Derivatives 101: 3

It is an unfortunate fact of life, and even when not unfortunate still a fact, that the future is for the most part a closed book. Que sera, sera. While we can be certain of some outcomes (for example, that everybody will die sooner or later) and reasonably confident of others (night will follow day), most of the interesting details are inevitably mysterious. Since investment, whether of billions of Euros in customers' pension contributions or of minutes of one's life reading circumlocutory blog posts, is all about the future, this can be a bit of a problem.

There is, as many have noted and based their careers on, some difficulty even about knowing what has gone on in the past; while knowing what is going on right now is a physical impossibility unless we define now in some awkward way involving the speed of light. So things that haven't happened yet are pretty much up for grabs.

You never know, for example, when the bottom is going to fall out of the chocolate coated marzipan rodent market, in consequence of which the value -- the present value -- of chocolate coated marzipan rodents in the future -- of things in the future in general -- is almost always less than their value now.

Or, to put it another way, a bird in the hand is worth e^rt in the bush.

(If this looks a bit impenetrable to you, don't worry. The only thing you need to understand is that there's generally less value in knowing you'll have something at some time in the future than in having that same thing here and now (though there are some provisos, for which see a couple of paragraphs down).)

One of the interesting things to note about this rather dispiriting notion of futurity is that, at least to some extent, it applies to both sides in any deal, because both have to contend with risk. Thus, in our filmgoing example, I can't say for sure that I won't be taken ill between now and the outing, that I'll actually be alive and hungry for popcorn; nor can you be 100% certain all your friends won't have seen the movie in the meantime and thoroughly put you off with their withering critiques, turning our date into an unappealing chore. It would all be a lot more dependable for both of us if we were going tonight, leaving a good deal less scope for the corrosive effects of time to work their insidious magic.

At least, up to a point. But you might be otherwise engaged right up to the appointed hour, in which case tickets for earlier perfs won't be much use to you; and if you give me the popcorn today it'll be pretty fucking stale by the time we make it to the cinema.

More generally, there are pretty good reasons why people might want to undertake forward contracts (and futures, which you're more likely to have heard of and are closely related, but more complicated on account of the administrative infrastructure behind them, some of which we may or may not get into in a future episode; they're also geared less towards actual delivery and more towards gambling) -- especially when it comes to things like agricultural commodities.

If I happen to know that I'm going to need a kilo of gold for my laser satellite weapon systems in six months time, and I have a bunch of cash on hand and gold happens to be going really cheap right now, I might as well buy it and store it in my secret volcanic lair until I'm ready to take over the world. It's not like the stuff's going to go off.

If, however, I reckon my hamburger chain is going to need a hundred tonnes of beef next August, those cattle would have to be at a really rock bottom price for it to be worth buying them now and then feeding, watering, housing and husbanding the motherfuckers all that time. To say nothing of paying off government health inspectors, dealing with outbreaks of foot and mouth, Jesus, the whole nightmare deal. Do I look like a fucking cowboy? I'm in fast food!

So -- just as with the original film trip -- there are often wholly legitimate reasons for undertaking these kind of contracts. Or partly legitimate reasons. Or evil capitalist hegemonizing reasons. Whatever. The point is, they make sense.

Nevertheless, if there is scope to trade them -- that is, if you can sell to a third party either your agreement to buy the cattle or your agreement to supply them -- there is scope for someone to come out ahead. To make money not by selling the goods themselves, but some comparatively intangible agreement concerning them. By, in effect, buying and selling the uncertainties in which they are enmeshed.

That's what a derivative is; and, having admitted that level of abstraction, the sky is pretty much the limit.
Posted by matt at January 26, 2006 10:38 PM