Gaurav Pote | #11726 | 301

Assignment on Speculation, Investment Decisions, KUSOM

THE ART OF FINANCIAL SPECULATION

In a world without speculation, lets suppose, where people trade many
commodities, one of which is rice, there is a certain demand of rice in April 1. The
demand stems from people wanting to eat rice, hotels serving rice and rice-related
products, local alcohol brewers who want rice to ferment traditional spirits, industries that
produced rice-based products and more. In the world with no speculation in practice,
people think less about the future and all the rice is sold today for Rs.10 per bag. Since
we lack futures market, all the rice will be sold in spot market for a price based on
demand and supply on March 1.
Similar demand levels will also exist on a future date as it does on March 1. But
the supply levels may not match the demand for several reasons. Perhaps its not the
harvesting season or perhaps there is a strong quake that causes much damage to supply
chain. Lets consider June 1, which happens to be a future date that doesnt exist now so
the demand levels that days cannot be predicted accurately. The people and firms who
will demand rice that day will be the same, people, regular business, etc.
But what is the supply level falls all the way down to zero on June 1? The demand
will exist but there will be a shortage in supply. The people and businesses could have
bought their years supply of rice on March 1 but then they would have to pay for the
storage. Some form of storage cost will have to be incurred.
Now if a seller manages to import a few bags of rice during such heightened
scarcity, the seller can charge premium price, say Rs. 50, for each of those bags on June
1. Given there are no rice available until only a few bags were bought from abroad, it
seems like a sound assumption. Needless to say, there is a sound profit to be made by
selling something as common as rice, but at the time when its not available easily.
So, what we can also do is store some of that rice bags instead of selling them. We
would sell them on June 1 at Rs. 50 when there will be no supply but the some level of
demand would still exist, and earn a killing profit than we would have on March 1 at
Rs.10. But there are storage and other costs that we would need to bear in order to do
that.
But what we just discussed to do hoarding the rice, or any other commodity for
that matter, until just the right time and sell it then at a higher price later during its high
demand but low supply is what we refer to as Speculation, and by association, we
would be the speculators. The idea is to buy things in order to sell it when it is more

scarce, which is how a speculator makes more money. But with the possibility of higher
profit there is also some probability of loss. As the real world demand levels on any given
day cannot be accurately predicted, if the seller decides to trade on the day when the price
is below his cost, he is going to lose his money. So, speculation involves great risk and
speculators are risks takers by professional requirement.
There are, also, certain costs that are inherently associated with this arrangement,
which are listed below:

Storage cost: After purchasing the rice bags, we have to store them until the day
we sell it from March 1 to June 1 here so, we will have to pay for the storage.
Transaction cost: Every transaction that we make as speculators will attract some
costs, which can range from foreign exchange costs, service charges, regulatory
payments, etc.
Opportunity cost: Since we have our capital tied up in rice, which is sitting idle
in the storage, we cannot make any financial investments with better returns.
Insurance cost: Sometimes, we are also obliged to insure the things we buy and
store against various risk, which increases our cost even more.

The impact of speculation on the market may vary depending on how intensely it
is practiced in any economy. Nonetheless, the activities of speculators have some
common predictable impact on the market. They are as follows:

As a group of speculators start buying rice for profit motive, in order to store it
and not to consume, they tend to become more prominent as a separate group of
buyers besides the regular rice consumers. The speculators will then end up
increasing the demand, and thereby the prices, in the spot market today.

This increase in the price of rice from Rs. 10 per bag to say Rs. 20 per bag will
increase the inflation rate and some of the previous buyers will no longer be able
to purchase rice at that price. They will then exit this market. But this also means,
along with those who leave the market, the people who can still afford the rice
will start consuming it less. This will check the consumption levels of rice
everywhere.

But, since the speculators have substantial quantity of rice stored to sell in June 1,
the previous price of rice on June 1 will no longer be Rs 50. The decreased
scarcity will force the price to fall down below the earlier projected level, lets say
Rs 35. This will ensure that price inflation is more or less controlled while at a
cheaper rate more Nepalis can consumer rice on June 1.

Gaurav Pote | #11726 | 301

Assignment on Speculation, Investment Decisions, KUSOM

That said, we should also know when and how speculation stops. A speculator
usually stops speculating when the sum of price in the spot market, storage costs and
other transaction costs equals the expected price in the future market. At this level, there
no profit can be made so there is no purpose of speculating.
Now, since the future price always amounts to the sum of the current spot price,
storage costs and other transaction costs, the fact that speculation exists makes no
difference. Had speculators not existed, the profits wouldve been simply channeled to
larger corporations. In order words, the activities of the speculators have no new impact
on the market. Instead, they get everyone to slow down consumption, so there is more
rice for future consumption. The slowing down of consumption is possible only when the
current price go up, which speculators make happen. If speculators dont drive current
prices up, the companies taking deliveries will have to incur storage costs and well end
up with precisely same prices.
Some of the things that happened due to the speculation:

We dont run out of rice or any other resource on June 1.

We reallocated the rice from today when the supply is good to a future date when
its scarcity is high.
We have also moved the rice from a time when it is of lesser value to a time when
it is of more value.
We have also provided farmers an incentive to produce more rice as they will now
get Rs. 20 instead of Rs. 10 for each bag of their rice in the spot market.

In modern capitalist market, speculation has a rather important and interesting

role. Since it has become so prominent over the recent time, we have created a separate
futures market for it. The reason why it has been created is the speculators wanted to
eliminate all the inherent costs transaction, storage, maintenance and insurance costs
associated with the process. In other words, futures market makes things easier for the
speculators because now we have a market system where the rice or any other goods exist
virtually, in our minds but not in reality. So, there is no storage costs or insurance for the
rice. There is but a piece of paper called futures contract, an agreement with the buyer at
specified financial rates that promises to deliver a specified amount of rice on June 1 for
say Rs. 35, which we agreed on today, and there by called June rice futures price. This is
to be paid when the delivery of the rice is made.
The reason behind engaging in trades like this is the inherent risk of market rate
fluctuations in the futures market. Since no one really knows how exactly the market will

behave in future date, a buyer might believe that the price of rice is going to be higher
than lets say Rs. 35, which is technically referred to as taking a long position. The seller
of the futures contract might anticipate, on the contrary, that the price of rice is going to
be lower than Rs. 35, which is referred to as taking a short position.
Come June 1, lets suppose the rice sold in the spot market for Rs. 40. The buyer
was right. But interesting thing is that he does not need any rice delivered on his
doorsteps. He is concerned only about the Rs. 5, the difference that the seller will have to
pay him while clearing out this contract. He, like many other speculators in todays
market, is less concerned about the physical possession of the commodities. They buy
and sell futures contract without ever having to incur storage and other costs, and is
concerned with the cash payment at the end.