Woe is me, laments Job in the Old Testament, Shakespeare’s Hamlet, and a now popular rock band. Lately, speculators also are singing this sad tune.
Speculators were first under attack for their perceived role in the 2007 to 2009 financial crisis.
This same group is taking a hit for rising commodity prices.
French President Nicholas Sarkozy, who heads the Group of 20 leading developed and developing economies, called unregulated commodity markets “a free-for-all” operating under “jungle law.” Sarkozy is proposing regulation aimed to curb commodities speculation in the derivatives markets.
Derivatives are financial contracts where the price depends upon (is derived from) some other asset.
The contract itself has no independent value, and traders need not hold or have any direct interest in the underlying asset.
Derivative markets exist for many types of assets, including stocks, bonds, commodities, currencies or mortgages.
Unfortunately, many now see derivative markets as no more than financial casinos. This is not their function, nor is speculation in these markets in and of itself bad. Speculation improves the operation of all markets and supports economic growth.
Derivatives can be used to speculate, but they serve other very important functions.
Price discovery, for example, is the process whereby investors, speculators and hedgers alike determine the most probable, or expected, price and value in the future.
Hedging risk in derivative markets helps many different businesses.
Idaho companies like Micron Technology use derivatives to hedge the risk of changes in foreign currency values.
Idaho Power uses derivatives to manage risks in the natural gas market.
Derivatives are an efficient way for firms to protect themselves and their shareholders.
But as in any market, speculators are needed as well.
Restricting speculation reduces trading in the underlying assets because less information is available. Without active market participation from hedgers and speculators, investors are less willing to hold assets because they are harder to sell when needed.
Fewer investors in stock or bond markets would mean companies would have a harder time raising the capital they need to expand their business and create jobs.
Fewer commodities traders would mean businesses would need to hold more inventory. This raises costs that are passed on to consumers.
Speculation can actually improve market operations by reducing price volatility. When a speculator thinks prices will rise, he or she places orders to buy the commodity in the future. The transaction only happens if there is a “short seller,” someone who promises to deliver in the future.
If no short seller is there to meet this offer, the “futures” price rises — potentially dramatically.
The speculator only makes a profit on this trade if the market is better off.
By paying the higher future price, the speculator has pulled product from the market when the need was low (today), and moved product for trading to when the need is high (future). Speculators can’t make money if there is no need to deliver in the future.
Woe to the speculator. Apparently global leaders think they can do no good for doing right.