Whilst arbitrage is certainly something which exists in the financial markets, the vast majority of what's done isn't arbitrage. Arbitrage assumes differing views on valuation of an asset today. So I can buy something from person A, which they believe to be worth value x, and sell it to person B, who believes it to be worth y, where y > x. That's arbitrage in its simplest form - the market has priced something incorrectly, and I can buy it from willing sellers, and sell it to willing buyers at different values at the same time.
The vast majority of financial transactions aren't this - they're speculative. They bank on the idea that money now is worth more than money in the future, and the future value of an asset (using the definition of an asset that it's a sequence of cashflows) is both variable and uncertain. So therefore the promise of future money is inherently tied to the concept of risk. The majority of financial markets trading is based around this concept of risk, and the management of it.
There's vastly more complexity under the hood, but that's roughly speaking, accurate.
Commodities, homes, lands, water, minerals, etc (let’s call them real assets) can not inflated as freely as possible, the way money can be expanded/inflated. That’s the large source of speculation. This is why people borrow in order to acquire real assets.
Third world countries want to issue debt in American dollars, because no one wants to buy their bonds in their home currencies.
Gotcha gotcha, that makes sense, thanks for the clear explanation! So I can see how the arbitrage (thusly defined) has the risk mitigation benefits other people talk about, can the same be said about speculation?
Think about it this way, actors in financial markets all have various beliefs about the future, and all of these beliefs are on a scale of accurate to inaccurate. Speculation allows these beliefs to be aggregated into a single market price (which btw implies no arbitrage) for various types of contingencies and risks, and the price will rapidly update to reflect updates to reality and thus updates to everyone’s beliefs.
Sure. You mitigate risk on speculation by hedging. I'll try and give a similarly simple (if not perfectly accurate and far more lengthy) explanation. Someone mentioned farming financials in the comments around this, so we'll use that. It's also something I know well, as I know a lot of farmers.
Let's imagine that a commercial farmer, whom we'll call Jeremy plants 100 acres of wheat on a farm. Market values for wheat (and everything else you can farm, from livestock to grains and so on) vary and move constantly, as a function of supply and demand. We saw this in an extreme form with the invasion of the Ukraine, and the droughts in Italy last year.
Now the problem with farming is your timescales are long compared to the movements of values for your product in the market, so you've no real idea as to what what you're planting will be worth by the time the bloody thing has actually grown and you've got it harvested and into barns to be sold. And once the seed is in the ground, you can't exactly just plough it all over and plant something else (not strictly accurate, but you don't want to go down that route).
So now let's fast forward. Jeremy now harvests his wheat, and let's say the price has moved up a lot between planting and harvest. Jeremy is a happy man, who's going to have a bumper time, even if his crop doesn't produce as much per acre as he might like at the minute, because it's not raining enough. Or conditions are perfect, and the price has gone up, and he makes a huge amount and can reinvest. Jeremy is a happy camper.
However, if the price falls, Jeremy is not going to be quite so chipper. As such, Jeremy can move his risk, through the use of a hedge. Let's say Jeremy hunts around to find someone to buy his wheat at the start of the season. He might sign a contract with a flour producer, stating that they will promise to buy x tonnes of his grain at £y per tonne. Jeremy now has a fixed price, which has hedged his risk profile. Now his risk has moved from financial to productive - he has to be able to provide the x tonnes. If he can't produce it all on the farm, he needs to source the difference. On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract, but that then gets complex). This is a very good thing, but means if the market prices his wheat vastly higher than he expected, he'll miss out on that upside.
This is called a forward contract. There's other types of contract which can be used to do similar things (futures, derivatives...) but that gets a bit more complex.
> On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract
So basically a third party would step in to assure him that he'd be paid the fixed price for a small fee? Are there no repercussions if the contract isnt honored?
I mean, shit is still going to hit the fan if the contract isn't honoured, but in the simplest terms, yes, he'll still get paid by the insurer if the contract party defaults on the contract. (As a massive scale version of this, see 2007/2008 financial crash. That's basically what happens when counterparties default at scale and insurance contracts have to pay out everywhere, to the level that the insurers themselves have to be rescued.)
Simple example - let's say the contract is for 100 tonnes of wheat at £175 a tonne. So Jeremy should get £17,500 for the wheat he's contracted to deliver. Now let's say that Jeremy has the 100 tonnes ready to go, but the flour merchant can't/won't pay up. Maybe he's in financial troubles, maybe Jeremy ran off with his wife, who knows. But for whatever reason, he refuses to pay.
Now let's also imagine two scenarios - one in which the price of wheat has gone up, and one where it's gone down. In the former, Jeremy is actually happy with this, as he can now sell his grain on the open market for more than the contract, and claim the insurance payout on the contract. On the other hand, if the price went down, Jeremy still has to sell his grain, but he might only get £100 a tonne, which is going to result in a loss of £7,500. At this point Jeremy is very glad of the insurance.
Now the interesting bit is the insurer has the estimate the risk of default, and the likely movement on the market, to be able to offer a sensible insurance product to Jeremy. So Jeremy might pay £1,000 for an insurance product which pays out £10,000 on the default of the purchaser, for example. Obviously the numbers involved here are fictional (apart from the price of wheat per tonne, which is probably around the mark given at the moment), but the principle is accurate.
> Are there no repercussions if the contract isnt honored?
Basically the entire point of futures markets is to standardize the contracts and process by which these contracts are fulfilled to the point where all of that is just part of the pricing mechanism.
Ancient civilizations invented the jubilee (loans should be repaid in 7 years) to prevent speculation on them. But unfortunately, preventing extreme concentration of wealth has fallen out of favour
The vast majority of financial transactions aren't this - they're speculative. They bank on the idea that money now is worth more than money in the future, and the future value of an asset (using the definition of an asset that it's a sequence of cashflows) is both variable and uncertain. So therefore the promise of future money is inherently tied to the concept of risk. The majority of financial markets trading is based around this concept of risk, and the management of it.
There's vastly more complexity under the hood, but that's roughly speaking, accurate.