This description of hedging is accurate but from the perspectives of each the two parties to the contract. This latter perspective is vital in order to understand why these contracts arise. I suggest another perspective here: the advantage to the economy. Adam Smith perhaps first took this perspective as he described why trade between individuals led to an overall gain for the economy. It is not quite as simple as noting that the two individuals were each better off. (Or is it?)
The shift in perspective is like the shift from the perspective of a person explaining why he chooses to eat now, and the perspective of the evolutionary biologist who explains why people make such decisions. In short it is ‘going meta’. Seeing as how ‘each agent acting on its own behalf’ leads more often to mayhem than to cooperation, this is not a simple matter.
Kropotkin, a favorite of the communists, wrote of natural situations where ‘mutual aid’ occurred, intra-species, or even inter-species. His insights were valid but Kropotkin was unable to fit this into a Darwinian structure. This is perhaps why the Soviet Union tended to down-play or even deny Darwin. The work of Axelrod with the prisoner’s dilemma showed precisely how cooperation could arise at least in an idealized population, and all according to Darwin’s rules. It took nearly 100 years.
My question−‘Is it good to allow hedging?’−can be asked from these perspectives:
Adam Smith explained why local transactions contributed to the commonweal at least by increasing the total wealth of two individuals without decreasing that of anyone else. If the hedger is a baker who sells bread and is able stay in business while selling at a lower price than other bakers, then others benefit directly from the lower price and indirectly from the hedging. To make this more precise we must average over possible outcomes weighted by probabilities thereof. This increase is not nullified if more bakers begin to hedge; then the effect is increased and not canceled; it is a win-win game.
If the baker hedges with someone who likes to gamble and has no insight into the price of wheat beyond a memory thereof, there is still an overall benefit; the gambler is in effect investing in the baking business. If the baker hedges with someone with a valid insight into weather patterns, then the total benefit (to the two) is even greater. How that surplus benefit is divided is not relevant to the larger questions. The economy wide benefit is increased by the synergy of baking skill and weather savvy—and all with a simple to understand contract. Achieving synergy is seldom so simple.
If a wheat futures broker enters the picture, and is able to connect futures buyers to futures sellers, then the broker is in a position to ‘create yet more wealth’ and capture some of that for himself.
We must pause here and describe more carefully where the ‘real’ wealth arises and how it is increased in this complex scenario.
The futures seller who has valid weather savvy is likely to sell futures at a better price than the seller without — again averaged over many seasons. We can thus assume that the prices of wheat futures will decline and that is a component in the price of bread, assuming that there is competition between bakers. This works because when bad weather for wheat looms, the future prices will rise and bakers will cut back on their projected output and perhaps refrain from selling bread futures, which will raise the price of those, which will stimulate steps to increase production of other food stuffs, in time to counter the looming bread shortage. The ‘real wealth’ is thus created when alternate food production is increased soon enough to offset the shortage of wheat. Sellers of that alternate food will be compensated by the greater quantity that they produced on account of the early price signals.
I have glossed over many necessary technical details involved in convexity of utility curves, technical details that most market participants understand intuitively.
Marx and later communists proposed that central planning would accomplish all of this. That has not worked out for reasons amply described elsewhere.
We can see from this proposed scenario that price signals in the futures market must travel fairly quickly, and I have omitted a few steps. I think that it is fairly obvious that those with insight into the direct means of wealth production, such as growing wheat, are in a better position to create more wealth (and keeping some for themselves) than the mere technical trader that only remembers price patterns. The technical trader can make the market more efficient, which creates wealth, but my intuition is that is not the main contribution of the futures market to the commonweal—and thus that is not where the wealthiest traders will be found.
Some ask “What is the point of all this ‘meta’ analysis?”. What is the point of biology? It is to help us cheat nature, or sometime shortcut what nature might have done itself in another million years. We fly today because we observed birds and wondered “Why can’t we do that too?”. That was going meta. Popper said somewhere, something like “Let our hypotheses die in our stead.”. We can carry out simulations of different sorts of derivatives in our heads and decide which ones will are likely to make money. This shortcuts actually trying them in most cases. Better with an understanding of where real wealth is created, and an understanding of how the derivative enhances that process many schemes will be shown to be pointless and a few will be shown to be productive.
When I pick up Barron’s or one of most such investor magazines, the talk is only of anticipated prices of derivatives and not of the real wealth creation which underlies those derivatives and gives them their substance. It reminds me of an engineer trying to build some mechanical apparatus without understanding conservation of energy. Such engineers invent no end of perpetual motion machines but mysteriously none of them work. Conservation of energy is a meta concept. Engineers with such concepts are more productive.
I think there are principles such as energy conservation in the market, but they are not so simple and absolute. ‘No free lunch’ is a good start but we must make that more precise.
I think that there is a useful sense in which wealth is not created on Wall street, but yet Wall street, at its best, increases the wealth that is created in Detroit and Kansas City. Wall street thus deserves some of the virtual wealth that it does create.
One theory of management is to maximize the bottom line. Apple is where it is today because Jobs spent more hours obsessing about quality and image than the bottom line. He might or might not have been able to tell you how those obsessions would benefit the bottom line.
Part of the magic of the financial market is to work at a high level and not be bogged down in the product details. But that same argument can be made as a reason that the engineer should not spend time learning energy conservation.