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Three kinds of dealers engage in market activities: hedgers,
speculators and arbitrageurs. Each type of dealer has a different
set of objectives, as discussed below.
Hedgers: Hedging includes all acts aimed to reduce
uncertainty about future [unknown] price movements in a commodity,
financial security or foreign currency. This can be done by
undertaking forward or futures sales or purchases of the commodity
security or currency in the
OTC forward or the organized
futures market. Alternatively, the hedger can take out an option
which limits the holder's exposure to price fluctuations.
Speculators: Speculation involves betting on the
movements of the market and try to take advantage of the high
gearing that derivative contracts offer, thus making windfall
profits. In general, speculation is common in markets that exhibit
substantial fluctuations over time. Normally, a speculator would
take a ``bullish'' or ``bearish'' view on the market and engage in
derivatives that will profit her if this view materializes. Since
in order to buy, say, a European call option one has to pay a
minute fraction of the possible payoffs, speculators can attempt
to materialize extensive profits.
Arbitrageurs: They lock riskless profits by taking
positions in two or more markets. They do not hedge nor speculate,
since they are not exposed to any risks in the very first place.
For example if the price of the same product is different in two
markets, the arbitrageur will simultaneously buy in the lower
priced market and sell in the higher priced one. In other
situations, more complicated arbitrage opportunities might exist.
Although hedging and [mainly] speculating are the reasons
that have made derivatives [im]famous, the analysis of pricing
them fairly depends solely on the actions of the arbitrageurs,
since they ensure that price differences between markets are
eliminated, and that products are priced in a consisted way.