Trading and Markets

This article focuses on how traders and funds have an effect on the financial market. The success of the financial market is important to everyone the world over. The article explores the role of a trader and reviews hedge funds and how their emergence has changed the market.

Keywords Bond Markets; Capital Markets; Commodity Markets; Financial Markets; Futures Markets; Hedge Funds; Money Markets; Stock Markets; Traders; Trading

Finance > Trading & Markets

Overview

Financial Markets

The success of the financial market is important to everyone across the world. "We live in a world that is shaped by financial markets and we are profoundly affected by their operation. Our employment prospects, our financial security, our pensions, the stability of political systems and nature of the society we live in are all greatly influenced by the operations of these markets" (Fenton-O'Creevy, Nicholson, Soane, & Willman, 2005, p. 1-2). If the market is not healthy, there is potential for crises.

Financial markets could be defined in two ways. The term could refer to organizations that facilitate the trade of financial products or it can refer to the interaction between buyers and sellers to trade financial products. Many who study the field of economics tend to utilize both definitions, but finance scholars more often use the second definition. Economic markets can be both domestic and international.

Financial markets can be seen as an economics term because it highlights how individuals purchase and sell economic securities, merchandise and other products at low transaction prices that emulate effective markets. The overall objective of the process is to gather all of the sellers and put them in one place so that they can meet and interact with potential buyers. The goal is to create a process that will make it easy for the two groups to conduct business.

When looking at the concept of "financial markets" from a finance perspective, one could view financial markets as a way to facilitate the process of raising capital, transferring risk and conducting international trade. The overall objective is to provide an opportunity for those who want capital to interact with those who have capital. In most cases, a borrower will issue an acknowledgement to the lender agreeing to return the capital in full. These receipts are also known as securities and they are both purchasable and sellable. Lenders expect to be compensated for lending the money. Their compensation tends to be made through interests or dividends.

Types of Financial Markets

There are different categories of financial markets, and some of them are:

• Capital markets. Capital markets are comprised of primary and secondary financial venues, and are considered a critical factor in American capitalism. Newer securities that were formed more recently are purchased and sold in the primary market and investors sell their securities in the secondary markets. Companies rely on these markets to raise funds for the purchase of equipment required to run the business; conduct research and development; and assist in securing other items needed for the operations of the company.
• Stock markets — In order to raise a large amount of cash at one time, public corporations will sell shares of ownership to investors. Investors gain profits when the corporations increase their earnings. Many view the Dow Jones Industrial Average as the stock market, but it is only one of many components. Two other components are the Dow Jones Transportation Average and the Dow Jones Utilities Average. Stocks are traded on world exchanges such as the New York Stock Exchange and NASDAQ.
• Bond markets — Bonds are the opposite of stocks. Usually, when stocks go up, bonds go down. The differing forms that bonds come in include Treasury bonds, corporate bonds, and municipal bonds. The most significant results are usually from mortgage interest rates.
• Commodity markets. Commodity markets help the trading of raw or primary commodities run more smoothly. The commodities are traded on regulated commodities exchanges. According to Amadeo (n.d.), the most significant commodity to the American economy is oil, and the cost is decided upon by the commodity’s prospective market. Futures “are a way to pay for something today that is delivered tomorrow, which helps to remove some of the volatility in the American economy. However, futures also increase the trader's leverage by allowing him to borrow the money to purchase the commodity. If the trader guesses wrong, it can have a huge impact on the stock market, and the American economy” (Amadeo, n.d., “What are commodities”).
• Money markets. Money markets offer short-term debt financing and investment. The financial market is the international money market for briefer, more temporary borrowing. The market allows for temporary liquid funding for the international economic system. Borrowers tend to accept loans for shorter time periods that rarely extend beyond 13 months. Money markets trade by using paper as their financial instruments.
• Derivatives markets. Derivatives markets offer tools to facilitate the governance of and control over economic risks.
• Futures markets Allow for standardized forward contracts that trading products can use in the future.
• Insurance markets. Help to further and redistribute the variety of risks that might be dealt with.
• Foreign exchange markets. Help to make trading easier for foreign exchange.
• Hedge fund markets. In recent times, hedge funds have accelerated in popularity because of their assumed higher returns for high-end financiers. Because hedge funds invest most often and more heavily in future stocks, some investors believe that they have slowed the once steady evaporation of the stock market and, by extension, the American financial state. But in 1997, Long Term Capital Management, the then biggest hedge fund in the world, nearly diminished the U.S. economy entirely (Amadeo, n.d.).

Application

Hedge Funds

Hedge funds have become popular over the last years due to their ability to take both short (sold) and long (bought) positions (Lubochinsky, Fitzgerald & McGinty, 2002). In other words, positions are "market neutral" but with leverage (Edwards, 1999). The funds are well received because they have the ability to utilize "active management skills to earn positive returns on capital regardless of the market direction" (Lubochinsky, Fitzgerald & McGinty, 2002, p. 33).

A hedge fund is a small group of investors who have formed a private club. Given the extent of the risks involved and the need to bypass regulation, most of the members of the small investor group are high-net-worth investors with over one million dollars in net worth or more than $200,000 in annual income. Therefore, many of the traditional mutual fund investors are not a part of this group. Some of the differences between hedge funds and mutual funds are that hedge funds.

• Can buy a wider variety of securities;
• Are restricted to fewer investors;
• Can try to produce a gain regardless of whether or not stock and bond markets are rising or falling;
• Have not been subjected to strict SEC regulations and disclosure requirements (one exception is the new "funds of funds");
• Tend to concentrate their portfolios in fewer investments;
• Have more leeway to "time" the market;
• Cannot advertise;
• Can limit the number of contributions and withdrawals;
• Have a compensation method based on incentive and management fees that are usually much higher than those for mutual funds; and
• Can invest in long, short and leveraged securities (Evans, Atkinson & Cho, 2005).

The "hedge fund" club will invest in a variety of securities, and they use diverse market philosophies and analytical techniques to develop models that will yield them the greatest return. The models tend to be sophisticated, quantitative and proprietary to the fund.

Most hedge funds have two distinct features. First, the funds need to be what is called absolute return funds. The goal is not to get too many returns over a short benchmark period. Earning the proper absolute returns for the risk at hand is the main goal of the process. The second feature is the funds’ use of leverage. The level of leverage involved tends to vary. There are three main mechanisms that hedge funds can leverage into new asset positions. They are: Traditional margin loans have been extended by prime brokers to their clients, fixed income hedge funds make extensive use of repurchase agreements, and leverage can be obtained from the use of all types of derivative positions including future contracts, total return swaps, and options (Lobochinsky, Fitzgerald, & McGinty, 2002).

In addition, there are different types of hedge funds. According to Evans, Atkinson and Cho (2005) the following list is an example of the various types of hedge funds.

• Relative value (or "arbitrage") funds. The practice of combining longer security positions with shorter positions that will help to compensate for each other and gather returns that act independently from market movements.
• Event-driven funds. Long-term positions that revolve around certain types of business transactions like mergers, acquisitions, and tenders. Such forms of hedge funds often involve lengthy positions in a company’s stock that acts as a leading mark for takeover.
• Equity funds. Occurs when any type of position is taken in security equities. In addition, focus is given to obtaining a fast and hearty turnaround from businesses that have the potential to increase their standing.
• Global asset allocator (or "macro") funds. This is the most diverse and complex global investment. It combines stocks, futures, forward contracts, options and commodities. This type of hedge fund may take a long position in a currency that is undervalued and an equal, short position in another currency that is overvalued.
• Short-selling funds. There is a trade with securities or currencies that are considered to be overpriced, but not owned by the hedge fund. The desired outcome is to be able to buy them back at lower prices in order to generate gains.

The Long Term Capital Management (LTCM) Collapse

One of the most important events in hedge fund history involved Long Term Capital Management (LTCM). LTCM collapsed in August, 1998. The event almost caused a crisis in the world economy. What happened? LTCM was a hedge fund that was set up in 1994. Its purpose was to exploit arbitrage opportunities. The investment team included some of the more respected theorists and traders in each respective industry. John Meriwether, a well known trader from Salomon Brothers' arbitrage group, was the leader of the LTCM team.

In the first two years of trading, investors earned approximately 45% in returns. However, the return level dropped significantly in 1997. The fund was operating with funds of $4.7 billion, and loans brought the value of the funds to approximately $125 billion. The objective was to seek assets whose prices were closely related.

Unfortunately, there was a turn of events in the market on August 17, 1998. Russia defaulted on its public debt, and investors began to panic. The reaction caused a negative effect on the market and LTCM found it hard to reposition itself. As a result, LTCN received assistance from a group of fourteen major banks that had been organized by the US Federal Reserve. If the Federal Reserve had not stepped in, LTCM's defaults would have caused many banks around the world to collapse.

Viewpoint

Traders

"The role and importance of international financial markets and the traders who inhabit them have grown dramatically in the past few decades. The level of financial flows in these markets can rise to quite staggering levels" (Fenton-O'Creevy, Nicholson, Soane, & Willman, 2005, p. 2). Professional traders are highly visible, especially in the media. For example, there have been times when one can get a glimpse of a trading floor on the local news or there is a talk show host interviewing a senior trader to explain the trends and future of the market. In addition, professional traders tend to be in a position to exploit market imperfections and have access to priviledged information, critical mass, or proprietary knowledge and models.

Traders & their Strategies

Traders can be divided into three categories, which are trading on behalf of the customer, market making and propriety trading (Abolafia, 1996). Traders with the least amount of risk are the ones who act on behalf of the customer. At the other end of the spectrum are proprietary traders who take on the greatest risk. Regardless of the category, traders tend to utilize a set of strategies and approaches in order to make a profit. Four of the main strategies include:

• Insider Strategy — The trader achieves an advantage by exploiting priviledged access to information (Casserley, 1991). However, the trader must be cautious because some of techniques may be illegal. For example, information about company earnings and potential takeovers could be considered illegally obtained information. Insider strategies gives the trader an opportunity to anticipate market movements.
• Technical Strategy — Some traders attempt to exploit market imperfections by analyzing past price information. One form of technical strategy involves the use of patterns in price data in order to identify potential turning points in price trends. This is referred to as charting. Traders will attempt to identify trends early, buy into those trends and exit before the trend breaks. There are a number of traders who will use the technical strategy to compliment other techniques.
• Fundamental Strategy — Fundamental strategies focus on the relationship between the economic value of the underlying asset and the market price. Traders will use this strategy to seek expertise and information in order to obtain an accurate valuation of securities. There is an assumption that market values will converge to theoretical values.
• Flow Strategy — This strategy predicts prices as a function of demand and supply for securities in the market (Fenton-O'Creevy, Nicholson, Soane, and Willman, 2005).

Fenton-O'Creevy, Nicholson, Soane, & Willman (2005) argued that traders had to be comfortable with a certain level of risk. In their minds, most traders: Did not pause to think about the risks that they were taking, see risk as a price to pay in order to achieve what they want or need, have a psychological need to seek out risky ventures, and may have a conception of risk that tends to be irrational and distorted.

Conclusion

Financial markets could be defined in two ways. The term could refer to organizations that facilitate the trade of financial products or it can refer to the interaction between buyers and sellers to trade financial products. Many who study the field of economics tend to utilize both definitions, but finance scholars more often use the second definition. Economic markets can be both domestic and international.

Most hedge funds have two distinct features. First, the funds tend to be what is called absolute return funds. The goal is not to earn excess returns over a fixed benchmark. It is to earn the appropriate absolute returns for the risk that is involved. The second feature is the funds use of leverage. The level of leverage used by hedge funds tends to vary. There are three main mechanisms that hedge funds can leverage new asset positions. They are: Traditional margin loans extended by prime brokers to their clients, fixed income hedge funds make extensive use of repurchase agreements, with leverage obtained from the use of all types of derivative positions including future contracts, total return swaps, and options (Lobochinsky, Fitzgerald, & McGinty, 2002).

Evans, Atkinson, and Cho (2005) created a list of typical risks associated with hedge funds. Examples of such risk include:

• Political risk. When an investment is made in a foreign nation and under the laws and sovereignty of that nation, the risk is loss due to possible nationalization.
• Transfer risk. This occurs when a foreign government restricts the delivery of a foreign currency.
• Settlement risk. A dispute between the parties to a contract could prevent the fulfillment of the contract in accordance with its stated terms.
• Credit risk. This happens when the counter party to a contract does not perform due to insolvency.
• Legal risk. This occurs when the contract is declared unenforceable due to legal problems.
• Market risk. Market movements can cause losses.
• Liquidity risk. This occurs when a market dries up and it becomes impossible to liquidate a position.
• Operations risk. Clerical errors can cause risk (Evans, et. al., 2005).

Traders can be divided into three categories, which are trading on behalf of the customer, market making and propriety trading (Abolafia, 1996). Traders with the least amount of risk are the ones who act on behalf of the customer. At the other end of the spectrum are proprietary traders who take on the greatest risk. Regardless of the category, traders must utilize a set of strategies and approaches in order to make a profit.

Terms & Concepts

Bond Markets: The market where many different kinds of bonds are available and utilized, either through exchange or through over-the-counter trades.

Capital Markets: An economic market where long-term debt responsibilities and equity securities are traded through series of purchases and sales.

Commodity Markets: A market where buyers and sellers of raw materials (eg. wool, sugar, coffee, wheat, metals, etc.) trade.

Financial Markets: Markets that are based on the exchange and trading of capital and credit, such as money and capital markets.

Futures Markets: Focus on margins as they relate to the initial deposit of “good faith” that is made to an account with the intent to then engage in a futures contract. The margin is also known as good faith due to its help in debiting daily losses that may be incurred.

Hedge Funds: Funds that are willing to take short (or sold) positions in the securities as well as the long (or bought) positions. They are funds that attempt to utilize active governing and control abilities as a means of earning positive returns on capital despite which direction the market goes in.

Money Markets: Money market securities are often considered a safe alternative to riskier ways of investing. They usually return a lower interest rate that aligns properly with the temporary cash storage and short-term future expectations.

Stock Markets: The arranged trading system of stocks that are traded through exchanging and making over-the-counter trades.

Traders: An individual or corporation that purchases and sells securities for the benefit of its own individualized account and not necessarily for the benefit of any potential clients.

Trading: The act of purchasing and selling securities, good, or commodities for the short-term in an attempt to earn fast profits.

Bibliography

Abolafia, M. (1996). Making markets: opportunism and restraint on Wall Street. Cambridge, MA: Harvard University Press.

Amadeo, K. (n.d.) An introduction to the financial markets. Retrieved on July 31, 2007, from http://useconomy.about.com/od/themarkets/a/capital%5fmarkets.htm.

Casserley, D. (1991). Facing up to the risks. New York: John Wiley & Sons, Inc.

Edwards, F. (1999). Hedge funds and the collapse of long term capital management. Journal of Economic Perspective, 13, 189-210.

Evans, T., Atkinson, S., & Cho, C. (2005). Hedge fund investing. Retrieved September 10, 2007, from https://www.aicpa.org/PUBS/jofa/feb2005/evans.htm.

Fenton-O'Creevy, M., Nicholson, N., Soane, E., & Willman, P. (2005). Traders: Risks, decisions, and management in financial markets. Oxford: Oxford University Press.

Lubochinsky, C., Fitzgerald, M., & McGinty, L. (2002). The role of hedge funds in international financial markets. Banca Monte dei Paschi di Siena SpA, 31, 33-57.

Suggested Reading

Blumberg, D. (2007). Bond prices recover from Friday's fall. Wall Street Journal — Eastern Edition, 250, c9.

Dorr, D. (2007). Longevity trading: Bridging the gap between the insurance markets and the capital markets. Journal of Structured Finance, 13, 50-53.

Ewing, J. (2007, August 2). Deutsche bank calms jittery markets. Business Week Online, 20. Retrieved August 26, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26053448&site=ehost-live