Single-Stock Futures Part 3

Hedgers, Speculators and Arbitrageurs

In the last lesson, we learned that futures could, in fact, be used conservatively if used as a hedge. Remember that a hedge is an asset that is expected to offset the loss of another position and not necessarily used as a means for profit. Why, then, is there so much publicity with risk in the futures markets?

There are two main parties involved with most futures contracts: hedgers and speculators. The hedgers are those who are trying to avoid risk and transfer it to another party. For example, a farmer may sell wheat futures contracts as a way to protect his selling price. If the price of wheat falls, he will lose on the sale of his crops but gain on the value of the short futures contract, thus offsetting his loss. This is a classic use of futures contracts as a hedge.

In many cases, that person on the other side of the trade is a speculator -- someone who actively seeks risk to make a profit. Speculators are willing to expose themselves to price risk because they expect to profit from price movements. For instance, the farmer who sells futures to protect his selling price may have a speculator for a buyer. The speculator is just someone who thinks the price of wheat will rise and is willing to invest some money based on that belief. Unfortunately, the speculators are the ones who get the spotlight in the newspaper and give futures markets their risky reputation.

There's a good reason you don't read about hedgers in the news. They make boring stories, which is certainly not good for journalists. Think about which of the following hypothetical headlines would make you buy a newspaper:

• Quaker Oats protects their oat supply through futures markets
• Historic Baring's Bank bankrupt by rogue gambler in the futures markets

Both stories used futures contracts. Both parties took their respective positions along with their respective risks, yet only one is heard about. Futures markets can be risky if used thoughtlessly.

Would We Be Better Off Without the Speculators?

You may be tempted to think that we'd be better off without the speculators since they are the ones responsible for the negative publicity Well, that's not exactly true. In fact, without the speculators, you have no futures market! Speculators are essential for providing liquidity (lots of willing buyers and sellers), which helps to keep narrow spreads between bid and ask prices. For instance, with a lot of speculative sellers available, prices tend to be lower, which is good for the conservative buyer. Likewise, with a lot of speculative buyers, prices tend to be higher, which is good for the conservative seller.

Speculators are necessary for any well-functioning market, not just the futures markets. You may be thinking, "None of those speculative markets for me; I'm sticking with my conservative bonds." Well think about who is on the other side of that conservative bond trade of yours. It's a speculator. It is someone who thinks they can make more money by borrowing from you at one rate and creating something of value that yields a higher rate. Without high -risk speculators, the conservative bond market would cease to exist.

Speculators should actually be a welcomed element of the markets. If you are selling any asset, say shares of stock, should it matter to you if the buyer is going to conservatively lock them up in a safe deposit box for 10 years or recklessly gamble and try to flip them for 1/4 -point profit? Obviously, it shouldn't matter. A buyer is a buyer and the more buyers there are, the more competitive the prices become, which is great for you as a seller. So don't fall prey to the belief of the financial press, which often claims that speculators destroy the financial markets. Speculators are an absolute necessity for financial markets to operate -- and occasionally make interesting headlines as well!

Arbitrageurs

Technically, there is a third party involved in the functioning of the futures markets known as arbitrageurs. Arbitrageurs are those who look for "free money" lying around in the market. When we say free money, we really mean a guaranteed profit for no cash outlay. Many people incorrectly believe that an arbitrage profit is simple a guaranteed profit, but that is only half correct. If this second condition of "no cash outlay" were not met, the purchase of a government bond would qualify as arbitrage because a profit is guaranteed. However, the government bond requires a cash outlay for a specific time before the profit is realized.

The classic example of arbitrage is where a stock trader may see shares of IBM asking $125 on the American Exchange and bidding $125.10 on the New York. The arbitrageur could buy them on the American and immediately sell them on the New York for an immediate 10-cent profit. These actions will put buying pressure on the American Exchange and selling pressure on the New York and will continue until IBM is priced the same on both exchanges. While this may not sound like a big profit, bear in mind that large institutions often carry out arbitrage in large block trades and the profits can quickly add up. It is very big business. In fact, in the early 1990s there was a Japanese firm that paid $23 million dollars in order to gain one secon quicker access time to currency quotes for the purpose of arbitrage.

Thought Question: You find a compact disc at Wal-Mart for $9.99 and see the same one at K-mart for $10.99. 1) How would you arbitrage? 2) Why do you suppose that most stores require receipts if exchanging merchandise for cash?

While arbitrage may sound like the ideal way to invest, it is, unfortunately, nearly impossible for retail investors mainly due to speed of executions and commissions. Large institutions have traders on the floors that actively seek out these opportunities and pay a very small processing fee to do so. In fact, you may have seen the strange hand signals that are used on the floors of futures exchanges to designate the orders. These signals evolved from the arbitrageurs. If traders were to see a trade in one pit on the exchange and needed another trade in another pit across the room, it was much easier to flash a hand signal to that pit to complete the trade. If not, by the time they walked over to it, the opportunity would probably be gone

Thought Question: Do you think it is fair that some institutions can obtain guaranteed profits from the market? In other words, should arbitrage be legal?

The word arbitrage is derived from the French word arbitrer, meaning to judge. Arbitrageurs are "judging" the values between two assets and profiting from any discrepancies. Many incorrectly feel that this should be illegal as if these arbitrageurs are cheating the markets. However, arbitrageurs are actually performing an important economic function by ensuring that prices are, in fact, fair for everybody. If one asset is relatively too cheap, you can be assured that arbitrageurs will come to the rescue and bid up its price. Likewise, if one should become relatively too expensive, arbitrageurs will quickly sell it and bring the price down.

So while you will likely never participate in an arbitrage trade, just be aware that they are going on throughout every day to keep futures prices from getting out of line from where they theoretically should be trading in relation to their underlying assets.

Key Point

There are three distinct types of participants in the futures markets:

• Hedgers
• Speculator
• Arbitrageurs

For the most part, retail investors are either hedgers or speculators with the vast majority being speculators. Arbitrageurs are mainly large institutions that can carry out the necessary trades quickly and with low commissions. It is the speculators that give futures markets their risky reputations.

Using the Web Of course, there are rules and regulations as to how, when, and why arbitrage may take place. For an interesting article on how NOT to carry it out click here: http://www.businessweek.com/1996/32/b34876.htm

When and Why Did Futures Begin Trading?

The earliest futures contract was recorded in 1851, although evidence of forward contracts date back to Biblical times. The roots of the modern day futures contract started in the Midwest in the 1800s. It was there that grain traders faced volatile market conditions, which ultimately led to the creation of a futures exchange.

Chicago, just by coincidence, was strategically located. It was centrally located to the grain farmers and also situated at the base of Lake Michigan -- one of the five Great Lakes in North America. Easy access to the Great Lakes made shipping easier and the farmers and grain traders found it convenient to meet in Chicago and exchange commodities through agreements called to arrive contracts. In 1848, merchants formed the Chicago Board of Trade. (CBOT), the first and still the largest futures exchange in the world today.

Using the Web
To learn more about the Chicago Board of Trade (CBOT), click here: http://www.cbot.com/cbot/www/page/0,1398,10,00.aspx. You will need to click on the various links at the left of the page.

To learn more about the Chicago Mercantile Exchange (CME), click here: http://www.cme.com/about/

Today, the CBOT and CME are two of the primary exchanges for many commodity and financial futures contracts although there are many other exchanges including:

• Kansas City Board of Trade (KCBT)
• MidAmerica Commodity Exchange (Mid Am): This is technically owned by the CBOT but operates independently.
• Minneapolis Grain Exchange (MGE)
• New York Board of Trade (NYBOT)
• Philadelphia Board of Trade (PBOT)
• New York Cotton Exchange (CTN/NYCE)
• New York Mercantile Exchange (NYMEX/COMEX)
• Twin Cities Board of Trade (TCBT)
• Winnipeg Commodity Exchange (WCE)

You can buy futures contracts covering many different categories including:

• Agricultural (e.g., corn, soybeans, and lean hog)
• Metals (e.g., gold, silver)
• Chemicals (e.g., benzene and mixed xylenes)
• Interest rate/financial (e.g., eurodollars, Treasury bonds)
• Forest products (e.g., lumber)
• Indexes (e.g., S&P 500, Nasdaq 100)
• Currencies (e.g., Australian dollar, Brazilian real)
• Weather (e.g., heating degree day, cooling degree day)

Hopefully you're starting to see that futures contracts have a valuable role in society and just may be beneficial to your investment portfolio as well. They provide and efficient means to transfer risk from one party to another. Do you remember our Lexus dealer who was hedging his purchase price of Japanese yen from the previous course lessons? There, the dealer was concerned with falling prices and a lost sale while you were concerned with rising prices and the possibility of never finding the car. By using the futures (forward) contract, you each transferred your fears (risks) to the other party -- and both you and the car dealer considered it a good deal.

These are motivating reasons why futures markets were created. They provide a means for providing more liquidity and thus lower prices. The fact that there are some speculatorswilling to gamble on some trades for a profit is irrelevant. The risk the speculators take is voluntary and should not be considered a negative aspect of the futures markets. Because there are speculators willing to gamble on price movements, manufacturers are able to reduce their risk and create products for less money, which is good for all of us. Hopefully you now understand the naivete of those who claim that futures markets are nothing more than a forum for legalized gambling.