MISUNDERSTOOD FINANCIAL INSTRUMENTS

I wanted to buy a property. I made a search and found one property for sale. I found the owner and made a proposal. We bargained and agreed on a price. As the property was highly priced, I needed some time to raise some money. I requested 3 months to raise the funds. The price was fixed at Rs100 lakhs. I paid the property owner Rs5 lakhs an advance. If I broke the contract and did not buy the property within 3 months, I will lose Rs5 lakhs. The owner of the property gave me a written contract specifying area of the property, and other relevant details and acknowledged the receipt of 5 lakhs. It is stipulated that he amount of advance will not be adjusted when property was sold to me. The cost of the property after by buying is Rs105 lakhs.

It was specified that I could sell the right to buy the property to any one I liked.

The owner promised to sell the property within 3 months if I raised the funds. I have the right not to buy it if I felt that price will fall. Then money paid as advance is lost. The cost of these options is therefore 5 lakhs.

I went home. I thought of borrowing some money from my friends and relatives. Thus, all my friends and relatives knew about the deal. A rich friend wanted the property and offered me Rs110 lakhs. I agreed and took Rs10 lakhs as advance.

The property remained with the old owner and I sold my contract to my friend for Rs10 lakhs. It was a clean profit of Rs5lakhs. As I was in good profit and I handed over contract and took my Rs5 lakhs profit.Now, the option contract is worth 10 lakhs.

Then, a news came out about a highway is coming near that property. The property became very hot. Many wanted it. The second buyer sold the contract to a third person for 15 lakhs. By the time, the 3 months were over, my contract changed hands many times. Each buyer sold the contract to another getting a profit. The poor owner saw all this happenings and could not do anything. He saw his property being traded at very high prices by many unknown people.In fact they were not trading his property, they were trading the right to trade the property. The property got a premium.

What is this premium?The property owner got an assured price if 100 lakhs plus 5 lakhs extra. He was ready to hand over the property for for 100 lakhs on the day he sold the option to sell it within 3 months. He faced a risk. The price of his land might go up. An increase of 5 lakhs is reasonable. Thus, he got a compensation for the risk of his land price going up within 3 months. If the buyer of the option failed to buy the property he gets 5 lakhs free.

Then a news came out denying the construction of the high way. Suddenly, the demand for the property went down. The last holder of the contract wanted to sell it off. This created a downward journey in its value and the price. The last owner of the contract was forced to sell the contract at a price much lesser than he paid. He refused to buy the property after 3 months. He lost the premium he paid. The property remained with the old owner.

When all these transactions were taking place, the owner remained totally unaware of what is happening behind his back.

People used to make such transaction through out the history of man kind.

Here an asset was priced at Rs100 lakhs. Buyer of the contract had many options.

1. He could buy the property.
2. He decided not to buy because he felt that price will fall and lost Rs5 lakh premium he paid.
3. He can sell the option contract to others at a profit or loss.

The owner of the first option contract decided to take the 3rd option. He sells the contract for a premium of 10 lakhs. Others followed.

All in this story are genuine buyers.But, here all buyers turned traders finally. They were not selling a property. They did not have the property. But, they made money by selling the options to buy the property.

The value of the option they bought and sold was derived from value of the property. Therefore options are derivative financial instruments.

But a few people in the locality saw what is taking place and found an opportunity to make quick money out of the situation. They did not have Rs100 Lakhs. They have money to give advances. Some thought that prices will go up. Some other persons hoped the prices will go down. Both were speculating.

These people offer contracts to the first group of people to sell the property at a premium of Rs5 lakhs after 3 months. But, they hope that price may go down and they could buy back the contract at Rs4 lakhs within three months . They get a profit of Rs1 Lakh for a small capital say Rs5 lakhs. If they manage one such trade every month, they create 12 lakhs a year. This amounts to 12/5*100=240% return.

Do you think it ethical to sell something one does not own? Is it fair to get such profits doing nothing when hard earned money gives a return of 7% in a bank?

If some people who have no knowledge of property markets enter into the field and start trading these options, would they make money?

In this story, the owner of the property sold an option contract to the first buyer to reduce his loss if prices fell. He got a premium of Rs5 lakhs as a cushion. If the property prices rose to Rs103 lakhs he gains still Rs2 Lakhs. Only if the price rose above Rs5 lakhs would he lose. If prices fell below Rs100 lakhs his cushion of Rs5 lakhs protects him. The buyer of the option gains if prices rose above Rs105 lakhs.

Here, the buyer and seller hedge their positions and it creates a win-win position to both. But, when the speculators enter the field, everything goes out of hand.

They do not know anything about the assets they trade. Their small capital (5 lakhs) allows them to handle 100 lakh worth of assets.

This is all about derivative trading.

Derivatives were designed to reduce risks to investors.

An option is a derivative. Its premium depends on the property value.

When speculators trade options, it is natural that many will lose and some will gain. As trading goes on based on hunches or past price behavior, even the best traders having many years of trading experience, will lose in the long run because trades have a cost.

Derivative contracts are created by exchanges and owners of assets have no say. If proper care is not taken derivative contracts could exceed notional values of assets they represented.. This will create blow ups and crashes.

Suppose 10 people sold options to sell it. 10 people bought them. The buyers did not sell their options till the expiry of 3 months. What can sellers do? They have to honor their promise. Naturally, they will raise the price of options. As no one was ready to sell the options they bought, all sellers are in trouble. In order to prevent default, they go on raising premiums. But, sky rocketing premiums alerts the buyers and many fail to close their contracts. finally many will default.

In fact these contracts can leverage the available assets many times. In 2007, the leverage had gone up 30 times.

This example shows how it is possible.

Suppose a bank has a capital of $1000 million ($1 Billion) allocated for housing loans. It gives 2000 loans at half a million to 2000 households. The loan carries 10% interest. This finishes its capital. But, the demand is more. The bank then creates 1000 bonds with a face value of $1 million at an interest of 8%. $1000 million worth of mortgages act as collateral. Historically, default risk of house loans is very low. Rating agencies give triple AAA rating to such bonds. As risk free rates are very low, pension funds, provident funds and mutual funds buy these bonds at 8%, as these bonds have triple A ratings. Every year bank gets 10% interest from mortgage owners. It pays 8% interest to bond owners. It gets its $1000 back when it sells the bonds to investors.

Now the bank has another $1000 million in hand. It creates another 2000 mortgages getting back the capital. In 2007, a bank has created 30 times it allocated capital for mortgages. Here, only $1000 belonged to banks. It has leveraged its $1000 million by 30 times. Even Federal Reserve Chairman applauded the bond makers.

This feat called the secularization. The assets of 2000 house owners were mortgaged for $1000 million by the first group of mortgage owners to Banks. Banks created another $1000 million using the asset, creating another $1000 million assets. This asset creation could produce abnormal amounts of money for housing.

FED was happy. A boom in the housing industry creates a boom in the house construction industry. A house needs, bricks, wood, cement, electrical cables, roads and water pipes. Spending on them will increase the GDP. Jobs will be created. A real win-win situation for all.

Managers of banks took millions as bonuses and salaries.

There was a flaw.

There was a limit to house demands by credit worthy people. Banks exhausted the list very easily. New people with low credit rating were given loans. At 30 times leverages, everybody got loans. Insurance companies provided insurance to the bonds at very low premiums.

A booming economy created inflation. This forced FED to increase taxes. Most house loans had variable rates. Increased payments created defaults. Banks tried to possess the houses defaulted and sell them. But, there were no takers. The supply exceeds demand. Insurance companies like AIG defaulted.

The rest of the story is known to all.

Derivatives are created to reduce risks. But, they became nuclear bombs in the hands of speculators.

Americans are dare devils when they see an opportunity to make money. They adopted this way of trading to stocks, commodities and currencies. Thus, exchanges under government control were established to regulate speculation in everything under the sky.

Another instrument called"Futures" were introduced imitating old ways of trading commodities among countries. An importer in the US promises and an exporter in Australia to buy a ship load of mutton after 12 months at a certain price. Both know each other. Here the delivery takes place after 12 months. Buyer gets his mutton at a reasonable price probably at a price slightly above the current price and seller managed to sell his mutton at a reasonable rate. There are no intermediaries. This naturally creates default. These contracts are known as forward contracts.Governments wanted to prevent defaults.

As international trade is very important, Governments created exchanges where official transactions could be taken. Exchanges collected a small margin to prevent defaults. Almost all commodities were traded for future delivery. This trading is known as futures trading. Everything went well till speculators entered the picture. If Brazil had excess rains, those who knew the implications bought huge amounts of coffee futures from unsuspecting traders. When delivery time arrived, there was no coffee available at the contracted price. Prices of coffee went over the roof and buyers of futures got huge profits while sellers went bankrupt. Here payment of a low margin allowed the speculators to handle huge amounts of coffee. Futures trading can create huge leverage, disturbing international trade and domestic trade.

This is the reason Buffet called them nuclear bombs.