Role of Financial Markets
In order to understand how traders contribute to the welfare of society, it is first necessary to understand the three major roles that financial markets play, that is, to:
- Allocate capital. The allocation of capital is the engine that makes our economy run. Without the flow of funds from investors to those in need of funds, new start-up companies would never succeed and company projects would wither. It is also vital that this process allocate needed funds to worthy projects and deny funds to unworthy projects.
- Spread risk. Financial markets reduce the burden of risk by spreading it across many individuals. No one person has to face the prospect of a large catastrophic event.
- Provide information. Individuals look to financial markets to anticipate the future, understand the value of assets, and plan. Many decisions are based on financial market information such as how much should be saved for retirement and which projects should be undertaken.
Role of Speculators
Speculators seem to appear like storm crows during times of shortage. They buy up commodities at a low price and then reap profits as the shortage becomes apparent and prices soar. They have long been blamed for creating these shortages, however, this is more misperception than reality. The author was surprised to observe commentators in a business news show-who should know better-dismissing speculators as troublemakers, while at the same time, explaining that there may have been other good reasons for a swing in commodities prices.
Imagine that you are an early settler living in the prairie who relies on growing wheat to feed your family. It is vital to anticipate shortages or your family could starve, but with forewarning your family can reduce consumption and, ultimately, suffer less. Fortunately, your mysterious neighbor, Acumen, has almost magical powers to predict shortages. You gladly make him generous payments and Acumen enjoys a prosperous living because of his valuable gift.
Could Acumen have a modern-day equivalent? The answer is yes-the speculator.
Speculators anticipate shortages and buy up commodities early, thereby removing them from the market. This alerts consumers to the oncoming shortage, fulfilling the important financial market role of providing information and allowing them to reduce consumption as prices rise. Later, the speculator sells, ameliorating the shortage while making a profit.
Speculators anticipate and warn others about shortages-they do not cause shortages. As a result of their trades, price swings are less severe than they otherwise would have been. We do not blame doctors, police, or firemen for profiting from the misfortune of others because it is understood that they help a bad situation. Speculators deserve the same consideration.
In Essays in Positive Economics, Milton Friedman points out that only irrational speculators will make price swings worse. Such individuals buy up commodities during times of plenty-in effect buying high and selling low-and will not survive in financial markets.
A number of academic papers have been published since Friedman’s assertion, some of which challenge the beneficial role of speculators. However, none assert that because we see speculators buying before times of shortage we can assume that they are causing the shortage.
Critics are quick to point to egregious examples of market manipulation by speculators. Enron’s trading in electricity futures is an obvious example, as is British Petroleum’s trading in natural gas futures. It is interesting to note that Enron went bankrupt and British Petroleum lost money as results of their manipulation.
Just as we do not blame all police or doctors because there are a few bad apples that harm others, all speculators should not be painted with the same brush as their “bad apple” counterparts. Furthermore, participants in these schemes have been punished under existing law for their misdeeds.
Role of Futures Traders
Someone unfamiliar with futures markets might ask: “Aren’t futures just gambles? After all, when one person wins the other person loses. The stock market is more worthwhile because if stock prices go up, everybody can win.” The answer to this question is that futures markets provide insurance and insurance is a zero sum game, just like a bet.
Imagine that you hear a knock at the door. You open the door to be greeted by: “Want to bet that your spouse kicks the bucket? You can win a big payout.”
Is this person a ghoulish apparition, a monster? Actually, he is a life insurance salesman. The reader might object to the language of the sales pitch, because obviously there are valid reasons for taking out life insurance-namely, to protect or compensate someone who has suffered a terrible loss. The futures market fulfills a very similar role-providing insurance in the event of a loss-and should receive similar verbal consideration.
Returning to the farming analogy: A farmer borrows to buy a bushel of wheat seed for planting. When it is time to harvest the wheat, the price has fallen and the farmer can only get $7.00 for the wheat produced, while the wheat seed cost the farmer $8.00. The farmer would have gone bankrupt unless he sold wheat futures and locked in a profitable sales price. For instance, if wheat futures were selling for $9.40 when the farmer bought his wheat, he could lock in a profit of $1.40 per bushel. Wheat futures perform an important role by shifting risk away from the farmer to the broader financial markets.
Heating oil provides a good example of how important futures markets are for protecting individuals and businesses. A potential hedger is an individual or institution that, like the farmer above, could potentially use futures to protect him or herself. An example of a potential hedger would be a refiner; if heating oil prices fall, the refiner will suffer a loss.
Open interest is a measure of the size of a futures market, and is the number of open futures contracts at any given time. Among a sample of heating oil futures traders, potential hedgers account for 83 percent of the average daily open interest. Refiners were found to represent 34 percent of open interest and their typical trading position was to protect themselves from a price drop. Fuel oil users, who would be hurt by a price rise, were typically found to take positions to protect themselves against price increases.
Looking forward, we can expect individuals who would not normally trade in financial futures to benefit from the protection that futures can provide. A relatively recent innovation is the introduction of housing futures and options by the Chicago Mercantile Exchange (now the CME Group). These will allow homeowners (as well as banks, home builders, etc.) to protect themselves against a decline in housing prices in their area.
Futures markets also provide reliable information by taking enormous quantities of data available to many individuals and distilling it into one opinion reflected in a price. There is honesty behind this opinion because people are putting their money behind their trades. Orange juice futures, for example, can predict the weather in Florida better than just relying on weathermen.
Interestingly, “prediction markets” have begun to emerge to serve this purpose and have been found to be reasonably accurate. There are a number of websites that publish measures of the probabilities of various events happening, based on trading in these events. One can look up expectations of weather events, election outcomes, various political events, housing price declines, scientific discoveries, Federal Reserve policy decisions, academy award winners, etc, on the Internet. On http://www.tradesports.com/, a prediction market was offered for the likelihood of weapons of mass destruction being found in Iraq by a certain date.
Perhaps the biggest political lead balloon of all time was an effort by Admiral Poindexter (of the Iran-Contra scandal) to start a terrorism futures market among analysts within the defense community. Admiral Poindexter clearly had a “tin ear” with regard to how this would be viewed. However, his purpose was to create a prediction market. Employers have a common problem in that when they ask an employee their opinion, they are cheerfully told “What would you like to hear?” Admiral Poindexter was trying to obtain the honest opinion of analysts about threats. I cannot help but wonder how the existence of data from an analyst prediction market would have framed the debate over government honesty and the failure to find weapons of mass destruction in Iraq.
It is interesting to note that businesses are beginning to create prediction markets to take advantage of their accuracy. Hewlett-Packard (HP) created a prediction market among employees to forecast various product sales, and the prediction market consistently beat official, traditional, HP forecasts. Siemens and Google have also experimented with prediction markets. Google created a prediction market where employees bid on 146 events in 43 different subject areas, such as product launch dates and new office openings. Google found that the prediction market prices came very close to the actual probability of an event.
A note of caution is in order here. Prediction markets are susceptible to the misperception that they are “just gambling.” Therefore, individuals and businesses should proceed with caution in order to avoid violating legal restrictions within the United States against Internet gambling. Some prediction markets exist overseas where these restrictions do not hold. Others use virtual currency, and may award prizes for the most successful traders. Perhaps when the usefulness of these markets becomes more widely known, legal restrictions will be relaxed.
Role of Hedge Funds
Many may regard hedge funds as a rich people’s gambling club whose members are granted special privileges over ordinary investors-privileges that could destabilize financial markets with their high debt levels. In order to understand the role that hedge funds play, it is necessary to understand the classical arbitrage strategy that they were traditionally based on.
Consider two individuals that stand ready to buy and sell widgets. One will buy and sell for $0.50 and the other for $1.00. An arbitrageur, possibly in the form of a hedge fund, notices the price disparity. He immediately arranges to simultaneously buy from the low-priced widget dealer and sell to the high-priced dealer. The hedge fund immediately makes a profit of $0.50, buying low and selling high. But why stop there? How about one million trades, 50 million?
This is the essence of classical arbitrage and it depends on absolute secrecy. If the widget dealers find out about each other, prices will equalize and the game is over; the arbitrageur can no longer make money. It is to be expected that this kind of mispricing will not last forever, that the arbitrageur must trade as quickly as possible before the mispricing is discovered. The maintenance of strict secrecy and rapid trading is required and this is why the issue of regulating hedge funds is so difficult (among other reasons).
A natural question that arises is how important is arbitrage? Would not the widget dealers eventually figure out that their prices are off? And what difference does it really make? Suppose that a stock price is too high but the stock earns a good return forever. No one is hurt, right? The answer is that, unfortunately, there can be substantial damage. It is vital to the economy that securities are priced correctly. One only has to look at the Internet bubble to see this.
It is widely believed that during 1998 to 2000 stock prices were much too high for Internet companies, many of which never made a profit and eventually went out of business. And yet, because of the high stock prices, investors’ money flowed into these unproductive businesses (including a flood of capital into IPOs), while other kinds of businesses starved for capital. The consequences were very real and very harmful. This is why, against common wisdom, it is important to let stock prices fall as well as rise.
Research by Ofek and Richardson points to restrictions on short sales as a major contributor to the Internet bubble and its subsequent collapse. (Short sales involve betting that a stock price will decline, and can cause the stock price to fall.) They argue that when there are a large number of overly optimistic investors, restrictions on short selling by more level-headed investors can prevent stock prices from being corrected. Short sale restrictions were put in place in response to the stock market crash that began in 1929, and subsequent great depression. However, instead of asking how to prevent stock prices from falling, a more to the point question might have been, “Are we causing stock prices to get too high in the first place?” Recently the SEC suspended “tick” and “bid” tests for short selling, and developed more flexible margin requirements for a range of securities.
The strength of the American economy can be attributed in no small measure to the efficiency of U.S. financial markets. It is vital to the efficiency of the economy that financial markets do a good job of pricing securities and allocating capital correctly. This is what arbitrageurs do-they correct securities prices. Speculators and futures traders can also perform this type of role.
Role of Bond Traders
Bond traders are an unpopular group. In the acclaimed novel, Bonfire of the Vanities, a bond trader is destroyed (unjustly) in part because bond traders are so disliked. However, bond traders perform a role that we have seen is vital; they correct securities prices. They buy bonds that are underpriced, driving up the price, while selling overpriced bonds.
Bond prices are of vital importance because they are the primary means by which companies raise funds. Since 1994, companies have bought back more stock than they have issued. Bonds fund the capital expenditures and working capital needs of companies as well as funding their stock buy-backs. In 2006, corporate net borrowings equaled $454.5 billion.
In Bonfire of the Vanities, the bond trader’s little daughter asks him what he does. She was impressed to learn that her friend’s father is a publisher; he is in charge of 80 people, and he makes books. When the bond trader tries in a confusing, fruitless effort to explain what he does, his daughter bursts into tears. Unfortunately, it is difficult to explain the vital role of bond traders, but that does not make their contributions any less important.
Our financial markets are the envy of the world and deserve a great deal of the credit for our prosperous economy. Much of the thanks for this success should go to the traders in our financial markets.
Unfortunately, there are a host of negative perceptions about the role of financial markets and the contributions of financial practitioners to the welfare of society. The result is that during times of hardship or market disruptions, angry calls for regulation catch the attention of regulators, and ultimately destroy jobs and decrease welfare.
It is important for financial practitioners to be actively involved in communicating the benefits of financial market activities to the business community as well as to everyone else, and to reach out to communities directly through public service.
 Two movies that portray the widely held but dim view of speculation are Stalag 17, DVD, directed by Billy Wilder (1953; Calabasas, CA, USA: Paramount, 2006), and Empire of the Sun, DVD, directed by Steven Spielberg (1987; Borehamwood, Hertfordshire, England, UK: Warner Home Video, 2001).
 Milton Friedman. Essays in Positive Economics, (Chicago: University of Chicago Press, 2000).
 Some point to specific rather than general circumstances, while others suggest that irrational speculators can influence markets. For a review of this literature, see Carol L. Osler, John A. Carlson. “Rational Speculators and Exchange Rate Volatility,” Federal Reserve Board of New York Staff Report, no. 13, (New York: Federal Reserve Bank of New York, 1996/05).
 Timothy Egan. “Legacy of Power Cost Manipulation,” The New York Times, December 22, 2002, at section 1, National Desk.
 It was announced that one employee has pleaded guilty to market manipulation and the investigation is ongoing. See Department of Justice. Former BP North America Trader Pleads Guilty to Conspiracy to Manipulate and Corner the Market, press release, http://www.usdoj.gov/opa/pr/2006/June/06_crm_401.html.
 Louis Ederington, Jae Ha Lee. “Who Trades Futures and How: Evidence from the Heating Oil Futures Market,” The Journal of Business, 75, no. 2, (2002/04): 353-73.
 Richard Roll. “Orange Juice and Weather,” American Economic Review, 74, no. 5, (1984/12): 861-80.
 Justin Wolfers, Eric Zitzewitz. “Prediction Markets,” Journal of Economic Perspectives 18, no. 2, (2004): 107-26.
 IEM. Iowa Electronic Markets, University of Iowa Henry B. Tippie College of Business, http://www.biz.uiowa.edu/iem/; Hollywood Stock Exchange. The Entertainment Prediction Market, http://www.hsx.com/; PopSci.com. The PopSci Predictions Exchange, http://ppx.popsci.com/ (no longer accessible), HedgeStreet Exchange. Home Page, http://www.hedgestreet.com/; and Intrade. The Prediction Market, http://www.intrade.com/.
 Shailagh Murray. “Pentagon Retreats from Terror Futures in Face of Criticism,” The Wall Street Journal, July 30, 2003, at C1.
 After this happened, an Internet site was started that took bets on when Admiral Poindexter would resign.
 Kay-Yut Chen, Charles Plott. “Information Aggregation Mechanism: Concept, Design and Implementation for a Sales Forecasting Problem,” California Institute of Technology Social Science Working Paper, no. 1131, (2002/03).
 Bo Cowgill. “Putting Crowd Wisdom to Work,” The Official Google Blog, http://googleblog.blogspot.com/2005/09/putting-crowd-wisdom-to-work.html.
 Adam Peter, Michael D. Kinsman. “The SEC Quest to Regulate Hedge Funds Hits Speed Bump,” Graziadio Business Report, 10, no. 1, (2007).
 Eli Ofek, Matthew Richardson. “DotCom Mania: The Rise and Fall of Internet Stock Prices,” Journal of Finance, 58, no. 3, (2003/06): 1113-37.
 They further argue that the expiration of a large number of “lock-up” provisions in 2000 effectively amounted to a relaxation on short sales and caused the Internet bubble to burst.
 Lynn Bai. “The Uptick Rule of Short Sale Regulation – Can It Alleviate the Downward Pressure from Negative Earnings Shocks?” University of Cincinnati Research Paper Series, no. 07-20, (2007/10).
 Chicago Board Options Exchange. SEC Approves CBOE’s New Portfolio Margining Rules to Benefit Customer Accounts, press release, http://www.cboe.com/AboutCBOE/ShowDocument.aspx?DIR=ACNews&FILE=20061213.doc&CreateDate=13.12.
 Tom Wolfe. The Bonfire of the Vanities, (New York: Random House, 2005).
 For non-financial corporate business total net borrowings, and net stock issuance, see: The Federal Reserve Board Flow of Funds Accounts, First Quarter, 2007, at http://www.federalreserve.gov/Releases/z1/.
 For non-financial corporate business total net borrowings, and net stock issuance, see: Board of the Governors of the Federal Reserve System. “Flow of Funds Accounts of the United States: Flows and Outstanding, First Quarter 2007,” Federal Reserve Statistical Releases, http://www.federalreserve.gov/Releases/z1/20070607/z1.pdf.