Chapter 8 Why People Trade

Utilitarian tradersInvestors and borrowersAsset exchangers HedgersGamblersFledglingsCross-subsidizersTax avoiders

Investors and borrowersSolve inter-temporal cash flow timing problemsPeopleCorporationsGovernmentsFinancial assets and real assets Fishers separation theoremExpect fair rate of return (risk free rate + risk premium) (vs. Speculators)

Asset ExchangersUse markets to exchange assets that they own for other assets that are of greater immediate use to themSpot commodity markets and foreign exchange marketsIn most asset exchanges, a buyer pays money or financial assets to a seller who deliver a commodity or a currencyInvesting and borrowing are special cases of asset exchanges

Hedgers and hedgingFinancial risks (four examples)Wheat farmers Wholesale bakersTraders who speculate in individual stocksBanks that lend money at fixed long-term rates and borrow money at variable short-term rates

HedgingHedgers use markets to reduce their exposure to financial risksThey hedge risks by selling or buying instruments whose values are correlated with the risks that they faceThey use forward contracts, futures contracts, option contracts, and swaps

Forward contractsFarmers and bakers can manage their price risks by using forward contractsForward contract is an agreement to trade something in the future at a price that is set now.A farmer would sell a forward wheat contract to a baker

Futures contractsA futures contract is a standardized forward contract for which a clearinghouse guarantees the performance of the buyer and seller by interposing itself between the buyer and seller of every trade

Hedging with stock optionsBuying a stock and put option simultaneouslyIn a futures hedge, the hedger gives up upside potentialIn an options hedge, the hedger keeps the upside potential, but at a price (i.e., option premium)

GamblersGamblers are not speculatorsGamblers are uninformed tradersThey trade for entertainmentThey are foolish if they believe that they will be successful speculatorsMany stock traders who think that they are speculators are actually gamblers (unless they can clearly articulate their reason for trading)Gamblers are not necessarily bad for financial markets

FledglingsFledglings trade to learn whether they can trade profitablyFledglings become profit-motivated traders if they learn to trade profitablyFledglings who cannot trade well, and who continue to trade, are futile tradersLuck vs. SkillsLearning trading is similar to learning disciplines like medicine, engineering, sports, and management

Futile tradersFutile traders expect to profit from trading, but they do not profit, on averageFutile trades include inefficient traders and victimized tradersInefficient traders lack the skills, resources, and access to information necessary to trade profitably. The most common type is the pseudo-informed traders who believe that they are well-informed, but actually are not.Victimized traders rely on brokers, advisors, or employees who fail to meet their fiduciary responsibilities