This week’s learning is part 10 of a 12 part series on The Ascent of Money by Niall Ferguson. (Parts 1, 2, 3, 4, 5, 6, 7, 8, 9)
The origins of hedging are agricultural. A farmer enters into a “futures” contract with a merchant promising to sell his crop at $5/kg. If the price goes down, the farmer is protected as he still receives $5/kg. However, if the price is $6/kg then the merchant makes $1 for every kg he bought.
This futures market created a home for hedging in Chicago. Partly because of unease at futures being like gambling, the futures market led to the birth of derivatives.
Derivatives are the financial equivalent of “options.” Instead of signing a “futures” contract, the same merchant can sign a “buy option” giving him the right (not obligation) to buy an agreed quantity of the crop at $5/kg (the “strike price“) within a specific time after harvest, at an agreed quantity before a certain time at a certain price known as strike price. The merchant buys options because he expects the price of the crop to rise.
If, instead, the farmer had signed a “put option,” he would now have the right to sell the crop at $5/kg to the merchant at a particular time. He would do this if he felt the crop price is going down. If it’s heading up, he would keep it and sell at a higher price.
Finally, we have a “swap” or an exchange of a bet between parties. Let’s assume the farmer wanted to raise money and issued farm “bonds” that assured 5% interest for 10 years to investors (the farmer assumes he’ll be rich enough in 10 years to pay everyone). Since the investors take a risk on the farmer’s success, they can pay a portion of the interest they receive into a “credit default swap“/CDS to an insurance company who will pay the investors the original amount they paid in case the farmer “defaults.” In essence, a CDS is a bet on whether the farmer will go bankrupt.
In 2007, there were many trillion of credit default swaps betting on households being able to pay for their home loans. When these bets failed altogether, the global economic crisis was triggered..
As much as derivatives are despised by investors like Buffett (who has nevertheless made money from them), they are a key part of the finance system and have divided the world into those who can and can’t be hedged. For example, weather derivatives are sold by insurance companies to hedge funds. This means that hedge funds will pay the insurance amount should bad weather/catastrophes happen. And until then, they get an attractive rate of interest on their principle amount from insurance companies.
While companies and large organizations can hedge to protect their assets, individuals can’t do any hedging and have to rely on insurance. Many go for saving for a rainy day and betting on houses.. More on that in the next 2 editions.
A Learning a Day 