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Speculation: Trading With High Risks, High Potential Rewards

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Speculation is the process of predicting future prices and entering into a trade that has a significant risk of loss but also the potential for profit. The investor attempts to benefit from the short-term fluctuations in the market as a result of macroeconomic and political events around the globe.

What is Speculation?

In the world of finance, speculation, or speculative trading, refers to the act of conducting a financial transaction that has a substantial risk of losing value but also holds the expectation of a significant gain or other major value. With speculation, the risk of loss is more than offset by the possibility of a substantial gain or another recompense.

An investor who purchases a speculative investment is likely focused on price fluctuations. While the risk associated with the investment is high, the investor is typically more concerned about generating a profit based on market value changes for that investment than on long-term investing. When speculative investing involves the purchase of a foreign currency, it is known as currency speculation. In this scenario, an investor buys a currency in an effort to later sell that currency at an appreciated rate, as opposed to an investor who buys a currency in order to pay for an import or to finance a foreign investment.

Without the prospect of substantial gains, there would be little motivation to engage in speculation. It may sometimes be difficult to distinguish between speculation and simple investment, forcing the market player to consider whether speculation or investment depends on factors that measure the nature of the asset, the expected duration of the holding period, and/or the amount of leverage applied to the exposure.

How Does Speculation Work?

For example, real estate can blur the line between investment and speculation when buying a property with the intention of renting it out. While this would qualify as investing, buying multiple condominiums with minimal down payments for the purpose of reselling them quickly at a profit would undoubtedly be regarded as speculation.

Speculators can provide market liquidity and narrow the bid-ask spread, enabling producers to hedge price risk efficiently. Speculative short-selling may also keep rampant bullishness in check and prevent the formation of asset price bubbles through betting against successful outcomes.

Mutual funds and hedge funds often engage in speculation in the foreign exchange markets as well as bond and stock markets.

Speculation and the Forex Market

Forex markets execute the world’s highest total volume and dollar value, with an estimated $6.6 trillion per day changing hands between buyers and sellers.1 This market trades around the world for 24 hours a day while positions can be taken and reversed in seconds, utilizing high-speed electronic trading platforms.

Transactions typically feature spot deals to buy and sell currency pairs, such as EUR/USD (Euro-US Dollar), for delivery through options or simple exchange. This market is dominated by asset managers and hedge funds with multi-billion-dollar portfolios. Speculation in the forex markets can be hard to differentiate from typical hedging practices, which occur when a company or financial institution buys or sells a currency to hedge against market movements.

For example, a sale of foreign currency related to a bond purchase can be deemed either a hedge of the bond’s value or common speculation. These relationships can get complicated to define if the current position is bought and sold multiple times while the fund owns the underlying bond.

Speculation and the Bond Market

The global bond market is valued at over $100 trillion, of which approximately $40 trillion is based in the United States, and these assets may include debt issued by governments and multinational corporations.2 Asset prices can fluctuate greatly and are strongly influenced by interest rate movement as well as political and economic uncertainties. The largest single world market trades U.S. Treasuries, with prices in that venue often driven by common speculation.