free encyclopedia. This article is about the financial term. For other uses, see Speculation disambiguation.
For the Montana mining incident, see Speculator Mine disaster. For the archaic tactic in rugby, see Field goal rugby. Speculative attackCurrency crisisBlack Wednesday trading in derivatives encourage investors to speculate, Fictitious capitalFinancial transaction taxCurrency transaction tax trading in derivatives encourage investors to speculate, Tobin taxand Spahn tax.
The Trading in derivatives encourage investors to speculate Step toward a Rational Dialogue". The Journal of Alternative Investments. A guide to the language of the futures industry". Commodity Futures Trading Commission. Retrieved 28 August Retrieved 27 August Gambling, the Gambling Culture, pp.
Essays on Economic Stability and Growth. The Free Press of Glencoe. The results suggest that the departures from fundamental values are not caused by the lack of common knowledge of rationality leading to speculation, but rather by behavior that itself exhibits elements of irrationality.
From Catastrophe to Chaos: A General Theory of Economic Discontinuities: Mathematics, Microeconomics, Macroeconomics, and Finance. Retrieved 29 August Stephen Spratt of Intelligence Capital September Stamp Out Poverty report.
Stamp Out Poverty Campaign. Retrieved 2 January Retrieved 21 August Retrieved 13 February Retrieved 28 May Lei, Vivian; Noussair, Charles N. Lack of Common Knowledge of Rationality Vs. Thrills, the Economy, and Popular Discourse. Primary market Secondary market Third market Fourth market. Common stock Golden share Preferred stock Restricted stock Tracking stock.
Authorised capital Issued shares Shares outstanding Treasury stock. Electronic communication network List of stock exchanges Trading hours Multilateral trading facility Over-the-counter. Alpha Arbitrage pricing theory Beta Bid—ask spread Book value Capital asset pricing model Capital market line Dividend discount model Dividend yield Earnings per share Earnings yield Net asset value Security characteristic line Security market line T-model.
Algorithmic trading Buy and hold Contrarian investing Day trading Dollar cost averaging Efficient-market hypothesis Fundamental analysis Growth stock Market timing Modern portfolio theory Momentum investing Mosaic theory Pairs trade Post-modern portfolio theory Random walk hypothesis Sector rotation Style investing Swing trading Technical analysis Trend following Value investing.
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