Against the Gods: The Remarkable Story of Risk (59 page)

The decisive step from superstition to the supercomputer was about
to be taken.

erivatives are the most sophisticated of financial instruments,
the most intricate, the most arcane, even the most risky. Very
1990s, and to many people a dirty word.

Here is what Time magazine had to say in an April 1994 cover
story:

[T]his fantastic system of side bets is not based on old-fashioned
human hunches but on calculations designed and monitored by computer wizards using abstruse mathematical formulas ... developed by
so-called quants, short for quantitative analysts.

We have just looked at the fantastic system of side bets based on
old-fashioned human hunches. Now we turn to the fantastic system
concocted by the quants.

Despite the mystery that has grown up about these instruments in
recent years, there is nothing particularly modern about them. Derivatives go back so far in time that they have no identifiable inventors:
no Cardano, Bernoulli, Graunt, or Gauss. The use of derivatives arose
from the need to reduce uncertainty, and surely there is nothing new
about that.

Derivatives are financial instruments that have no value of their
own. That may sound weird, but it is the secret of what they are all about. They are called derivatives because they derive their value from
the value of some other asset, which is precisely why they serve so well
to hedge the risk of unexpected price fluctuations. They hedge the risk
in owning things like bushels of wheat, French francs, government
bonds, and common stocks-in short any asset whose price is volatile.

Frank Knight once remarked, "Every act of production is a speculation in the relative value of money and the good produced."' Derivatives cannot reduce the risks that go with owning volatile assets, but
they can determine who takes on the speculation and who avoids it.

Today's derivatives differ from their predecessors only in certain
respects: they are valued mathematically instead of by seat-of-the-pants
methods, the risks they are asked to respond to are more complex, they
are designed and managed by computers, and they are put to novel purposes. None of these features is the root cause of the dramatic growth
in the use of derivatives or the headlines they have grabbed.

Derivatives have value only in an environment of volatility; their
proliferation is a commentary on our times. Over the past twenty years
or so, volatility and uncertainty have emerged in areas long characterized by stability. Until the early 1970s, exchange rates were legally
fixed, the price of oil varied over a narrow range, and the overall price
level rose by no more than 3% or 4% a year. The abrupt appearance of
new risks in areas so long considered stable has triggered a search for
novel and more effective tools of risk management. Derivatives are
symptomatic of the state of the economy and of the financial markets,
not the cause of the volatility that is the focus of so much concern.

Derivatives come in two flavors: as futures (contracts for future
delivery at specified prices), and as options that give one side the opportunity to buy from or sell to the other side at a prearranged price.
Sophisticated as they may appear in the fancy dress in which we see
them today, their role in the management of risk probably originated
centuries ago down on the farm. The particulars may have changed
over time, but the farmer's fundamental need for controlling risk has
not. Farmers cannot tolerate volatility, because they are perennially in
debt. Their huge investments in land and equipment and in inventories
of seed and fertilizer make bank financing unavoidable. Before the farmer sees any money coming his way, he has to pay for his inputs,
plant his crop, and then, constantly fearful of flood, drought, and blight,
wait months until harvest time. His great uncertainty is what the price
will be when he is finally in a position to deliver his crop to the market. If the price he receives is below his cost of production, he might
be unable to pay his debts and might lose everything.

The farmer is helpless before the risks of weather and insects, but he
can at least escape the uncertainty of what his selling price will be. He
can do that by selling his crop when he plants it, promising future
delivery to the buyer at a prearranged price. He may miss out on some
profit if prices rise, but the futures contract will protect him from catastrophe if prices fall. He has passed along the risk of lower prices to
someone else.

That someone else is often a food processor who faces the opposite
risk-he will gain if the prices of his inputs fall while the crop is still in
the ground, but he will be in trouble if prices rise and boost the cost of
his raw materials. By taking on the farmer's contract, the processor lets
the farmer assume the risk that agricultural prices might rise. This transaction, involving supposedly risky contracts for both parties, actually
lowers total risk in the economy.

On occasion, the other side of the deal is a speculator-someone
who is willing to take over uncertainty from others out of a conviction
about how matters will turn out. In theory at least, speculators in commodities will make money over the long run because there are so
many people whose financial survival is vulnerable to the risks of
volatility. As a result, volatility tends to be underpriced, especially in
the commodity markets, and the producer's loss aversion gives the
speculator a built-in advantage. This phenomen goes under the strange
name of "backwardation."

In the twelfth century, sellers at medieval trade fairs signed contracts, called lettres de faire, promising future delivery of the items they
sold. In the 1600s, Japanese feudal lords sold their rice for future delivery in a market called cho-ai-mai under contracts that protected them
from bad weather or warfare. For many years, in markets such as metals, foreign exchange, agricultural products, and, more recently, stocks
and bonds, the use of contracts for future delivery has been a common
means of protection against the risks of volatile prices. Futures contracts for commodities like wheat, pork bellies, and copper have been trading
on the Chicago Board of Trade since 1865.

Options also have a long history. In Book I of Politics, Aristotle described an option as "a financial device which involves a principle of
universal application." Much of the famous Dutch tulip bubble of the
seventeenth century involved trading in options on tulips rather than in
the tulips themselves, trading that was in many ways as sophisticated as
anything that goes on in our own times. Tulip dealers bought options
known as calls when they wanted the assurance that they could increase
their inventories when prices were rising; these options gave the dealer
the right, but not the obligation, to call on the other side to deliver
tulips at a prearranged price. Growers seeking protection against falling
prices would buy options known as puts that gave them the right to put,
or sell, to the other side at a prearranged price. The other side of these
options-the sellers-assumed these risks in return for premiums paid
by the buyers of the options, premiums that would presumably compensate sellers of calls for taking the risk that prices would rise and to
compensate sellers of puts for taking the risk that prices would fall.

Incidentally, recent research has punched a hole in the tales of the
notorious mania for tulips in seventeenth-century Holland, supposedly
fueled by the use of options. Actually, it seems, options gave more
people an opportunity to participate in a market that had previously
been closed to them. The opprobrium attached to options during the
so-called tulip bubble was in fact cultivated by vested interests who
resented the intrusion of interlopers onto their turf 2

In the United States, options appeared early on. Brokers were trading put and call options on stocks as early as the 1790s, not long after
the famous Buttonwood Tree Agreement established what was to become the New York Stock Exchange.

An ingenious risk-management contract was issued on June 1, 1863,
when the Confederate States of America, hard up for credit and desperate for money, issued the "7 Per Cent Cotton Loan." The loan had
some unusual provisions that gave it the look of a derivative instrument.3

The principal amount was not repayable in Confederate dollars nor
was it repayable at the Confederate capitol in Richmond, Virginia.
Instead, it was set at "3 Millions Sterling Or 75 Millions Francs" and
it was repayable in forty semiannual installments in Paris, London, Amsterdam, or Frankfurt, at the option of the bondholder-who was given the additional option of taking payment in cotton rather than money, at the rate of sixpence sterling per pound, "at any time not later than six months after the ratification of a Treaty of Peace between the belligerents."

The embattled Confederate government was using a sophisticated form of risk management to tempt English and French investors to lend them urgently needed foreign exchange to finance their armament purchases abroad. At the same time, it was building up a foreign constituency with a vested interest in the Confederacy's survival. The risk of devaluation of the Confederate dollar was covered by the option of repayment in British or French money.*
The option of collecting the debt in cotton was a hedge against inflation and was sweetened by offering cotton at sixpence when the prevailing price in Europe was 24 pence. Furthermore, as the obligation was convertible "at any time" into cotton, this option was something of a hedge against the fortunes of war for those lenders nimble enough to pick up their cotton before the Confederate States collapsed.