Chapter 8 Why People Trade

Utilitarian traders Investors and borrowers Asset exchangers Hedgers Gamblers Fledglings Cross-subsidizers Tax avoiders

Investors and borrowers Solve inter-temporal cash flow timing problems People Corporations Governments Financial assets and real assets Fisher’s separation theorem Expect fair rate of return (risk free rate + risk premium) (vs. Speculators)

Asset Exchangers Use markets to exchange assets that they own for other assets that are of greater immediate use to them Spot commodity markets and foreign exchange markets In most asset exchanges, a buyer pays money or financial assets to a seller who deliver a commodity or a currency Investing and borrowing are special cases of asset exchanges

Hedgers and hedging Financial risks (four examples) Wheat farmers Wholesale bakers Traders who speculate in individual stocks Banks that lend money at fixed long-term rates and borrow money at variable short-term rates

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

Forward contracts Farmers and bakers can manage their price risks by using forward contracts Forward 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 contracts A 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 options Buying a stock and put option simultaneously In a futures hedge, the hedger gives up upside potential In an options hedge, the hedger keeps the upside potential, but at a price (i.e., option premium)

Gamblers Gamblers are not speculators Gamblers are uninformed traders They trade for entertainment They are foolish if they believe that they will be successful speculators Many 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

Fledglings Fledglings trade to learn whether they can trade profitably Fledglings become profit-motivated traders if they learn to trade profitably Fledglings who cannot trade well, and who continue to trade, are futile traders Luck vs. Skills Learning trading is similar to learning disciplines like medicine, engineering, sports, and management

Futile traders Futile traders expect to profit from trading, but they do not profit, on average Futile trades include inefficient traders and victimized traders Inefficient 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