What is Speculation
Speculation is the act of conducting a financial transaction that has substantial risk of losing all value but with the expectation of a significant gain. With speculation, the risk of loss is more than offset by the possibility of a huge gain. Otherwise, there would be very little motivation to speculate. It may sometimes be difficult to distinguish between speculation and investment, and whether an activity qualifies as speculative or investing can depend on a number of factors, including the nature of the asset, the expected duration of the holding period, and the amount of leverage.
BREAKING DOWN Speculation
Real estate is an area where the line between investment and speculation blurs. Buying property with the intention of renting it out would qualify as investing, but 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.
Mutual funds and hedge funds often engage in speculation in the foreign exchange, bond and stock markets.
Foreign Exchange Market
The FX market is the world's largest market, with an estimated $5 trillion per day changing hands. The market trades around the world 24 hours a day; positions can be taken and reversed in seconds, utilizing high-speed electronic trading platforms. Transactions range from spot deals to buy and sell currency pairs, such as EUR/USD, for delivery in two business days to complex options structures with long-term payouts. The market is dominated by asset managers and hedge funds with multi-billion-dollar portfolios.
Speculation in the FX market can be hard to differentiate from hedging, which is when a company or financial institution buys or sells a currency to protect itself from 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 speculation; this can be especially complicated to define if the currency position is bought and sold multiple times while the fund owns the bond.
The global bond market is valued at an estimated $100 trillion, of which approximately $40 trillion is based in the United States. It includes debt issued by governments and multinational corporations. Prices can be very volatile, and they are strongly influenced by interest rate moves as well as political and economic uncertainty. The largest single market is for U.S. government Treasury bonds, and prices in that market are often driven by speculators.
Global stock markets are valued at an estimated $64 trillion. While many pensions and individual retirement accounts are for long-term investments, market movements are frequently driven by speculators.