There are three main reasons for trading in derivatives: risk management, speculation and arbitrage. The players in the derivatives markets are driven and categorized on these three motives.
Hedgers are traders who are driven by the risk management motive. Risk management is the process by which an organization or individual defines the level of risk it wishes to take, measures the level of risk it is taking and adjusts the latter to equal the former.
Hedging includes all acts aimed to reduce uncertainty about future (Unknown) price movements in an asset.
There are two types of hedging:
Long Hedges: are used when one is EXPECTING to acquire an asset in the future, but there is concern that its price might rise in the meantime. To alleviate this price risk, the Hedger takes a long position in the futures/forwards or enters into an option agreement and then if the price does rise, his profit on the Hedge can be used to offset the higher cost of purchasing the commodity. The same principal applies if the price falls.
Short Hedges: Used to reduce risk associated with possible changes in the price of OWNED Assets. The hedger takes a short position in the futures/forwards or enters into an option agreement to cover against price risks.
Hedgers help in increasing market liquidity and price discovery through their activities.
Speculators are motivated by the desire to earn supernormal returns on their investment. The ratio of the Profit to the amount of funds that were potentially at risk, rather than the ratio of the profit to the cash that was put up on margin is the correct way to measure the return on investment.
Speculation involves betting on the movements of the market and tries to take advantage of the high gearing that derivative contracts offer, thus making windfall profits. In general, speculation is common in markets that exhibit substantial fluctuations over time.
A speculator takes either a ‘‘bullish ‘’ or ‘‘bearish’’ view on the market and then engages in derivatives that will profit him if his view materializes.
Their main roles include: Shifting risk from Hedgers to themselves; increasing market liquidity; and price discovery
Arbitrageurs are dealers who seek to gain from mispricing (arbitrage opportunities) in the market. They lock risk less profits by taking positions in two or more markets. They do not hedge nor speculate, since they are not exposed to any risks in the very first place.
Arbitrage is an opportunity to make a risk-less profit without having to make any net investment. There is a no Arbitrage principle in Financial Theory. However, market imperfections allow for some arbitrage opportunities.
The main role played by arbitrageurs is ensuring that price differences between markets are eliminated, and that products are priced in a consisted way.
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