The Price of Possibilities & the search for Derivatives

The rice sellers of Osaka in the 1600s realized the importance of Price, counter-party risks and how to mitigate risks in a highly volatile commodity. From the Forward contracts, they quickly moved to the Futures contract and created the modern day Futures market and the buyers and sellers were disconnected from knowing each other completely. All that happened was at a specified date in the future a pre-determined quantity of rice was exchanged between two parties at a specified price.

As a rice seller all you can do is store rice, you have no understanding of what the price a buyer will be willing to buy now or at a future date. Even today this is the fundamental problem with everything we buy or sell.

This I think was one of the pioneering innovations in Finance.

Without Price you are in a fix, you can neither buy nor sell or hold; you are in a state of limbo. It is like a Symphony without sound, or a piece of art without a paint or a vision of anything.

But almost anything that you buy, your starting position is somewhat that. You do not know the right price and you start with the condition of ignorance. You chart out a process of discovery of this price, when you want to buy or you want to sell or you want to hold the decision for the time being.

The timing also cannot be ignored, there is a saying that there is a time for everything and for the right price it is everything. My wife makes her killing by entering a store (where bargaining is possible) at the closing time when almost the shutters are ready to be pulled down, or when the shutters are just opened for the day. The marginal cost of sales at both these hours are ideally suited for a good bargain.

Nothing in this world has a fixed price, if you think those in the shelves are having one, you are wrong. It is just a matter of time, the price will change over time.

The price of possibilities therefore could have a range and every person will have a different path of discovery of this range. This is true for even things we buy that have a fixed price to things which has no price as such and you have to chart out the possibilities of this price. Between two parties transacting, this could be a game of discovery.

Take Stock for example and it is a volatile item of value, whose price changes the moment you decide to buy or sell and when you have done so, you are left with a remorse. Stocks have Options trading possibility, with Call or Put options, investors have the option of buying or selling a stock at a predetermined strike price. This option itself has a cost and its price point is visible to others in this market. It acts as a derivative, influencing the actual movement of the price of the stock that is being traded.

When you see the stock futures opening at a higher value than at close the previous day, it could be a signal or a call to be taken. Participants in the market would interpret these signals very differently. But that is how the prices get discovered in the stock market, either from new information or from these price signals from the derivatives market.

Take buying of the simplest item, a piece of household item and you will find yourself straddled with the options that range widely. The price of possibilities remain highly judgmental therefore till you have the underlying benchmarks for comparison. You are actually searching for a derivative of the price.

A brand also induces you to this state of uncertainty; if you are buying a brand, your range of possibilities could actually widen; your search of the derivatives could take you to a path of discovery through many winding paths.

The seller on the other hand is not sitting idle to let this discovery move against the interests that he has to protect or not allow it to go below the cost plus reasonable profit.

A trade will happen when the two sides agree on this price. But the two sides may not actually be able to see each other in this journey, in the extreme case, both the sides could be blind to each other's moves or journey. The futures market actually helps both these sides, who never see or meet each other, transact with no counter-party risk involved.

At the macro level in the economy, the idea of an equilibrium is very important, otherwise prices would be out of bounds, while at the individual level of transactions, there could be situations where price movements could be seemingly not in equilibrium, leading to demand supply mismatch, stock outs or over supply.

Kenneth Arrow's optimality will prevail, no one can create a better allocation than the allocation that brought the market to the state of equilibrium, in other words, no one can be better off or worse off by a change from this state of equilibrium when the market reaches this state.

As an individual buyer or seller, your action on any particular transaction would always lead you to think otherwise, you can never posit that you made such an optimal allocation that any change from that leaves you with a worse off or better off situation.

Thus you have the Futures market for commodities, starting from agricultural produce to the metals of all kind to the more sophisticated financial products, like the S&P 500 Stock Futures. The underlying thread is the same everywhere, the Futures price is linked to the Spot Price through a simple equation:

Price (Future) = (1+r-s)*Price(Spot), where r is the interest rate and s is the cost of storage. For most commodities the Futures Price would be higher than the Spot Price, for Stock indexes, as dividend yield could be higher than the interest rates, the reverse could hold in the short run.

The futures price is your North Star, it guides you to a price in the future and on the date of maturity, both will eventually converge.

What happens when you do not have a price signal, which is the case for most of the things that we buy or sell? We work through an initial price allocation and we keep changing that allocation based on what happens in the market. The other participants do the same and so we get into the Game Theory approach. We have all the means to change the allocations by working on the quantity we bring or take out. We also take profits as a variable and have to work out quantities for the future.

Among the broad range of estimates of the variables that influence our price of possibilities, we cannot do this Math without a complex set of algorithms. But we simplify this into few principles. We must understand the underlying derivatives of your price possibilities.