2.7 Theoretical Markets
11
• Liquidity: Borrowing and lending money in unlimited quantities at the risk-free
rate r f is always possible. It is always possible to find a trading partner for buying
and for short selling.
• Equilibrium and no arbitrage: The market is in equilibrium and any possibilities
for arbitrage are removed immediately by a response of the market as a whole.
• Rational investors: all traders are rational and attempt to avoid risks or at least
maximize their gain for a given amount of risk.
• No transaction costs: normally every financial transaction incurs some fee to be
paid to the broker or bank. This effect can be minimized by trading large quantities
and we will ignore it.
• No taxation: taxation can affect decisions regarding stock markets, because incurring a loss on the stocks can be used to offset gains in other markets and thus
minimizing taxes. We ignore this effect.
• Transparency: all information is available to all traders. No inside information is
available.
In reality these idealized rules are at least approximately valid even in the real world,
whose occupants we consider in the next section.
2.8 Market Participants
Before discussing the participants we need to introduce a bit of lingo, because it is
frequently used in the context of finance. A trader, who sells a good and therefore
no longer owns it, is short of the good and assumes the short position in the trade.
Conversely, the buyer, who now owns the good, assumes the long position.
First we consider the hedgers. They try to balance risk of their portfolio and are
mostly interested in avoiding large losses while, at the same time, being forced to
accept risks. An example is a treasurer in a manufacturing company that converts
raw material into a more valuable product. The risks the company is exposed to are
the varying price of raw material and possibly fluctuating currency exchange rates,
if the raw material must be imported from abroad. The risk due to the price of raw
materials can be alleviated by buying options or futures in parallel to the raw material
and in this way reduce their price fluctuations. The currency risk can be hedged by
off-setting sales of the final product in the raw material’s country of origin. In fact,
most traders use some form of hedging to limit their exposure to risks outside their
realm of control. Note, however, that hedging has a price. Besides canceling risks it
also limits profits. Even if one side of hedging gives a large payoff, the other incurs
a loss.
A second large group of traders are speculators. They actually seek to increase
their exposure to risk in order to increase their chance of making a large profit,
albeit at the expense of losing big-time, in case the market develops in unwanted and
unexpected ways.
11
• Liquidity: Borrowing and lending money in unlimited quantities at the risk-free
rate r f is always possible. It is always possible to find a trading partner for buying
and for short selling.
• Equilibrium and no arbitrage: The market is in equilibrium and any possibilities
for arbitrage are removed immediately by a response of the market as a whole.
• Rational investors: all traders are rational and attempt to avoid risks or at least
maximize their gain for a given amount of risk.
• No transaction costs: normally every financial transaction incurs some fee to be
paid to the broker or bank. This effect can be minimized by trading large quantities
and we will ignore it.
• No taxation: taxation can affect decisions regarding stock markets, because incurring a loss on the stocks can be used to offset gains in other markets and thus
minimizing taxes. We ignore this effect.
• Transparency: all information is available to all traders. No inside information is
available.
In reality these idealized rules are at least approximately valid even in the real world,
whose occupants we consider in the next section.
2.8 Market Participants
Before discussing the participants we need to introduce a bit of lingo, because it is
frequently used in the context of finance. A trader, who sells a good and therefore
no longer owns it, is short of the good and assumes the short position in the trade.
Conversely, the buyer, who now owns the good, assumes the long position.
First we consider the hedgers. They try to balance risk of their portfolio and are
mostly interested in avoiding large losses while, at the same time, being forced to
accept risks. An example is a treasurer in a manufacturing company that converts
raw material into a more valuable product. The risks the company is exposed to are
the varying price of raw material and possibly fluctuating currency exchange rates,
if the raw material must be imported from abroad. The risk due to the price of raw
materials can be alleviated by buying options or futures in parallel to the raw material
and in this way reduce their price fluctuations. The currency risk can be hedged by
off-setting sales of the final product in the raw material’s country of origin. In fact,
most traders use some form of hedging to limit their exposure to risks outside their
realm of control. Note, however, that hedging has a price. Besides canceling risks it
also limits profits. Even if one side of hedging gives a large payoff, the other incurs
a loss.
A second large group of traders are speculators. They actually seek to increase
their exposure to risk in order to increase their chance of making a large profit,
albeit at the expense of losing big-time, in case the market develops in unwanted and
unexpected ways.