Why is it important to know the market participants?
Market participants pursue different goals, and they also choose different time horizons for their investments. That is why it is important to know who they are: it helps you put yourself in the shoes of those who actually move prices. Especially if you trade speculatively, it is worth considering at which price levels certain market participants will be forced to act.
All market participants want to achieve the highest possible return at the lowest possible risk. Unfortunately, these two goals are in direct conflict with each other. In perfect markets, an investor always receives the same return for a given level of risk.
Which market participants are there and what are their interests?
1. Institutional investors
Institutional investors include banks, insurance companies, corporations and investment funds, to name just a few. Because these investors pursue different investment objectives, no single, clear set of interests can be defined for them. What matters about this group, however, is that it moves very large amounts of capital. Day-to-day market fluctuations are of no interest to them, so the exact entry or exit point plays only a minor role. Instead, they trade major trends and long-term price developments. Most of their trading decisions are based on fundamental assessments or strategic considerations. When building up or reducing positions, they place only part of the total volume in the market at a time – otherwise they would move prices against themselves. Small investors should be aware of this, because trading against big capital is generally an uphill battle: ultimately, it is the large investors who determine the direction of the market.
2. Hedgers
Hedgers are market participants whose main aim is not to make a profit with their positions. Instead, they try to hedge existing positions or risks. A mechanical engineering company, for example, is exposed to changes in raw material prices. It can hedge against this risk and thereby secure its own cost calculations. To protect itself against rising raw material prices, the company could, for example, build up long positions in futures contracts. If raw material prices actually rise, the company's costs increase – but at the same time it makes gains on its futures contracts. If prices fall, its costs decrease, while the long positions produce a loss. In this way, the company protects itself against this type of price fluctuation.
3. Speculators
Speculators always try to make profits in the markets, regardless of whether prices are rising or falling. They try to identify where movement is developing and take positions accordingly. If they expect prices to rise, they open long positions; in the opposite case, they open short positions. In other words, they seek to generate systematic profits regardless of the market situation.
4. Central banks
Central banks form a separate group of market participants with a special role. Their task is to ensure price stability and to support general economic policy. By changing its key interest rate, a central bank can both safeguard the value of money and influence how much credit flows into the economy. Central banks can also buy and sell securities – these transactions are known as open market operations. For this reason, central banks have a decisive influence on the markets. They move even larger sums of capital than other institutional investors.
5. Arbitrageurs
Arbitrageurs are market participants who try to make risk-free profits. They exploit valuation differences within certain asset classes – for example, when the same security trades at different prices on two exchanges. Because arbitrageurs keep eliminating such differences, price discrepancies rarely persist in the markets. Today, much of this arbitrage is carried out by computers in high-frequency trading.
How well informed are the different market participants?
To understand how well informed the individual market participants are, you first need to look at the information efficiency of capital markets.
Under complete information efficiency, the future cash flows of securities would already be priced in, because all information relevant to their valuation would be reflected in prices. This requires that all market participants always have the same information at the same time and interpret it in the same way. In that case, a securities portfolio would always earn exactly the equilibrium return. In other words, the return of a securities portfolio could be expressed as a linear function of its risk, as in the capital asset pricing model (CAPM). Under complete information efficiency, there would be no outliers – neither upwards nor downwards.
What would complete information efficiency mean for capital markets?
- No arbitrage would be possible, because there would be no valuation differences between securities. The group of arbitrageurs would therefore not exist.
- No excess returns would be possible. Systematically analysing information would be pointless, because a securities portfolio would always earn the equilibrium return.
In reality, however, arbitrageurs do exist – which makes it clear that capital markets are not perfectly information-efficient. Market participants are not all equally well informed, because information in the market is not available free of charge.