Derivatives: Betting on futures
While plans to set up a new futures exchange here bode well for farmers and Poland's developing capital markets, pitfalls lie ahead for those who gamble with derivatives.
The recent collapse of the 233 year-old British merchant bank Baring Brothers is just the latest in a string of disastrous financial transactions around the world. During the past year, Metallgesellschaft lost $1.3 billion, Procter & Gamble saw $100 million fly out the window and California's Orange County went bankrupt.
At the root of these scandals are contracts called "derivatives" and even those who are supposedly savvy in the ways of high finance often don't fully understand their workings.
Before the fall of Barings Group, the idea that a single rogue trader could in a matter of weeks lose $1.5 billion - as has been alleged in the Nicholas Leeson case - seemed implausible. Ignorance was the basis for Procter & Gamble when it sued Banker's Trust over a bad derivatives deal. The consumer product multinational originally claimed that even the bank's senior financial executives did not completely comprehend the risks of the transaction.
The derivatives story begins with the first exchange-traded derivative instruments, the futures contract. The world's largest futures market, the Chicago Board of Trade (CBOT), was created in 1848 as a centralized market for buyers and sellers (farmers) of agricultural commodities.
Prior to that date, farmers arriving with their harvest were at the mercy of dealers who knew the farmer did not want to haul the grain back to his farm. This was compounded by the farmer's dependence on the purchaser's assessment of quality and weight.
The result was an inefficient market with the farmer often the loser.
The CBOT began as a means to improve the efficiency and equity of "spot" trades, those trades where the product was on hand. These spot contracts ultimately gave way to contracts specifying delivery at a future date and these futures contracts began trading in 1865.
Devil in the Details
The seller of a futures contract promises to deliver the commodity at a specific date, price and location. For example, a corn farmer could sell a six-month futures contract in April locking in the price for his October harvest. If a bountiful harvest causes a low spot price in October, the farmer is protected since he receives the price specified in the futures contract. In the event a poor crop forces the October spot price up, the purchaser of the contract, such as a cereal producer, has a guaranteed supply of corn at a set price.
The risk of large price swings in either direction is removed, or hedged, by using derivatives. The key is that both parties have an economic interest in the underlying commodity, in this case corn, which they want to safeguard.
At this point, it may be hard to imagine how the same instruments, which reduce risk in one application, can create the potential for unlimited losses in another. The answer is found in two market activities: speculation and leveraging.
The potential for big gains and losses arises when the derivative trader's motivation changes from hedging to speculation. A speculator has no economic interest in the derivative's underlying asset beyond the desire to profit from correctly predicting, or speculating, in which direction its price will move.
Speculators often claim superior ability or better information when predicting future prices, but years of empirical research have failed to support their claims. Much like "scientific" bettors at the race track, speculators will support their predictions with reams of charts and graphs rivaling the most sophisticated handicapping sheets.
Financial leverage, the second factor contributing to the risk of derivatives, is the ability to control assets for a small fraction of their value. Funds posted as a deposit when buying or selling futures contracts are called the margin.
If we purchase a $100,000 house with 5% down and a $95,000 mortgage, our investment, or equity, in the home is $5,000. If the house increases in value to $105,000 after one year, just a 5% gain, our equity goes from $5,000 to $10,000, an impressive 100% gain. It is important to note that leverage magnifies returns in both directions, a fact investors often choose to ignore. In this example, a 5% drop in the value of the house to $95,000 would completely wipe out our equity investment. Nearly all derivatives transactions utilize this concept of financial leverage, some contracts requiring as little as a 0.25% deposit.
The combination of high leverage, volatile prices and big profits from "beating the market" make this capital market poker game irresistible to some.
Traders often begin as hedgers, but are lured into the high-risk, high-reward world of speculation where fortunes are made and lost in the blink of an eye.
Mr. Leeson of Barings is an extreme example. He began trading derivatives using a low-risk strategy called "risk arbitrage." That's like using a money management system to bet red or black on the roulette wheel. The profits are small and so are the risks, and over time the strategy lacks excitement. Leeson moved on to pure speculation on the Japanese stock market. Specifically, he used futures contracts to bet that the Nikkei 225 index would stay within a narrow range.
What he didn't bet on, or obviously have any way of predicting, was the Kobe earthquake. When the Nikkei dipped immediately following the quake, rather than take small losses and live to trade another day, Leeson upped his bets.
When the Nikkei 225 plunged nearly 1,000 points nearly a week later, $1.5 billion of investors' funds and the two century- old merchant bank went down with it.
Richard Bliss is a professor of finance at the American Studies Center of Warsaw University. He is conducting research on the Polish financial system.
The recent collapse of the 233 year-old British merchant bank Baring Brothers is just the latest in a string of disastrous financial transactions around the world. During the past year, Metallgesellschaft lost $1.3 billion, Procter & Gamble saw $100 million fly out the window and California's Orange County went bankrupt.
At the root of these scandals are contracts called "derivatives" and even those who are supposedly savvy in the ways of high finance often don't fully understand their workings.
Before the fall of Barings Group, the idea that a single rogue trader could in a matter of weeks lose $1.5 billion - as has been alleged in the Nicholas Leeson case - seemed implausible. Ignorance was the basis for Procter & Gamble when it sued Banker's Trust over a bad derivatives deal. The consumer product multinational originally claimed that even the bank's senior financial executives did not completely comprehend the risks of the transaction.
The derivatives story begins with the first exchange-traded derivative instruments, the futures contract. The world's largest futures market, the Chicago Board of Trade (CBOT), was created in 1848 as a centralized market for buyers and sellers (farmers) of agricultural commodities.
Prior to that date, farmers arriving with their harvest were at the mercy of dealers who knew the farmer did not want to haul the grain back to his farm. This was compounded by the farmer's dependence on the purchaser's assessment of quality and weight.
The result was an inefficient market with the farmer often the loser.
The CBOT began as a means to improve the efficiency and equity of "spot" trades, those trades where the product was on hand. These spot contracts ultimately gave way to contracts specifying delivery at a future date and these futures contracts began trading in 1865.
Devil in the Details
The seller of a futures contract promises to deliver the commodity at a specific date, price and location. For example, a corn farmer could sell a six-month futures contract in April locking in the price for his October harvest. If a bountiful harvest causes a low spot price in October, the farmer is protected since he receives the price specified in the futures contract. In the event a poor crop forces the October spot price up, the purchaser of the contract, such as a cereal producer, has a guaranteed supply of corn at a set price.
The risk of large price swings in either direction is removed, or hedged, by using derivatives. The key is that both parties have an economic interest in the underlying commodity, in this case corn, which they want to safeguard.
At this point, it may be hard to imagine how the same instruments, which reduce risk in one application, can create the potential for unlimited losses in another. The answer is found in two market activities: speculation and leveraging.
The potential for big gains and losses arises when the derivative trader's motivation changes from hedging to speculation. A speculator has no economic interest in the derivative's underlying asset beyond the desire to profit from correctly predicting, or speculating, in which direction its price will move.
Speculators often claim superior ability or better information when predicting future prices, but years of empirical research have failed to support their claims. Much like "scientific" bettors at the race track, speculators will support their predictions with reams of charts and graphs rivaling the most sophisticated handicapping sheets.
Financial leverage, the second factor contributing to the risk of derivatives, is the ability to control assets for a small fraction of their value. Funds posted as a deposit when buying or selling futures contracts are called the margin.
If we purchase a $100,000 house with 5% down and a $95,000 mortgage, our investment, or equity, in the home is $5,000. If the house increases in value to $105,000 after one year, just a 5% gain, our equity goes from $5,000 to $10,000, an impressive 100% gain. It is important to note that leverage magnifies returns in both directions, a fact investors often choose to ignore. In this example, a 5% drop in the value of the house to $95,000 would completely wipe out our equity investment. Nearly all derivatives transactions utilize this concept of financial leverage, some contracts requiring as little as a 0.25% deposit.
The combination of high leverage, volatile prices and big profits from "beating the market" make this capital market poker game irresistible to some.
Traders often begin as hedgers, but are lured into the high-risk, high-reward world of speculation where fortunes are made and lost in the blink of an eye.
Mr. Leeson of Barings is an extreme example. He began trading derivatives using a low-risk strategy called "risk arbitrage." That's like using a money management system to bet red or black on the roulette wheel. The profits are small and so are the risks, and over time the strategy lacks excitement. Leeson moved on to pure speculation on the Japanese stock market. Specifically, he used futures contracts to bet that the Nikkei 225 index would stay within a narrow range.
What he didn't bet on, or obviously have any way of predicting, was the Kobe earthquake. When the Nikkei dipped immediately following the quake, rather than take small losses and live to trade another day, Leeson upped his bets.
When the Nikkei 225 plunged nearly 1,000 points nearly a week later, $1.5 billion of investors' funds and the two century- old merchant bank went down with it.
Richard Bliss is a professor of finance at the American Studies Center of Warsaw University. He is conducting research on the Polish financial system.
