All Commentary
Wednesday, September 1, 1999

Speculation and Risk

Is Market Speculation on Par with Gambling?

Last month I showed that speculators are best thought of as conservationists. They are constantly looking to the future and conserving resources they believe are becoming more valuable. Since no one can predict the future with full confidence, speculators necessarily take risks. And when a speculator misjudges the future, he moves resources from periods when they are worth more to periods when they are worth less. But speculators who consistently make mistakes are soon left without the finances to continue speculating, and their mistakes create profitable opportunities for better prognosticators to take corrective action.

Recall last month’s advice not to complain out loud about the mistakes that you think speculators are making. If your criticism is correct, you can make a fortune by not sharing your information and entering the market yourself. You will increase the value realized from our scarce resources. If you are wrong, however, you can lose lots of money. Again, speculation is risky.

Many people disapprove of speculative markets because of the risk associated with them. They believe these markets are little more than gambling havens on par with Las Vegas and Atlantic City casinos. The critics fear that allowing speculative markets to proliferate, as they have in recent years (allowing people to speculate on such things as foreign currencies and the rate of inflation, as well as on resources such as petroleum and agricultural products), creates harmful levels of risk in society. Wrong! There is a fundamental difference between the risks in Las Vegas casinos and the risks in speculative markets.

Craps versus Crops

A crucial difference between the risk of playing craps and the risk of speculating on the price of wheat is that the game of craps creates a risk that otherwise would not have existed. Creating risk for the enjoyment of people who like to take chances is the purpose of gambling games. Of course, some people also enjoy the risks of “betting” on the future price of wheat in speculative markets. But speculative markets do not create risks. The risks associated with speculative markets are inherent in the act of growing crops and are necessarily borne by someone. If speculative markets were outlawed, farmers would have to take the risk of “betting” that the cost of planting a crop today is less than the unknown “payoff” from selling it at harvest. Only those who hate gambling more than they love eating should criticize the risks associated with speculative markets. Actually speculative markets lower the cost of unavoidable risks.

Consider the farmer who invests most of his wealth in planting wheat each spring. Taking a risk on the future price of wheat is extremely costly for him. He could win, of course, if the price of wheat is higher than expected. But the price might plummet, in which case he could lose everything. Even enthusiastic gamblers are reluctant to put their life savings on one roll of the dice. Thus our farmer would like to eliminate the risk of declining wheat prices so he can concentrate on growing wheat, which is risky enough. And that is exactly what he can do in the speculative (futures) market for wheat. In the spring he can arrange to sell his harvest for the fall price that currently prevails in the futures market for the type of wheat he is growing. The farmer eliminates the risk he faces from declining prices by locking in his sales price.

This doesn’t eliminate the risk of price declines. The farmer has simply passed that risk on to those who agreed to pay the specified future price. If the price of wheat increases above that price, the buyers of the futures win; but if it falls below that price, they lose. This is not just a game of “hot potato” in which the cost of holding the risk is the same no matter who holds it. Those who accept the price risk have a lower cost associated with that risk than the farmer does; maybe they are less averse to risk. Also, the farmer passes the risk to many people, each of whom takes just the amount he wants. Finally, those accepting the risk can diversify, agreeing to buy many different products. Because of speculative markets, the “hot potato” of risk ends up in the hands of those with the thickest gloves.

In some cases, speculative markets allow risk to be eliminated almost entirely. In fact, the term “speculative market” can be a misnomer, since parties on both sides of the market often use them to avoid speculating. Those who agree to pay a wheat farmer a specified future price for his harvest may do so to avoid speculating in wheat prices themselves. Consider bakers whose profits are reduced if the price of their primary ingredient, wheat, increases in the future. The risk bakers want to avoid (wheat prices going up) is exactly opposite to the one wheat farmers want to avoid (wheat prices going down). So farmers and bakers can eliminate the risk they fear most by using “speculative” markets to agree now to a specified price in the future. The risk of fluctuating wheat prices isn’t eliminated—the farmer risks losing the gain from rising prices and the baker risks losing the gain from declining prices. But the degree of risk has been greatly reduced for both.

Derivatives Don’t Cause Risk

Agreements to buy and sell agricultural products at specified future prices are made with futures contracts. These contracts are traded on markets, and their prices fluctuate over time with changes in the expected prices of the products. So the value of each of these futures contracts is derived from the value of something else. Any contract whose value is derived from something else is called a derivative. Derivatives have proliferated in recent years, allowing people to speculate on the future prices of a wide range of things (including interest rates). Unfortunately derivatives are widely blamed for the risks that have resulted in a few large losses suffered by businesses and governments that speculated in them. This criticism reverses cause and effect. Increased risk caused the derivative, not the other way around. The increase in the numbers and types of derivatives was the predictable response to the increased risks caused by such things as the uncertain value of the dollar due to the inflation of the 1970s and ’80s, the volatility of prices of resources such as oil, and the move to floating exchange rates for foreign currencies. These risks were not caused by derivatives. Derivatives emerged as a way of reducing risks in the same way farmers and bakers reduce the cost of fluctuating wheat prices with futures contracts.

Blaming risks on derivatives is as silly as blaming diseases on doctors.

  • Dwight R. Lee is the O’Neil Professor of Global Markets and Freedom in the Cox School of Business at Southern Methodist University.