5.7. CFO’S SUMMARY 213
5.7.2 The Economic Roles of Arbitrageurs, Hedgers, and Speculators
tors
This is the second of two chapters on forward markets. One thing you do remem-
ber from these, it is hoped, is the fact that spot, money, and forward markets are
one intertwined cluster. Traditionally, players in these markets are categorized as
hedgers, speculators, or arbitrageurs. For current purposes, we shall define specula-
tion widely, including all pure financial deals, whether they are based on perceived
mispricing or not. Likewise, let’s temporarily broaden arbitrage to include not just
strict arbitrage but also shopping-around: both help enforcing the Law of One
Price. Let’s now see how these markets and these players interact to arrive at an
equilibrium.
The role of hedgers is obvious. In agricultural markets, for instance, soy farmers
want to have some certainty about the sales value of their next crop, so they sell
forward part or all of the expected harvest. Manufacturers that need soy as inputs
likewise are interested in some certainty about their costs and could buy forward.
Similarly, in currency markets, companies with long positions want to sell forward,
and players with short positions want to buy. But if hedgers were the only players,
the market might often be pretty thin, implying that the market-clearing price could
occasionally be rather weird. That is where speculators and arbitrageurs come in.
The role of arbitrageurs, notably, is to make sure that a shock in one market
gets immediately spread over all related markets, thus dampening its impact. For
instance, if excess sales by hedgers would require a sharp drop in the forward rate to
clear the market, thenCIPmeans that the spot rate will feel the pressure too; and
if the spot rate moves, all other forward rates start adjusting too. What happens,
in principle, is that arbitrageurs would rush in and buy, thus making up for the (by
assumption) “missing” demand from hedge-buyers; these arbitrageurs then close
out synthetically, via spot and money markets or via other forward currency and
forward money markets. So instead of a sharp price drop in one segment, we might
see a tiny drop in all related markets, or even no drop at all. In fact, the hedgers
themselves probably do some of the “arbitrage” work (in the wider sense), since
their shopping-around calculations would normally already divert part of the selling
towards spot markets if forward rates drop too deep relative to spot prices.
This role of spreading the pressure of course works for any shock, not just the
forward disequilibrium we just used as an example. Suppose for instance that a
central bank starts selling dollars for euros in a massive way. This would in a first
instance affect the spot value: market makers see a constant flow of sell orders
coming, which clogs up their books—so they lower their quotes to discourage the
seller(s?) and attract new buyers. But, at constant interest rates, all forward rates
would start moving also, thus also similarly influencing players in forward markets
too: there is less supply, and more demand, for these slightly cheaper forward dollars.
The pressure can even be born by other currencies too. For instance, suppose the
market sees the change in the usd/euro rate as a dollar problem; that is, they see