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2 Concepts of Finance
The third large group are the arbitrageurs, who try to exploit small imbalances
in the market fluctuations to make a risk-free profit. One example was already mentioned above, namely different prices of the same asset, for example Gold, in different
countries. Arbitrageurs buy at the inexpensive place an sell at the expensive place,
thereby driving demand up at the inexpensive place and leveling the price difference. A further example are traders that utilize small differences in the value of two
assets that normally track each other. Let us consider the share prices of soft-drink
makers Pepsi
® and Coca Cola
® . Both follow each other rather closely, because the
determining influences are very similar. If, by chance, a small discrepancy appears,
the arbitrageurs can be rather sure that at a later time the stock prices will converge
again. By exploiting this information, they can buy the temporarily too cheap asset
and short the expensive one. Arbitrageurs play an important role in the market. They
ensure that any imbalancing fluctuations are reacted upon and thereby reduced. They
keep the market in balance at its equilibrium.
Of course banks are participants in the market, and especially the central banks.
They set the discount rates, by which commercial banks can borrow money themselves and this determines all other interest rates. Often affiliated to banks are brokerage firms. They are financial advisors or stock-brokers, who assist other persons
in facilitating their trades.
Options are traded by market makers, which are often banks, but can be independent brokers. They provide the liquidity, mentioned above, to the market, because
they immediately react to external offers and purchase requests and thereby guarantee that stocks and options actually can be traded. They ensure that buying and
selling options, often for the purpose of continuous adaption of the hedging (see
below), always works.
The rules for trading are defined and enforced by national trade commissions
that supervise the exchanges. In the US this is the U.S. Securities and Exchange
Commission. In the Euro-zone as recent as 2014, the supervisory authority for large
banks was transferred to the European Central Bank.
Clearing houses are intermediaries between traders. They guarantee that the contracts between other market participants are honored. They normally require the
traders to maintain a margin account, which contains sufficient funds to cover any
expected and foreseeable losses.
After having discussed the prerequisites we can now turn to managing risk and
determine a portfolio that balances our appetite for profit and our distaste to the
exposure to risk. It turns out that this discussion is closely linked to the valuation of
stocks. Namely, the question of what determines the value of a given asset.
2 Concepts of Finance
The third large group are the arbitrageurs, who try to exploit small imbalances
in the market fluctuations to make a risk-free profit. One example was already mentioned above, namely different prices of the same asset, for example Gold, in different
countries. Arbitrageurs buy at the inexpensive place an sell at the expensive place,
thereby driving demand up at the inexpensive place and leveling the price difference. A further example are traders that utilize small differences in the value of two
assets that normally track each other. Let us consider the share prices of soft-drink
makers Pepsi
® and Coca Cola
® . Both follow each other rather closely, because the
determining influences are very similar. If, by chance, a small discrepancy appears,
the arbitrageurs can be rather sure that at a later time the stock prices will converge
again. By exploiting this information, they can buy the temporarily too cheap asset
and short the expensive one. Arbitrageurs play an important role in the market. They
ensure that any imbalancing fluctuations are reacted upon and thereby reduced. They
keep the market in balance at its equilibrium.
Of course banks are participants in the market, and especially the central banks.
They set the discount rates, by which commercial banks can borrow money themselves and this determines all other interest rates. Often affiliated to banks are brokerage firms. They are financial advisors or stock-brokers, who assist other persons
in facilitating their trades.
Options are traded by market makers, which are often banks, but can be independent brokers. They provide the liquidity, mentioned above, to the market, because
they immediately react to external offers and purchase requests and thereby guarantee that stocks and options actually can be traded. They ensure that buying and
selling options, often for the purpose of continuous adaption of the hedging (see
below), always works.
The rules for trading are defined and enforced by national trade commissions
that supervise the exchanges. In the US this is the U.S. Securities and Exchange
Commission. In the Euro-zone as recent as 2014, the supervisory authority for large
banks was transferred to the European Central Bank.
Clearing houses are intermediaries between traders. They guarantee that the contracts between other market participants are honored. They normally require the
traders to maintain a margin account, which contains sufficient funds to cover any
expected and foreseeable losses.
After having discussed the prerequisites we can now turn to managing risk and
determine a portfolio that balances our appetite for profit and our distaste to the
exposure to risk. It turns out that this discussion is closely linked to the valuation of
stocks. Namely, the question of what determines the value of a given asset.