Derivatives 101: 4

Curiously, the more consistent something is, the more exchangeable and dependable and universally acknowledged, the more you can rely on it losing its value. Anything perishable must be constantly renewed, and every regeneration allows its worth to be subtly redefined. A true medium of exchange must weather such advances -- weather, and be diminished by. As the prices of real, tangible objects increase, there is a concomitant decline in whatever it is that provides the metric for those prices.

To wit: money.

It is with some trepidation that I digress in this way just as we're beginning to approach the dark matter of derivatives proper -- as we prepare to touch up the intangible -- but it's my party and I'll etc. The sorry but unsurprising truth is that the circus freakshow of financial instruments is intimately beholden not only to money itself but to what is affectionately known as the time value of money. Which is just another way of saying that more is never enough.

Given its central role in modern life, it's easy to forget that money is an arbitrary signifier: its meaning is extrinsic; it has no inherent worth. Unlike pretty much everything that people want, money is not consumed. It has no nutritional value, or entertainment value, or any kind of value at all -- except monetary. True, you can roll it up to snort cocaine through, but you can still spend it afterwards. It exists only to be handed over for something other than itself.

Which is not meant deprecatingly, by any means. Barter is all very well, but it doesn't scale in either space or time. For every lucky situation where someone with a surfeit of luscious young virgins, tied in silken ropes and satin for five years on raspberries and chamois milk, happens to meet someone else who has an excess of walnuts¹, there are a hundred situations where every bastard in the village has a barn full of wind-cured naked mole rats they can't get rid of for love nor... well, you know.

Even supposing that there's a legitimate exchange in the offing, it may still involve a discontinuity, an IOU floating around for months making trouble.

Let's say I've just acquired eight buckets of strawberries from you for my daughter's wedding banquet. The agreed price is six cords of high-grade firewood, brought to your doorstep in November on the day of the new moon. It's no skin off my nose if, sometime in late August, you swap three of those cords with your neighbour Rhiannon for a flask of rough brandy and a tray of spice biscuits. Nor, really, when she passes two to Reverend Williams for a harvest blessing and he in turn gives them to young Selwyn, the altar boy, in return for unspecified favours in the vestry. I might start getting a bit miffed, however, bearing in mind the delivery arrangements, when Selwyn goes and exchanges one of his cords for a couple of firecrackers at the equinox feast with some visiting reprobate from three villages over. I've better things to do on a Monday than be carting faggots over half the county, especially when the recipients would have perfectly good firewood of their own if only they could be bothered to wield an axe.

You see? Nothing but trouble².

What could be better, then, than to codify all that in some way? Some more abstract, more liquid way; a way that lubricates the whole process?

I can, of course, as a child of hippiedom, identify something better, that something being generosity, and social responsibility, and -- y'know, man -- love. But given that those commodities are often in short supply, it doesn't hurt to have money to smooth over the gaps.

The purpose of money is to remove the specificity from transactions. If it had any intrinsic value, then that purpose would be undermined and the transactions distorted. Money is a prime example of the triumph of the symbolic over the concrete.

But it is purely symbolic; not an end in itself, only a means³. Which brings us back to where we started.

Being worth nothing in its own right, money winds up as a nexus of the uncertainties surrounding the worth of other things. The value of, say, a yak, is in its yakness; a shoe its shoeness; a blog its blogness. Money, necessarily, lacks any such essence on which to anchor itself: a quid has no quiddity⁴.

Even though money can be exchanged for almost anything⁵, the desirability of each individual thing you might want to exchange it for is susceptible to the whims of fate and fashion. The future is still a closed book. If, six months from now, you have a pig, well, at the very least you can be fairly sure it's worth one pig. But if, six months from now, you have whatever amount of cash a pig is worth right now, who the hell knows what that will get you in pigs or anything else? If you can't spend it at the very moment you want, you're being deprived of its only real value, which is the ability to be spent.

Not only that: a pig requires upkeep, shoes repair, a blog maintenance. Money doesn't rot, takes up little or no space, is readily exchanged and has effectively no identity. There is no cost in keeping it until you need it, and therefore no incentive not to. Other than the sentimental bonds of fellowship and fraternity, what possible interest could anyone have in lending it?

Well, you know where this is going.

The purpose of usury is to incentivise lending: to compensate for a loss of the convenient utility of money's present value by offering more money in its future stead⁶. Whether we're talking about the outstanding balance on your credit card or whole nations sold out to Western imperialism by brutal dictators, the principle is the same. (Only the principal differs, boom-boom.)

This is, on the whole, not a bad thing, since some people have far too much money and many don't have enough, and it doesn't do anyone any good if the rich just sit their well-padded arses down on the cash, letting it gather dust and perhaps using the occasional banknote to light their Cuban cigars. Interest can turn their avarice into potential utility, albeit at the peril of inflicting appalling indebtedness on the already deprived with the sanctimonious backing of our beloved leaders.

Anyway.

Virtually everyone and everything needs or wants to borrow money at some point or other, including major financial institutions that have an enormous amount of the stuff already, and even governments, who can actually print more if push comes to shove (though they prefer not to do that excessively because it tends to diminish its worth). All of these borrowers, even the most dependable, need to provide some kind of reward for lending to them, and this means that interest is payable even on the most secure and reliable investments.

This whole business gives rise to a lot of abstruse notions with names like yield to maturity and the term structure of interest rates, but the only one that is really relevant to our present discussion is risk-free rate. Given the huge number of potential lenders and the huge number of potential borrowers, many of which are really quite solid and unrisky, there will pretty much always be some minimum interest rate at which it is possible to lend or borrow without really gambling, and consequently a return against which all other less certain investments must be judged.

Unfortunately, the risk-free rate (typically denoted r) tends not to be directly measurable, and also varies over time as the demand for and supply of debt and/or capital ebbs and flows. Nevertheless, r can usually be estimated from a bunch of more concrete interest rates, and it provides a fairly clear substrate for the uncertainties that underlie our true subject.

To which, I guess, we can now return.

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[1] The probability of anyone recognising this reference is so vanishingly small it can barely be said to exist at all, but if you do then please email me.
[2] Much of the general shape of this trouble should feel somewhat familiar by now.
[3] It's no accident that means means both money and anything used to achieve some purpose; that it also signifies signification is, alas, just a coincidence.
[4] Deplorable as this joke is, it does manage to sum up everything so far in just five words.
[5] I don't care too much for money, money can't buy me love.
[6] There are usually taken to be at least three things that interest is meant to compensate for: inflation risk, which is the certainty that the money lent will be worth less in future; credit risk, which is the possibility of not getting it back; and loss of liquidity, which is to say, having to wait for the loan to be repaid before you can spend it yourself. All these, however, are just expressions of the malevolent unknowability of the future. That's what time value is really about.

Posted by matt at February 6, 2006 11:29 PM