Charta is on Google Play: practise on the go. Get the app
Charta

Distinguish hedgers, speculators and arbitrageurs as broad categories of trader.

FRM® Part I · Financial Markets and Products · Introduction to Derivatives · FRM1.FM.4.e

The idea

Derivative users fall into three broad groups. Hedgers already face a price risk, such as a farmer long wheat or an importer owing foreign currency, and take an offsetting derivative position to reduce it, accepting that they give up some gain. Speculators have no underlying exposure and take positions to bet on price moves, adding risk in search of profit and supplying liquidity to the market. Arbitrageurs lock in a riskless profit by trading the same or equivalent assets at inconsistent prices, which pushes prices back into line. The category depends on purpose, not on the instrument. The same forward can be a hedge for one party and a speculation for the other, and a position larger than the underlying exposure is partly speculation.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which description best fits a hedger?

  1. A party that bets on price moves with no underlying exposureWhy not: Describes a speculator, who adds risk rather than reducing it.
  2. A party that locks in a riskless profit from inconsistent pricesWhy not: Describes an arbitrageur, who exploits mispricing and has no initial risk exposure.
  3. A party with an existing price exposure that takes a derivative position to reduce that risk - correct
  4. A party that quotes bid and ask prices to others and earns the spreadWhy not: Describes a market maker or dealer, which is not one of the three traders in the classification.

Hedgers start with a risk (inventory, a future purchase, a foreign receipt) and use derivatives to offset it. The three broad categories are hedgers, speculators and arbitrageurs.

A harder one

Consider three trades. (1) An airline buys call options on jet fuel to cap next year's fuel bill. (2) A fund with no physical exposure buys crude oil futures expecting a price rise. (3) A trader buys gold in one market at 1,900 and simultaneously sells identical gold in another market at 1,908. Which classification of trades (1), (2) and (3) is correct?

  1. Speculator, hedger, arbitrageurWhy not: Swaps the first two: the airline has the fuel exposure, and the fund has none.
  2. Hedger, speculator, arbitrageur - correct
  3. Hedger, arbitrageur, speculatorWhy not: Swaps the last two: the simultaneous buy and sell of identical gold is the arbitrage.
  4. Arbitrageur, speculator, hedgerWhy not: Misses that the airline reduces an existing exposure and that the gold trade is riskless.

Classification follows purpose. The airline offsets an exposure (hedge), the fund takes a naked directional view (speculation), and the simultaneous buy and sell of identical gold locks in 8 riskless (arbitrage).

The hardest tier

A producer expects to sell 50,000 barrels in three months and sells futures on 80,000 barrels at 75. At maturity the price is 70, and the futures are closed at 70. How much of the futures gain is a speculative profit rather than a hedge gain?

  1. USD 400,000Why not: Treats the entire futures gain as speculative instead of splitting off the hedged barrels.
  2. USD 250,000Why not: Gives the hedge portion (50,000 x 5), not the speculative excess.
  3. USD 150,000 - correct
  4. USD 30,000Why not: Reports the excess number of barrels rather than the dollar profit on them.

Futures gain = (75 - 70) x 80,000 = 400,000. The hedge part covers 50,000 barrels: 250,000. The excess of 30,000 barrels earns 5 x 30,000 = 150,000, which is speculation.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Introduction to Derivatives