Chapter 8
Why People Trade
Utilitarian traders
Investors and borrowers
 Asset exchangers
 Hedgers
 Gamblers
 Fledglings
 Cross-subsidizers
 Tax avoiders
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Investors and borrowers
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Solve inter-temporal cash flow timing
problems
 People
 Corporations
 Governments
Financial assets and real assets
 Fisher’s separation theorem
 Expect fair rate of return (risk free rate +
risk premium) (vs. Speculators)
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Asset Exchangers
Use markets to exchange assets that they
own for other assets that are of greater
immediate use to them
 Spot commodity markets and foreign
exchange markets
 In most asset exchanges, a buyer pays
money or financial assets to a seller who
deliver a commodity or a currency
 Investing and borrowing are special cases
of asset exchanges
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Hedgers and hedging
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Financial risks (four examples)
• Wheat farmers
• Wholesale bakers
• Traders who speculate in individual
stocks
• Banks that lend money at fixed long-term
rates and borrow money at variable shortterm rates
Hedging
Hedgers use markets to reduce their
exposure to financial risks
 They hedge risks by selling or buying
instruments whose values are correlated
with the risks that they face
 They use forward contracts, futures
contracts, option contracts, and swaps

Forward contracts
Farmers and bakers can manage their
price risks by using forward contracts
 Forward contract is an agreement to trade
something in the future at a price that is
set now.
 A farmer would sell a forward wheat
contract to a baker
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Futures contracts

A futures contract is a standardized
forward contract for which a clearinghouse
guarantees the performance of the buyer
and seller by interposing itself between the
buyer and seller of every trade
Hedging with stock options
Buying a stock and put option simultaneously
 In a futures hedge, the hedger gives up
upside potential
 In an options hedge, the hedger keeps the
upside potential, but at a price (i.e., option
premium)
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Gamblers
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Gamblers are not speculators
Gamblers are uninformed traders
They trade for entertainment
They are foolish if they believe that they will be
successful speculators
Many stock traders who think that they are
speculators are actually gamblers (unless they can
clearly articulate their reason for trading)
Gamblers are not necessarily bad for financial
markets
Fledglings
Fledglings trade to learn whether they can
trade profitably
 Fledglings become profit-motivated traders
if they learn to trade profitably
 Fledglings who cannot trade well, and who
continue to trade, are futile traders
 Luck vs. Skills
 Learning trading is similar to learning
disciplines like medicine, engineering,
sports, and management
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Futile traders
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Futile traders expect to profit from trading, but they
do not profit, on average
Futile trades include inefficient traders and
victimized traders
Inefficient traders lack the skills, resources, and
access to information necessary to trade profitably.
The most common type is the pseudo-informed
traders who believe that they are well-informed,
but actually are not.
Victimized traders rely on brokers, advisors, or
employees who fail to meet their fiduciary
responsibilities