What Is Speculative Risk?
Speculative risk is a category of risk that, when undertaken, results in an uncertain degree of gain or loss. All speculative risks are made as conscious choices and are not just a result of uncontrollable circumstances. Since there is some chance of either a gain or a loss, speculative risk is the opposite of pure risk, which is the possibility of only a loss and no potential for gain.
- Speculative risk happens when there is an uncertain potential for gains or losses.
- Assuming speculative risk is usually a choice and not the result of uncontrollable circumstances.
- Pure risk is the potential for losses and, in contrast to speculative risk, there is no opportunity for gain.
- Buying a call option contract is an example of taking on a speculative risk, as there is potential for gains, while the possibility of losses—in terms of the premium paid for the contract—exist as well.
- Sports betting, investing in stocks, and buying junk bonds are other examples of activities that involve speculative risk.
Almost all investment activities involve some speculative risks, as an investor has no idea whether an investment will be a blazing success or an utter failure. Some assets—such as an options contract—carry a combination of speculative risk and risk that you can hedge.
Understanding Speculative Risk
Some investments are more speculative than others. For example, investing in government bonds has much less speculative risk than investing in junk bonds because government bonds have a much lower risk of default. In many cases, the greater the speculative risk, the higher the potential for profits or returns on the investment.
A speculative risk has the potential to result in a gain or a loss. It requires input from the person looking to assume the risk and is therefore entirely voluntary in nature. At the same time, the result of a speculative risk is hard to anticipate, as the exact amount of gain or loss is unknown. Instead, various factors—such as company history and market trends when buying stocks—are used to estimate the potential for gain or loss.
Speculative Risk vs. Pure Risk
In contrast to speculative risk, pure risk involves situations where the only outcome is loss. Generally, these sorts of risks are not voluntarily taken on and, instead, are often out of the control of the investor. Pure risk is most commonly used in the assessment of insurance needs. For example, should a person damage a car in an accident, there is no chance that the result of this will be a gain. Since the outcome of that event can only result in a loss, it is a pure risk.
Examples of Speculative Risk
Most financial investments, such as the purchase of stock, involve speculative risk. It is possible for the share value to go up, resulting in a gain, or go down, resulting in a loss. While data may allow certain assumptions to be made regarding the likelihood of a particular outcome, the outcome is not guaranteed.
Sports betting also qualifies as having speculative risk. If a person is betting on which team will win a football game, the outcome could result in a gain or loss, depending on which team wins. While the outcome cannot be known ahead of time, it is known that a gain or loss are both possible.
If you buy a call option, you know in advance that your maximum downside risk is the loss of the premium paid if the option contract expires worthless. At the same time, you do not know what your potential upside gain will be since nobody can know the future.
On the other hand, selling or writing a call option carries unlimited risk in exchange for the premium collected. However, some of that speculative risk can be hedged with other strategies, such as owning shares of the stock or by purchasing a call option with a higher strike price. In the end, the amount of speculative risk will depend on whether the option is bought or sold and whether it is hedged or not.