188 CHAPTER 5. USING FORWARDS FOR INTERNATIONAL FINANCIAL MANAGEMENT
5.4 Using Forward Contracts (3): Speculation
What is speculation? One possible definition is that a speculator takes a position
in currencies (or commodities or whatever) for purely financial reasons, not because
she needs the asset or wants to hedge another position. In that sense, speculators
are the agents that pick up the positive or negative net position, long minus short,
left by all hedgers taken together. The forward contracts must be priced such that
total net demand by hedgers and speculators is zero.
On reflection, however, almost all investments are for purely financial reasons,
so by that definition almost all investors would be speculators. So while this is a
perfectly valid definition, it does not necessarily match what the average person has
in mind when hearing the word speculation. Many people would say that specula-
tion involves risk-seeking, in contrast to hedging where risk is reduced rather than
sought. Again, we should refine this: even buying the market portfolio involves
taking risk, so by that standard most investors are again speculators. Perhaps,
then, the crucial element that distinguishes speculation from ordinary investment is
giving up of diversification, that is, taking positions that deviate substantially from
weights chosen by the average investor in a comparable position.
If this is what we mean by speculation, the question arises whether such specu-
lation can be rational, for risk-averse investors; shouldn’t normal investors diversify
rather than putting an unusual amount of money into a few assets? The answer is
that speculation, or underdiversification, can be rational provided that there is a
sufficient expected return that justifies giving up diversification. Extra expected re-
turns arise from buying underpriced assets or shortselling overpriced assets. But the
underdiversified speculator must realize that, by deeming some assets to be under-
or overpriced, her or his opinion is necessarily in disagreement with the market’s.
Indeed, if the entire market had concurred that asset X is underpriced and asset
Y overvalued, then you would not find any counterparts to trade at these rates,
and prices would already be moving so as to eliminate the mispricing. In short,
an underdiversified speculator thinks that (a) she or he spots mispricing which the
market, foolishly, does not yet notice; (b) the market will soon see the error of its
ways and come around to the speculator’s view; and (c) the gains from that hoped-
for price adjustment justify the underdiversification resulting from big positions in
the mispriced assets.
In this section we discuss speculation on the spot rate, the forward rate, and
the swap rate. In the examples we use speculation in the meaning of intentional
underdiversification.
5.4.1 Speculating on the Future Spot Rate
Example 5.15
Suppose Milton Freedman is more optimistic about the Euro than the market. As