Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. However, there is still the risk that no wheat will be available because of events unspecified by the contract, such as the weather, or that one party will renege on the contract. Although a third party, called a clearing house, insures a futures contract, not all derivatives are insured against counter-party risk.
From another perspective, the farmer and the miller both reduce a risk and acquire a risk when they sign the futures contract: the farmer reduces the risk that the price of wheat will fall below the price specified in the contract and acquires the risk that the price of wheat will rise above the price specified in the contract (thereby losing additional income that he could have earned). The miller, on the other hand, acquires the risk that the price of wheat will fall below the price specified in the contract (thereby paying more in the future than he otherwise would have) and reduces the risk that the price of wheat will rise above the price specified in the contract. In this sense, one party is the insurer (risk taker) for one type of risk, and the counter-party is the insurer (risk taker) for another type of risk.
Hedging also occurs when an individual or institution buys an asset (such as a commodity, a bond that has coupon payments, a stock that pays dividends, and so on) and sells it using a futures contract. The individual or institution has access to the asset for a specified amount of time, and can then sell it in the future at a specified price according to the futures contract. Of course, this allows the individual or institution the benefit of holding the asset, while reducing the risk that the future selling price will deviate unexpectedly from the market’s current assessment of the future value of the asset.
Derivatives trading of this kind may serve the financial interests of certain particular businesses. For example, a corporation borrows a large sum of money at a specific interest rate. The interest rate on the loan reprices every six months. The corporation is concerned that the rate of interest may be much higher in six months. The corporation could buy a forward rate agreement (FRA), which is a contract to pay a fixed rate of interest six months after purchases on a notional amount of money. If the interest rate after six months is above the contract rate, the seller will pay the difference to the corporation, or FRA buyer. If the rate is lower, the corporation will pay the difference to the seller. The purchase of the FRA serves to reduce the uncertainty concerning the rate increase and stabilize earnings.
An arbitrageur is a type of investor who attempts to profit from price inefficiencies in the market by making simultaneous trades that offset each other to capture risk-free profits. An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than one exchange by buying the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.
Arbitrageurs are typically very experienced investors since arbitrage opportunities are difficult to find and require relatively fast trading. Arbitrageurs also play an important role in the operation of capital markets, as their efforts in exploiting price inefficiencies keep prices more accurate than they otherwise would be.
A speculator utilizes strategies and typically a shorter time frame in an attempt to outperform traditional longer-term investors. Speculators take on risk, especially with respect to anticipating future price movements, in the hope of making gains that are large enough to offset the risk.
Speculators that take on excessive risk typically don’t last long. Speculators are who are profitable over the long-term control their risk through position sizing, stop loss orders, and monitoring the statistics of their trading performance. Speculators are typically sophisticated risk-taking individuals with expertise in the markets in which they are trading.