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Unformatted text preview: EC3070 FINANCIAL DERIVATIVES SPECULATION Speculation Speculation entails running the risk of a loss in the expectation of a high reward. A pure investment is devoid of risk and, therefore, of any specu- lative element. Financial speculation involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, real estate, derivatives, or of any other financial instrument, in order to profit from ﬂuctuations in its price. Leverage Leverage (or gearing) consists of disposing borrowed funds in some manner in the hope of deriving speculative returns that are greater than the cost of the borrowing. One way of speculating, which should not entail a great risk, would be to buy an asset at time t = 0 at the spot price of S in the expectation that an increased price S τ at time τ will enable one to realise a profit. A more risky way of speculating would be to use the same funds for buying options. The purchase at time t = 0 of a call option on an asset gives the buyer the right to purchase the asset at a given strike price K τ | at the future date of t = τ . If the price of the asset rises above K τ | , then the value of the call option will rise at a rate far greater than will the value the asset itself. However, if the spot price falls below K τ | , then the call option may become worthless, implying a much greater loss than if the money had been invested in the asset. A put option will allow the holder to make a similar speculation that envisages a fall in the price of the asset below the level K τ | of the strike price. To clarify these matters, we may examine the circumstances at time t = τ , which is when the options mature. Suppose that, at time t = 0, when the investment was made, the treasurer had a sum of V at his disposal. Then, he would be able to purchase N = V /S units of the asset. At time τ , when the price is S τ , his profit or loss from the speculation will be π τ = N ( S τ − S ) = V S ( S τ − S ) ....
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- Spring '12