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Thursday, June 26, 2008

Gnome-o-gram: Financial Derivatives I

One of the principal reasons to contemplate the kinds of defensive and apocalypse-hedge measures discussed in previous gnome-o-grams (1, 2, 3) is the potential for a chain-reaction collapse in financial institutions and markets due to the marking to market of worthless financial derivative instruments held on their books, and the impact on seemingly-hedged players when their counterparty goes bust.

Now, unless you follow this stuff, you probably have little or no idea what I just said, and aren't even sure what some of the words mean in this context, whatever it may be. So let's start with a simple example of a derivative transaction, not involving financial instruments at all, but something as simple and down-to-earth as grain. Derivatives of this kind (known today as “commodity futures”) have been traded for more than a century and a half. Suppose you own a bakery, and you know that for the three months beginning next September you're going to need 5,000 bushels of wheat to make the products you'll sell in that period. Your customers require fixed-price bids well in advance, so you need a way to bid for their business at a price which provides you a reasonable return. But if you're preparing a bid, say, nine months before deliveries commence under the contract (assuming you win it), there's a huge uncertainty. While many of your costs are reasonably constant: labour, rent, utilities, etc., the price of your principal raw material, wheat, varies based upon supply and demand and factors, such as the weather and the international trade situation, in ways which are not only unknown but unknowable in principle. You're going to have to buy the wheat then, at whatever the going price may be, so how do you budget now, not knowing the price in the future?

This is where futures markets come into play. When you're developing your business plan and preparing bids for your customers in, say, January, you can buy a standardised contract for the delivery of 5,000 bushels of wheat in September, thereby locking in the price you'll have to pay when that month rolls around. What's more, you can buy this delivery contract for a small “margin” deposit, which is much less than the capital you'd have to tie up if you simply bought the wheat now and paid the further expense of storing it in a grain elevator. And you don't have to worry about rats.

As the price of wheat inevitably fluctuates between the time you bought the contract and the time you'll actually buy the wheat, the value of the contract will increase or decrease accordingly. If the price of wheat rises, your contract will appreciate: you'll have a paper profit in it, but that's not the point—it's that when you finally sell the contract in September, the profit you make from it will make up for the higher price you'll have to pay for the actual wheat. Conversely, if the price of wheat falls, you'll have a paper loss on the futures contract (and you may have to put up more margin money to maintain the contract), but, come September, your “loss” will be exactly offset by the reduced price you pay for the physical wheat. In this way, you can “lock in” the price of wheat for delivery in September many months in advance and develop your business plan without the uncertainty due to the cost of your principal raw material.

Suppose, on the other hand, you're a farmer who, in the short January days in the northern hemisphere is deciding what to plant in the coming spring and how to budget the operations of your farm for the year. You know that based on current grain prices and the productivity of your land, seed and fertiliser costs, and harvesting expenses, wheat looks like an attractive crop, but while you're confident that barring disaster you can produce and deliver 5,000 bushels of wheat, you're worried about the possibility that by the time you're ready to bring it to market, the current heady price may have collapsed and you'll end up taking a loss on your crop. This is precisely the inverse of the baker's situation, and the risk can be similarly mitigated with a futures contract. In this case, you sell 5,000 bushels of wheat for delivery in September, thereby locking in the current price. If the price of wheat falls, your futures contract will appreciate in value, which will compensate you for the lower price you'll receive for your crop, and if wheat rises in price, your “loss” on the contract will be made up by the increased proceeds from the sale of the physical wheat. (Again, the farmer may have to put up additional margin to maintain the contract if the price rises while it is effect.)

Now note that neither the baker nor the farmer are shielded from all risks by the futures contract. While they've insulated themselves from the effects of fluctuations in the price of wheat, the baker still needs to worry about his business falling off so that he actually needs less wheat, and ending up with a loss in the futures contract which isn't compensated by purchases of physical wheat, and the farmer still bears the risk of a crop failure, which might leave him with a loss on a futures contract (if the price of wheat goes up, which is the way to bet should crop failures be widespread) that isn't offset by the increased value of his crop.

If futures markets consisted exclusively of Farmer Frank selling future delivery contracts to Baker Bob, they would be so small, volatile, illiquid, and expensive as to be useless to both. What makes them work is that the market is open to all kinds of players, including speculators. Frank and Bob are “hedgers”: they are actual producers and consumers of wheat, and have a direct financial interest in its price. A speculator, on the other hand, isn't interested in wheat, but rather the price of wheat, and by buying or selling contracts for the future delivery of wheat is effectively placing a bet that the price of wheat will increase (if buying) or decrease (if selling). The speculator may be trading in wheat because of a belief that inflation is rising or falling, based on estimates of global supply and demand, weather forecasts for growing regions, or predictions from market gurus or a Ouija board, but regardless, the wheat contract is, for the speculator, a purely financial instrument: while ultimately linked to the price of the physical commodity, it is bought and sold on financial markets just like a stock, bond, or currency, and its instantaneous price is set by the balance of buyers and sellers in the futures market (who are, of course, immediately influenced in their actions by real-world events affecting the supply of and demand for wheat).

So, there's wheat, the physical commodity, which you can produce, sell, buy, and consume, and then there's “wheat futures”, a financial instrument ultimately linked to the commodity, which producers and consumers can sell and buy to “hedge” their risk and speculators trade on both sides in the hope of profits in the market. The contract for future delivery of wheat is, then, a derivative of the commodity it represents, wheat—it is a purely financial instrument which acts as a proxy for the physical commodity and can be used, at much lower cost than warehousing the actual product, to hedge or speculate in its future value. In this way, we can say that something as mundane as wheat has been “securitised”: turned into a financial instrument which can be traded on an exchange. This is the power of derivatives: almost anything whose cash value can be determined at a given point in time can be the foundation of derivatives based upon it (of ever-increasing abstraction and complexity), which can be bought and sold without ever trading in the actual underlying asset. If this sounds like a fairy castle to you, that's because, in many cases, it is, as we'll see in subsequent gnome-o-grams. (I have chosen not to discuss the details of how, precisely, commodity futures are linked the the physical commodity, which would get us into warehouse receipts, delivery points, grade differentials, and other exquisite details of which even the vast majority of impassioned participants in these markets are ignorant. Besides, they differ from market to market, and we're aiming at an overview of derivatives here.)

One note on terminology which will probably be unnecessary for most readers but possibly enlightening for a few. I use the term “speculator” here to identify those participants in a market whose goal is not purchase, sale, or ownership of the actual asset but rather to profit from its appreciation or depreciation during the period it is held. Whenever prices jump, politicians are quick to blame “speculators”, failing to observe (or perhaps perceive, given their beady little eyes and birdlike brains) that since in every futures market there is one seller for every buyer, for every speculator making “obscene profits”, there is another making obscene grimaces as their fortune evaporates. It is speculators, constantly trading in and out of the market, who provide the liquidity (volume of transactions and number of open buy and sell offers at prices close to the market) which permit traders in the physical commodity to execute their orders without creating a large spike in the price to their own detriment. You may hear politicians rail about speculators, but you'll hardly ever hear the people producing and consuming the real stuff denigrate the risk-takers who take the other side of the transaction when they go to buy or sell. Those who denounce speculators should look in the mirror (Latin speculum) whenever they buy a stock because they expect it to “go up”—by doing so, they are speculating. If you buy a stock for the income you expect from its dividends and reinvested profits, then you're truly becoming an owner of the company expecting to profit as it does. Otherwise, you're speculating in its stock. It's cool—we all do it—get used to it. And laugh at the politicians.

Some may argue that the term “financial derivatives” should be reserved for derivatives based upon financial instruments as “financial futures” was originally used. Here, I'll use the term for any financial instrument which is derivative of something else, whether it's wheat, livestock, stock indices, currency exchange rates, or whatever. In the next gnome-o-gram, I'll move up one step on the ladder of abstraction and discuss how derivatives can be based upon financial instruments (including other derivatives—the universe, she's recursive!). We have a way to go toward understanding why derivatives pose such a dire threat to the present-day financial infrastructure (indeed, the ones discussed here are entirely benign); I hope said infrastructure holds up until this narrative is concluded.

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