Hedgers, Speculators, Arbitrageurs
People use derivativesIn finance, a derivative is a contract between a buyer and a seller. The derivative can take various forms, depending on the transaction, but every derivative has the following four elements:an item that can or must be bought or sold, a future act which must occur, a price at which the future transaction must take place, and a future date by which the act must take place.Read on Wikipedia → for different reasons. A company may want to make a future bill predictable. A trader may want to profit from a price change. Another participant may trade because related assets have different prices.
These purposes define three roles: hedgersA hedge is an investment position intended to offset potential losses or gains that may be incurred by a companion investment. A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, gambles, many types of over-the-counter and derivative products, and futures contracts.Read on Wikipedia →, speculatorsIn finance, speculation is the purchase of an asset with the hope that that asset will become more valuable in a brief amount of time. The term can also refer to short sales, in which the speculator hopes to profit from a decline in the asset's value. Speculation often has a pejorative connotation, as the activity is linked to bubbles, economic downturns, and financial crises.Read on Wikipedia →, and arbitrageursArbitrage is the practice of taking advantage of a difference in prices in two or more markets – striking a combination of matching deals to capitalize on the difference, the profit being the difference between the market prices at which the unit is traded. Arbitrage has the effect of causing prices of the same or very similar assets in different markets to converge.Read on Wikipedia →. The contract alone does not tell us which role a participant is taking. We also need to know what they already own or owe, and what they want the trade to achieve.
Reducing a risk that already exists
Suppose a US company must pay a supplier in British pounds. It earns dollars, so a rise in the pound would make the payment more expensive. The company can agree to buy the required pounds at a fixed rate using a forward contractIn finance, a forward contract, or simply a forward, is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed on in the contract, making it a type of derivative instrument. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.Read on Wikipedia →.
The contract reduces an existing currency risk. This is hedging, and the company is a hedger. If the pound becomes cheaper, the contract may show a loss compared with buying at the market rate. But the company still achieves its original aim: knowing the dollar cost of its payment in advance.
A hedge should therefore be assessed together with the payment or asset it protects. Its purpose is to reduce uncertainty, not necessarily to produce the highest possible profit.
Taking a risk to try to earn a profit
Now consider a trader who has no payment to make in pounds but expects the pound to rise. The trader buys a currency forward or futures contractIn finance, a futures contract is a standardized legal contract to buy or sell something at a predetermined price for delivery at a specified time in the future, between parties not yet known to each other. The item transacted is usually a commodity or financial instrument. The predetermined price of the contract is known as the forward price or delivery price. The specified time in the future when delivery and payment occur is known as the delivery date. Because it derives its value from the value of the underlying asset, a futures contract is a derivative. Futures contracts are widely used for hedging price risk and for speculative trading in commodities, currencies, and financial instruments.Read on Wikipedia → to benefit from that rise.
This is speculation. Unlike the company, the trader is adding a currency risk rather than reducing one. A correct forecast can produce a gain; an incorrect forecast can produce a loss.
The company and the trader could use the same type of contract. Their different starting positions explain why the trades serve different purposes. Both activities contribute to trading, alongside banks and other participants that provide liquidityIn business, economics or investment, market liquidity is a market's feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset's price. Liquidity involves the trade-off between the price at which an asset can be sold, and how quickly it can be sold. In a liquid market, the trade-off is mild: one can sell quickly without having to accept a significantly lower price. In a relatively illiquid market, an asset must be discounted in order to sell quickly. A liquid asset is an asset which can be converted into cash within a relatively short period of time, or cash itself, which can be considered the most liquid asset because it can be exchanged for goods and services instantly at face value.Read on Wikipedia →. Liquidity means being able to buy or sell without great difficulty; it is not guaranteed simply because many people use a market.
Trading a difference between prices
An arbitrageur looks for a price difference that can be captured through linked trades. For example, an equivalent share might be cheaper in one market than another after converting the currencies.
Buying in the cheaper market and selling in the more expensive one can fix a profit if the trades can be completed on the required terms. The difference must cover the costs of trading, funding, and any necessary currency exchange.
This differs from predicting that a share will rise tomorrow. The intended profit comes from the price difference available when the trades are made. The arbitrage article follows the full calculation.
Why a fund’s name does not identify its risk
A hedge fundA hedge fund is a pooled investment fund that holds liquid assets and that makes use of complex trading and risk management techniques to aim to improve investment performance and insulate returns from market risk. Among these portfolio techniques are short selling and the use of leverage and derivative instruments. In the United States, financial regulations require that hedge funds be marketed only to institutional investors and high-net-worth individuals.Read on Wikipedia → can use derivatives for all three purposes. Its name does not mean every trade reduces risk. Hull describes these funds as having greater freedom than traditional mutual funds to use complex strategies. The chapter’s typical fee example is 1–2% of assets plus 20% of profits, rather than a universal rule for every fund.
The strategies vary. A long/short equity fund buys some shares and sells others short, meaning it benefits if those borrowed and sold shares fall. A convertible strategy combines a bond that can be exchanged for shares with a short share position. Other funds invest in troubled companies or developing economies, or trade based on economic forecasts.
Some strategies depend on a particular event. In merger arbitrageRisk arbitrage, also known as merger arbitrage, is an investment strategy that speculates on the successful completion of mergers and acquisitions. An investor that employs this strategy is known as an arbitrageur. Risk arbitrage is a type of event-driven investing in that it attempts to exploit pricing inefficiencies caused by a corporate event.Read on Wikipedia →, the expected return depends on an announced business deal being completed. Despite its name, this strategy can lose money if the deal fails.
To understand a derivative position, identify the risk before the trade, then examine what the new contract changes. This is more useful than assuming a position is safe because its name includes “hedge” or “arbitrage.”
← Previous: Options: The Buyer’s Right, the Seller’s Duty · Next: Hedging: Fix the Price or Buy Protection →