L18 - Arbitrage, Hedging and Speculation

Question 1

What are the Advantages of Hedging?

Answer 1

• Hedging seeks to reduce or even eliminate risk.
• Risk comes from adverse movements in asset prices/interest rates/exchange rates
• Options and futures transactions costs are relatively low compared to positions in the spot market (lower bid-ask spread, lower commission and absence of stamp duty and so on)
  
  • Pretty cheap insurance

Question 2

What are Backwardation and Contango?

Answer 2

MEANT TO DO WITH FUTURES?

• The prices of contracts vary with supply and demand conditions in the market and, as with any market, the market sometimes under-prices or over-prices contracts.
• The ‘under-pricing’ of contracts is known as backwardation and it generates opportunities for profit for speculators. –> Forward price lower than the spot
• On the other side of the coin, backwardation allows hedgers to make net sales. (Speculators fill the gap between purchases and sales.)
• The ‘over-pricing’ of contracts is known as contango and it generates opportunities for profit for speculators. –> Forward price is greater than the spot

Question 3

What is the role of speculators in Hedging?

Answer 3

• When someone hedges the other party takes on their risk - speculators take this risk on and try and benefit from this
• The arrival of news to the market causes supply and demand for different instruments to change and this implies changes in the prices of instruments
• Neither is there any a priori reason to assume that speculation is destabilising since the actions of speculators might, in fact, offset each other.
  
  • You cant say hedging is good, buy speculators are not

Question 4

What is the difference between gambling and speculation?

Answer 4

Gambling refers to wagering money in an event that has an uncertain outcome in hopes of winning more money, whereas speculation involves taking a calculated risk in an uncertain outcome

• Gambling involves a game of chance. Generally, the odds are stacked against gamblers.
  
  • For example, a gambler opts to play a game of roulette instead of speculating in the stock market.
  • The gambler only places bets on single numbers. However, the payout is only 35 to 1, while the odds against winning are 37 to 1. So if the gambler bets €2 on a single number, his or her potential gambling income is €70, that is, (35)(€2), but the odds of winning are approximately 1/37.
• The speculation involves calculating risk and conducting research before entering a financial transaction.
  
  • For example, an investor may speculate that a market index will increase due to strong economic numbers by buying one futures contract written on some underlying. If the speculator’s analysis is correct, it might be possible to sell the futures contract (close out the futures position) at a profit before the futures contract closes. If the speculator is wrong, losses will be made.

Question 5

What is the Formal Treatment of Differences between Speculation and Gambling?

Answer 5

• Speculation as a risky type of investment, where investing means to put money to use, by purchase or expenditure, in something offering profitable returns, especially interest or income.
• Gambling involves playing a game of chance for stakes. To stake or risk money, or anything of value, on the outcome of something involving chance. It is a bet or a wager.

Question 6

How is the expect value different between speculation and gambling?

Answer 6

Speculation refers to the act of conducting a financial transaction that has a substantial risk of losing value but also holds the expectation of a significant gain or other major value.

• While speculation is risky, it does often have a positive expected return, even though that return may never manifest.
• Gambling, on the other hand, always involves a negative expected return - the house always has the advantage.

Question 7

What can speculators do in the futures market?

Answer 7

• Futures markets enable speculators to take positions of leveraged exposure to the market.
• Speculation is likely to add to informational efficiency of markets.
• It might seem intuitively obvious that the relatively low cost of speculation in futures markets encourages risk taking and leads to volatility of future prices which is transferred to the spot market.
• In reality, it is more likely that futures markets transfer information to the spot market and so reduce spot market volatility.

Question 8

What is Arbitrage?

Answer 8

• Arbitrage involves riskless gains from mispricing of assets.
  
  • For example, equity futures contracts should bear a consistent relationship to equity prices in the spot market. If equity prices are too high relative to underlying spot prices, arbitrage profits can be made by selling stock and simultaneously buying a futures contract in the same equity.
• Arbitrage will ensure mispricing is eliminated
• Arbitrage determines price boundaries for futures contracts, but it does not determine where, within the range, the contract price will settle.

Question 9

Is speculation bad?

Answer 9

Is speculation bad? Public criticism can be heavy. The objection to speculation generally centers on three beliefs,

(1) speculators manipulate market prices,
(2) speculation causes frequent and unwarranted price fluctuations and,
(3) speculation depresses cash prices.

• Speculation clearly adds to the volume of futures trading, and a number of studies have explored the impact of futures trading on cash prices.
• Most studies show that futures trading has a stabilizing influence on cash prices.
• Why would futures trading stabilize a cash market?
• More futures trading leads to more market price information, and this information is spread quickly to all players in the market.
• More information allows buyers and sellers to make more informed decisions, and the end result is cash prices that more closely represent supply and demand.