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52-805: Many speculators pay little attention to the fundamental value of a security and instead focus purely on price movements. In principle, speculation can involve any tradable good or financial instrument . Speculators are particularly common in the markets for stocks , bonds , commodity futures , currencies , cryptocurrency , fine art , collectibles , real estate , and financial derivatives . Speculators play one of four primary roles in financial markets, along with hedgers , who 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

104-632: A central bank , such as the US Federal Reserve bank , and raising additional capital. In a worst-case scenario, depositors may demand their funds when the bank is unable to generate adequate cash without incurring substantial financial losses. In severe cases, this may result in a bank run . Banks can generally maintain as much liquidity as desired because bank deposits are insured by governments in most developed countries. A lack of liquidity can be remedied by raising deposit rates and effectively marketing deposit products. However, an important measure of

156-492: A risk premium appropriate to the company in question. An alternative approach is to view intrinsic value as linked to the business' current operations . Here, under an asset-based valuation the business is seen as worth, at least, the sum of the fair market value of its assets (i.e. as opposed to their accounting-based book value , or break-up value ). Relevant here are the fixed assets , working capital and (initial) "opex" required so as to replicate or recreate

208-459: A bank's value and success is the cost of liquidity. A bank can attract significant liquid funds. Lower costs generate stronger profits, more stability, and more confidence among depositors, investors, and regulators. The market liquidity of stock depends on whether it is listed on an exchange and the level of buyer interest. The bid/ask spread is one indicator of a stock's liquidity. For liquid stocks, such as Microsoft or General Electric ,

260-469: A bid/ask spread or explicitly by charging execution commissions. By doing this, they provide the capital needed to facilitate the liquidity. The risk of illiquidity does not apply only to individual investments: whole portfolios are subject to market risk. Financial institutions and asset managers that oversee portfolios are subject to what is called "structural" and "contingent" liquidity risk . Structural liquidity risk, sometimes called funding liquidity risk,

312-411: A daily process requiring bankers to monitor and project cash flows to ensure adequate liquidity is maintained. Maintaining a balance between short-term assets and short-term liabilities is critical. For an individual bank, clients' deposits are its primary liabilities (in the sense that the bank is meant to give back all client deposits on demand), whereas reserves and loans are its primary assets (in

364-456: 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 form market bubbles. Auctions are

416-455: A liquid market is that there are always ready and willing buyers and sellers. It is similar to, but distinct from, market depth , which relates to the trade-off between quantity being sold and the price it can be sold for, rather than the liquidity trade-off between speed of sale and the price it can be sold for. A market may be considered both deep and liquid if there are ready and willing buyers and sellers in large quantities. An illiquid asset

468-480: A market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly. A liquid asset

520-434: A method of squeezing out speculators from a transaction, but they may have their own perverse effects by 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

572-639: A number of attempts over the years to introduce regulations and restrictions to try to limit or reduce the impact of speculators. States often enact such financial regulation in response to a crisis. Note for example the Bubble Act 1720 , which the British government passed at the height of the South Sea Bubble to try to stop speculation in such schemes. It remained in place for over a hundred years until repealed in 1825. The Glass–Steagall Act passed in 1933 during

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624-533: A smaller extent periodically included commodity futures and foreign currencies (see Chua and Woodward, 1983). His fund was profitable almost every year, averaging 13% per year, even during the Great Depression , thanks to very modern investment strategies, which included inter-market diversification (it invested in stocks, commodities and currencies) as well as shorting (selling borrowed stocks or futures to profit from falling prices), which Keynes advocated among

676-543: A steady stream of enterprise . But the situation is serious when enterprise becomes the bubble on a whirlpool of speculation. (1936:159)" 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 to

728-405: Is an asset which can be converted into cash within a relatively short period of time, or cash itself, which can be considered the most liquid asset because it can be exchanged for goods and services instantly at face value. A liquid asset has some or all of the following features: it can be sold rapidly, with minimal loss of value, anytime within market hours. The essential characteristic of

780-402: Is an asset which is not readily salable (without a drastic price reduction, and sometimes not at any price) due to uncertainty about its value or the lack of a market in which it is regularly traded. The mortgage-related assets which resulted in the subprime mortgage crisis are examples of illiquid assets, as their value was not readily determinable despite being secured by real property. Before

832-411: 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 can now hedge the price risk and plant the corn. Thus, speculators can increase production through their willingness to take on risk (not at the loss of profit). Speculative hedge funds that do fundamental analysis "are far more likely than other investors to try to identify

884-461: Is simply a higher-risk form of investment. Others define speculation more narrowly as positions not characterized as hedging. The U.S. 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". The agency emphasizes that speculators serve important market functions, but defines excessive speculation as harmful to

936-592: Is the risk associated with funding asset portfolios in the normal course of business . Contingent liquidity risk is the risk associated with finding additional funds or replacing maturing liabilities under potential, future-stressed market conditions. When a central bank tries to influence the liquidity ( supply ) of money, this process is known as open market operations . The market liquidity of assets affects their prices and expected returns. Theory and empirical evidence suggest that investors require higher return on assets with lower market liquidity to compensate them for

988-448: Is therefore defined as the net present value of all future net cash flows which are foregone by buying a piece of real estate instead of renting it in perpetuity. These cash flows would include rent, inflation, maintenance and property taxes. This calculation can be done using the Gordon model . Market liquidity In business , economics or investment , market liquidity is

1040-478: The Commodity Futures Trading Commission (CFTC) has proposed regulations aimed at limiting speculation in futures markets by instituting position limits. The CFTC offers three basic elements for their regulatory framework: "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

1092-521: The Great Depression in the United States provides another example; most of the Glass-Steagall provisions were repealed during the 1980s and 1990s. The Onion Futures Act bans the trading of futures contracts on onions in the United States, after speculators successfully cornered the market in the mid-1950s; it remains in effect as of 2021. The Soviet Union regarded any form of private trade with

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1144-577: The World Food Programme . In 1935, the Indian government passed a law allowing the government partial restriction and direct control of food production (Defence of India Act, 1935). It included the ability to restrict or ban the trading in derivatives on food commodities. After achieving independence in 1947, India in the 1950s continued to struggle with feeding its population and the government increasingly restricted trading in food commodities. Just at

1196-517: The appearance of the stock ticker machine in 1867, which removed the need for traders to be physically present on the stock exchange floor, stock speculation underwent a dramatic expansion through the end of the 1920s. The number of shareholders increased, perhaps, from 4.4 million in 1900 to 26 million in 1932. The view of what distinguishes investment from speculation and speculation from excessive speculation varies widely among pundits, legislators and academics. Some sources note that speculation

1248-417: The asset's own liquidity to shocks in market liquidity and the effect of market return on the asset's own liquidity. Here too, the higher the liquidity risk, the higher the expected return on the asset or the lower is its price. One example of this is a comparison of assets with and without a liquid secondary market. The liquidity discount is the reduced promised yield or expected return for such assets, like

1300-417: 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

1352-404: The bubble is followed by a precipitous collapse fueled by the same phenomenon. Speculative bubbles are essentially social epidemics whose contagion is mediated by the structure of the market. Some economists link asset price movements within a bubble to fundamental economic factors such as cash flows and discount rates. In 1936, John Maynard Keynes wrote: "Speculators may do no harm as bubbles on

1404-436: The crisis, they had moderate liquidity because it was believed that their value was generally known. Speculators and market makers are key contributors to the liquidity of a market or asset. Speculators are individuals or institutions that seek to profit from anticipated increases or decreases in a particular market price. Market makers seek to profit by charging for the immediacy of execution: either implicitly by earning

1456-453: The current time, the option could still be sold at nonzero price to an investor who speculates that the option might become in-the-money before it expires, due to a change in the value in the underlying stock. This describes what happened in one GameStop options trade that became famous: a trader spent $ 53,000 buying a large number of call options that were extremely cheap, since they were so far out-of-the-money that other traders thought it

1508-620: The difference between newly issued U.S. Treasury bonds compared to off the run treasuries with the same term to maturity. Initial buyers know that other investors are less willing to buy off-the-run treasuries, so the newly issued bonds have a higher price (and hence lower yield). In the futures markets , there is no assurance that a liquid market may exist for offsetting a commodity contract at all times. Some future contracts and specific delivery months tend to have increasingly more trading activity and have higher liquidity than others. The most useful indicators of liquidity for these contracts are

1560-405: The economy is price discovery . 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 consider planting corn on unused farmland . However, he might not want to do so because he

1612-423: 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

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1664-400: The higher cost of trading these assets. That is, for an asset with given cash flow, the higher its market liquidity, the higher its price and the lower is its expected return. In addition, risk-averse investors require higher expected return if the asset's market-liquidity risk is greater. This risk involves the exposure of the asset return to shocks in overall market liquidity, the exposure of

1716-570: The intent of gaining profit as speculation ( Russian : спекуляция ) and a criminal offense and punished speculators accordingly with fines, imprisonment, confiscation and/or corrective labor . Speculation was specifically defined in article 154 of the Penal Code of the USSR. Some nations have moved to limit foreign ownership of cropland to ensure that food is available for local consumption, while others have leased food land abroad despite receiving aid from

1768-411: The intrinsic value is the same as the "immediate value" or the "current value" of the contract, which is the profit that could be gained by exercising the option immediately. Formulaically: For example, if the strike price for a call option is USD 1.00 and the price of the underlying is US$ 1.20, then the option has an intrinsic value of US$ 0.20. This is because that call option allows the owner to buy

1820-443: The intrinsic value of a company. Here the "intrinsic" characteristic is the cash flow to be produced by the company in question. Intrinsic value is therefore defined to be the present value of all expected future net cash flows to the company; i.e. it is calculated via discounted cash flow valuation . (See also owner earnings and earnout .) Importantly, the required return used here to discount these cash flows, must include

1872-570: The limits". The proposed position limits would apply to 28 physical commodities traded in various exchanges across the US. Another part of the Dodd-Frank Act established the Volcker Rule , which deals with speculative investments of banks that do not benefit their customers. Passed on 21 January 2010, it states that those investments played a key role in the 2007–2008 financial crisis . Proposals made in

1924-428: The liquidity in a market, and therefore promote an efficient market . This efficiency is difficult to achieve without speculators. 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

1976-432: The market and make it easier or even possible for others to offset risk , including those who may be classified as hedgers and arbitrageurs. If any market, such as pork bellies , had no speculators, only producers (hog farmers) and consumers (butchers, etc.) would participate. With fewer players in the market, there would be a larger spread between the current bid and the asking price of pork bellies. Any new entrant in

2028-421: 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 from the difference in the spread and, in competition with other speculators, reduce the spread. Some schools of thought argue that speculators increase

2080-423: The measure in question. For an option , the intrinsic value is the absolute value of the difference between the current price ( S ) of the underlying and the strike price ( K ) of the option, to the extent that this is in favor of the option holder. Thus, the option is said to have intrinsic value if the option is in-the-money ; when out-of-the-money , its intrinsic value is zero . For an option, then,

2132-444: The ongoing business. Note though, that under this approach intangible assets (including "goodwill" ) are ignored, and the valuation may (will) then be understated . The valuation, then, will also often include (estimated) costs for any R&D and marketing required in this replication. (See also Replacement value and Tobin's q .) In valuing real estate , a similar approach may be used. The "intrinsic value" of real estate

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2184-450: The past to try to limit speculation – but never enacted – included: Fundamental value In finance , the intrinsic value of an asset or security is its value as calculated with regard to an inherent , objective measure. A distinction, is re the asset's price , which is determined relative to other similar assets. The intrinsic approach to valuation may be somewhat simplified , in that it ignores elements other than

2236-433: The possibility of future fluctuations. Further, options are valid for a duration of time, so inventors may buy or sell options contracts on their belief in the likelihood that the value of the stock will change before the option's expiration date. This is called the option time value . For example, while an out-of-the-money option has an immediate/intrinsic value of zero, since exercising the option would not be profitable at

2288-519: The principles of successful investment in his 1933 report: "a balanced investment position... and if possible, opposed risks". 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 volatility. The economic disadvantages of speculation have resulted in

2340-655: The proper functioning of futures markets. According to Benjamin Graham in The Intelligent Investor , the prototypical defensive investor is "one interested chiefly in safety plus freedom from bother". He adds 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." Thus, many long-term investors, even those who buy and hold for decades, may be classified as speculators, excepting only

2392-450: The rare few who are primarily motivated by income or safety of principal and not eventually selling at a profit. Nicholas Kaldor has long argued for 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". This view was later echoed by the speculator Victor Niederhoffer , in "The Speculator as Hero", who describes

2444-409: The sense that these loans are owed to the bank, not by the bank). The investment portfolio represents a smaller portion of assets, and serves as the primary source of liquidity. Investment securities can be liquidated to satisfy deposit withdrawals and increased loan demand. Banks have several additional options for generating liquidity, such as selling loans, borrowing from other banks , borrowing from

2496-628: The time the Forward Markets Commission was established in 1953, the government felt that derivative markets increased speculation, which led to increased food costs and price instabilities. In 1953 it finally prohibited options- and futures-trading altogether. The restrictions were not lifted until the 1980s. In the United States , following passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,

2548-399: The trading volume and open interest . There is also dark liquidity , referring to transactions that occur off-exchange and are therefore not visible to investors until after the transaction is complete. It does not contribute to public price discovery . In banking, liquidity is the ability to meet obligations when they come due without incurring unacceptable losses. Managing liquidity is

2600-402: The underlying stock at a price of 1.00, which they could then sell at its current market value of 1.20. Since this gives them a profit of 0.20, that is the current ("intrinsic") value of the option. The market price of an option is generally different from this intrinsic value, due to uncertainty: as alluded to, it is based on the current market value of the underlying instrument, but ignores

2652-502: The winner's curse phenomenon from causing mispricing to any degree greater than the spread. Speculation is often associated with economic bubbles . A bubble occurs when the price for an asset exceeds its intrinsic value by a significant margin, although not all bubbles occur due to speculation. Speculative bubbles are characterized by rapid market expansion driven by word-of-mouth feedback loops , as initial rises in asset price attract new buyers and generate further inflation. The growth of

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2704-405: Was very unlikely that they would ever hold intrinsic value. However, these options had an expiration date far in the future, and two years later the underlying GameStop shares spiked in value, putting the options in-the-money, which the trader was able to exercise for $ 48 million. In valuing equity , securities analysts may use fundamental analysis —as opposed to technical analysis —to estimate

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