Thursday, September 15, 2011

The long history of options

I just finished reading Niall Ferguson's book The Ascent of Money, which I strongly recommend to anyone interested in the history of economics and especially finance. Some readers of this blog may suspect that I am at times anti-finance, but this isn't really true. Ferguson makes a very convincing argument that finance is a technology -- a rich and evolving set of techniques for solving problems -- which has been as important to human well-being as knowledge of mechanics, chemistry and fire. I don't think that's at all overstated -- finance is a technology for sharing and cooperating in our management of wealth, savings and risk in the face of uncertainty. It's among the most basic and valuable technologies we possess.

Having said that, I am critical of finance when I think it is A) based on bad science, or B) used dishonestly as a tool by some people to take advantage of others. Naturally, because finance is complicated and difficult to understand there are many instances of both A and B. And of course one often finds concepts from category A aiding acts of category B.

But one thing I found particularly interesting in Ferguson's history is the early origins of options contracts and other derivatives. The use of derivatives has of course exploded since the work of Black and Scholes in the 1970s provided a more or less sensible way to price some of them. It's easy to forget that options have been around at least since the mid 1500s (in Dutch and French commodities markets). They were in heavy use by the late 1600s in the coffee houses of London were shareholders traded stocks of the East India Company and roughly 100 other joint-stock companies.

Looking a little further, I came across this excellent review article on the early history of options by Geoffrey Poitras of Simon Fraser University. This article goes into much greater detail than Ferguson on the history of options. As Poitras notes, early use in commodities markets arose quite naturally to meet key needs of the time (as any new technology does):

The evolution of trading in free standing option contracts revolved around two important elements: enhanced securitization of the transactions; and the emergence of speculative trading. Both these developments are closely connected with the concentration of commercial activity, initially at the large medieval market fairs and, later, on the bourses. Though it is difficult to attach specific dates to the process, considerable progress was made by the Champagne fairs with the formalization of the lettre de foire and the bill of exchange, e.g., Munro (2000). The sophisticated settlement process used to settle accounts at the Champagne fairs was a precursor of the clearing methods later adopted for exchange trading of securities and commodities. Over time, the medieval market fairs came to be surpassed by trade in urban centres such as Bruges (de Roover 1948; van Houtte 1966) and, later, in Antwerp and Lyons. Of these two centres, Antwerp was initially most important for trade in commodities while Lyons for trade in bills. Fully developed bourse trading in commodities emerged in Antwerp during the second half of the 16th century (Tawney 1925, p.62-5; Gelderblom and Jonker 2005). The development of the Antwerp commodity market provided sufficient liquidity to support the development of trading in ‘to arrive’ contracts. Due to the rapid expansion of seaborne trade during the period, speculative transactions in ‘to arrive’ grain that was still at sea were particularly active. Trade in whale oil, herring and salt was also important (Gelderblom and Jonker 2005; Barbour 1950; Emery 1895). Over time, these contracts came to be actively traded by speculators either directly or indirectly involved in trading that commodity but not in need of either taking or making delivery of the specific shipment.
 Another interesting point is the wide use in the 1500s of trading instruments which were essentially flat out gambles, not so unlike the credit default swaps of our time (ostensibly used to manage risk, but often used to make outright bets). As Poitras writes,
The concentration of liquidity on the Antwerp Exchange furthered speculative trading centered around the important merchants and large merchant houses that controlled either financial activities or the goods trade. The milieu for such trading was closely tied to medieval traditions of gambling (Van der Wee 1977): “Wagers, often connected with the conclusion of commercial and financial transactions, were entered into on the safe return of ships, on the possibility of Philip II visiting the Netherlands, on the sex of children as yet unborn etc. Lotteries, both private and public, were also extremely popular, and were submitted as early as 1524 to imperial approval to prevent abuse.”
 One other interesting point (among many) is the advice of observers of the 17th century options markets to use easy credit to fund speculative activity. A man named Josef de la Vega in 1688 wrote a book on the markets called Confusion de Confusiones (still an apt title), and offered some fairly reckless advice to speculators:
De la Vega (p.155) goes on to describe an even more naive trading strategy: “If you are [consistently] unfortunate in all your operations and people begin to think that you are shaky, try to compensate for this defect by [outright] gambling in the premium business, [i.e., by borrowing the amount of the premiums]. Since this procedure has become general practice, you will be able to find someone who will give you credit (and support you in difficult situations, so you may win without dishonor).”

The possibility that the losses may continue is left unrecognized.

Or, of course, perhaps the possibility of continuing losses was recognized, and it was also recognized that these losses would in effect belong to someone else -- the person from whom the funds were borrowed.

These points aren't especially important, but they do bring home the point that almost everything we've seen in the past 20 years and in the recent financial crisis have precursors stretching back centuries. We're largely listening to an old tune being replayed with modern instruments.