Risk Speculation and Gambling

One definition of speculation is "the assumption of considerable business risk in obtaining commensurate gain." Although this definition is fine linguistically, it is useless without first specifying what is meant by "commensurate gain" and "considerable risk."

By "commensurate gain" we mean a positive risk premium, that is, an expected profit greater than the risk-free alternative. In our example, the dollar risk premium is $17,000, the incremental expected gain from taking on the risk. By "considerable risk" we mean that the risk is sufficient to affect the decision. An individual might reject a prospect that has a positive risk premium because the added gain is insufficient to make up for the risk involved.

To gamble is "to bet or wager on an uncertain outcome." If you compare this definition to that of speculation, you will see that the central difference is the lack of "commensurate gain." Economically speaking, a gamble is the assumption of risk for no purpose but enjoyment of the risk itself, whereas speculation is undertaken in spite of the risk involved because one perceives a favorable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium to compensate risk-averse investors for the risks they bear. Hence, risk aversion and speculation are not inconsistent.

In some cases a gamble may appear to the participants as speculation. Suppose two investors disagree sharply about the future exchange rate of the U.S. dollar against the British pound. They may choose to bet on the outcome. Suppose that Paul will pay Mary $100 if the value of £1 exceeds $1.70 one year from now, whereas Mary will pay Paul if the pound is worth less than $1.70. There are only two relevant outcomes: (1) the pound will exceed $1.70, or (2) it will fall below $1.70. If both Paul and Mary agree on the probabilities of the two possible outcomes, and if neither party anticipates a loss, it must be that they assign

CHAPTER 6 Risk and Risk Aversion 157

p = .5 to each outcome. In that case the expected profit to both is zero and each has entered one side of a gambling prospect.

What is more likely, however, is that the bet results from differences in the probabilities that Paul and Mary assign to the outcome. Mary assigns it p > .5, whereas Paul's assessment is p < .5. They perceive, subjectively, two different prospects. Economists call this case of differing beliefs "heterogeneous expectations." In such cases investors on each side of a financial position see themselves as speculating rather than gambling.

Both Paul and Mary should be asking, "Why is the other willing to invest in the side of a risky prospect that I believe offers a negative expected profit?" The ideal way to resolve heterogeneous beliefs is for Paul and Mary to "merge their information," that is, for each party to verify that he or she possesses all relevant information and processes the information properly. Of course, the acquisition of information and the extensive communication that is required to eliminate all heterogeneity in expectations is costly, and thus up to a point heterogeneous expectations cannot be taken as irrational. If, however, Paul and Mary enter such contracts frequently, they would recognize the information problem in one of two ways: Either they will realize that they are creating gambles when each wins half of the bets, or the consistent loser will admit that he or she has been betting on the basis of inferior forecasts.

Assume that dollar-denominated T-bills in the United States and pound-denominated bills in the United Kingdom offer equal yields to maturity. Both are short-term assets, and both are free of default risk. Neither offers investors a risk premium. However, a U.S. investor who holds U.K. bills is subject to exchange rate risk, because the pounds earned on the U.K. bills eventually will be exchanged for dollars at the future exchange rate. Is the U.S. investor engaging in speculation or gambling?

Stocks and Shares Retirement Rescue

Stocks and Shares Retirement Rescue

Get All The Support And Guidance You Need To Be A Success At Investing In Stocks And Shares. This Book Is One Of The Most Valuable Resources In The World When It Comes To

Get My Free Ebook


Post a comment