26

FINANCIAL RISK MANAGEMENT

The direction in which prices will move over the longer term is of little
concern compared to determining what price will currently balance supply
and demand.
An amusing analogy can be made to gambling on sports. Position takers correspond to the gamblers who place their bets based on an analysis of
which team is going to win and by what margin. Market makers correspond
to the bookmakers whose sole concern is to move the odds quoted to a point
that will even out the amount bet on each side. The bookmakers concern
is not over which team wins or loses, but over the evenness of the amounts
wagered. Close to even amounts let the bookmakers come out ahead based
on the spread or vigorish in the odds, regardless of the outcome of the game.
Uneven amounts turn the bookmaker into just another gambler who will
win or lose depending on the outcome of the game.
As explained in Section 1.1, the focus of this book is on the active
use of trading in liquid markets to manage risk. This view is more obviously aligned with market making than with position taking. In fact, the
arbitragebased models that are so prominent in mathematical finance
have been developed largely to support market making. Position takers tend
more toward the use of econometric forecasting models. In Section 6.1.7, we
will further discuss the issue of the extent to which position takers should
adopt the risk management discipline that has been developed for market
makers.
Some authors distinguish a third type of financial market participant
besides market makers and position takersthe arbitrageurs. I believe it is
more useful to classify arbitrage trading as a subcategory of position taking. Pure arbitrage, in its original meaning of taking offsetting positions in
closely related markets that generate a riskless profit, is rarely encountered
in current financial markets, given the speed and efficiency with which liquid prices are disseminated. What is now labeled arbitrage is almost always
a trade that offers a low but relatively certain return. The motivations and
uses of models by those seeking to benefit from such positions are usually
closely aligned with other position takers.
A good example is merger arbitrage (sometimes misleadingly called risk
arbitrage). Suppose that Company A and Company B have announced a
forthcoming merger in which two shares of As stock will be traded for one
share of Bs stock. If the current forward prices of these stocks to the announced merger date are $50 for A and $102 for B, an arbitrage position
would consist of a forward purchase of two shares of A for $100 and a forward sale of one share of B for $102. On the merger date, the two shares of
A purchased will be traded for one share of B, which will be delivered into
the forward sale. This nets a sure $2, but only if the merger goes through
as announced. If the merger fails, this trade could show a substantial loss.