My understanding is the "speculators" create liquidity for the risk managers, thereby assuming their risk.
Why does the money leaking via commissions necessarily make the game sub-zero sum? Is it because we aren't looking at the big picture where everyone wins?
It seems like the risk managers must have a positive incentive to sell their risk on the marketplace instead of assuming it themselves. I.e. hedging another investment like someone else said already.
I was thinking about how to better answer your question concerning the sub-zero game statement I made. Let's remove ourselves from finance for a minute into something that is more traditional in the game theory studies--namely poker.
If the game is played where the players arrange transfers face to face such as in a home poker game, then the game is zero-sum. Your losses are my gains. No money is created. No money is destroyed. It stays inside the game. The minute we go to a casino to play the same game, the game becomes sub-zero due to the rake. You lose X to me and Y to the rake. I gain your X and lose Y to the rake.
Your cash flows: -X - Y. My cash flows: X - Y. In a zero-sum game your cash flows are the negative of my cash flows. This implies -(-X - Y) = X + Y. This is a contradiction. Therefore, the game is not zero-sum.
I was thinking that, because the market created value, it couldn't be zero or negative sum. Now I realize that it's negative sum within the scope of the market itself, even though it may create value in a grander scheme of things.
To truly understand the implications of game theory applied to the financial markets, you should look up the concept of Pareto improvements and Pareto optimums.
Good call. My roommate and I are about to start an econ discussion site. Shoot me an email if you're interested in helping us get conversation started or just have any suggestions for us.
Liquidity is one type of risk. There exist also interest rate risk, price risk, etc.
Commissions are an expense that both sides pay to play the game. Money is not transferred from one player to another, it is transferred to outside the game.
It is true that there is a positive incentive to sell risk from the risk-manager's view. That is the whole reason the markets were initially established, both derivatives and the underlying of the derivative.
Why does the money leaking via commissions necessarily make the game sub-zero sum? Is it because we aren't looking at the big picture where everyone wins?
It seems like the risk managers must have a positive incentive to sell their risk on the marketplace instead of assuming it themselves. I.e. hedging another investment like someone else said already.