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exchange to offer tradeable
derivatives in agricultural products
was the Chicago Board of Trade, in
- However, the possibility for
speculation that all derivative
contracts contain led to repeated
bans on their use. “Cash-settled”
contracts provoked particular
concern. These were derivative
contracts in which the delivery of
the underlying asset did not have
to take place on the specified day.
Cash could be exchanged in its place.
At this point all real connection
between the underlying product and
the derivative had been lost, and the
possibilities for purely speculative
behavior were immense.
Deregulation
Recognition of this speculative
potential motivated governments
to introduce strict regulations.
From the 1930s onward, cash-
settled derivatives in the US were
classified as a form of gambling,
rather than investment, and strictly
controlled. Exchanges were not
allowed to trade them. But with
the collapse of the fixed exchange-
rate system in 1971, a need rapidly
emerged for hedging against
potentially volatile floating
exchange rates. Restrictions were
lifted, and the market for derivatives
quickly expanded.
This provided the background
to a critical problem. There was no
reliable means to accurately price
derivatives since they were, by
nature, highly complex contracts.
Even a simple “option” (providing
the right but not the commitment
to trade an underlying asset at a
certain point in the future) had
a price that was determined by
several variables, such as the
current price of the underlying
asset, the time to the option’s
deadline, and the expected price
variation. The problem of providing
a mathematical formula for this
problem was finally solved in 1973
by US economists Myron Scholes
and Fischer Black, and expanded
upon by fellow American Robert
C. Merton the same year.
These economists built on
certain assumptions and insights
about financial markets to simplify
the problem. First, they made use
of the “no arbitrage” rule. This
means that prices in a properly
functioning financial market reflect
all the information available. An
individual share price would tell
you both the value of the company
today, and what market traders
expect of it in the future. It should
be impossible to earn guaranteed
profits by hedging against future
risk because prices alreadyFINANCIAL ENGINEERING
Option contracts are a type of
derivative that give someone the option
to buy or sell something, such as coffee,
at a certain price on a certain date.
The option need not be exercised.incorporate all the information
you are basing your hedge on.
The second assumption was that it
is always possible to put together
an option contract that mirrors a
portfolio of assets. In other words
every possible portfolio of assets
that can be assembled can be
perfectly hedged by options. All
risk vanishes with this insurance.
Third, they assumed that
although asset prices fluctuate
randomly over time, they vary
in a regular way, known as the
“normal distribution.” This
implies that, in general, prices
will not move very far over a
short time period.
By using these assumptions,
Black, Scholes, and Merton were
able to provide a mathematically
robust model for pricing a standard
option contract on the basis of
the underlying asset’s price
movements. Derivative contracts,
once seen as unreliable instruments,
could now be processed on a huge
scale using computer technology.
The path was cleared for a vast
expansion of derivatives trading.
The option pricing model Black,
Scholes, and Merton devised
provided a whole new way to think
about financial markets. It could
even run in reverse. Existing option
prices could be fed backwardDon’t cross a river
if it is four feet deep
on average.
Nicholas Taleb