Mutual Funds for the Utterly Confused

12th Century

In European trade fairs sellers sign contracts promising future delivery of the items they sold. In essence, this seems like a good idea. The money goes to finance the trade before the trade happens and allows the trading mission for goods in far off lands to happen. In the 12th century though, the risk that what you had invested would actually make it back to the marketplace was high. The New Cambridge Medieval History offers some insight into the financial transaction. Some investors demanded repayment only if the ship returned safely.

There are many examples contracts entered into by English Cistercian Monestaries who frequently sold their wool up to 20 years in advance to foreign merchants. During this century, derivatives, although that term was not coined for some time, and the risk the investor undertook was now accompanied by information about past trades, current trading conditions and the worth of not only the currencies being exchanged but the creditworthiness of the traders. Think silk road.

1634-1637 Tulip Mania in Holland

Fortunes are lost in after a speculative boom in tulip futures burst. Every financial writer mentions this at one time or another. I have - many times and never do i seem to understand why such foolish can happen. But this is where it began. Credit along with envy and greed pushed this exotic market and the world for that matter, to near collaspe.

Dojima Rice Futures

In Japan at Dojima, near Osaka a futures market in rice is developed to protect sellers from bad weather or warfare. To understand this, you have to consider rice as the coin of that ancient realm. Rice was paid to feudal lords and they, in turn needed to sell it. There was only so much rice a ruler could eat. Problem was, and it took almost a half-century after the Dojima was first licensed, to understand that the rich were controlling the prices, acting as a central bank for those that were paid in rice. It was until 1773 that the government realized, according to the SamuariWiki, that “the need for governmental control of such policies; exchange rates, monetary standards and the like had to be set by the government, and not left in the hands of an increasingly wealthy and powerful merchant class which was intended to be at the bottom of the neo-Confucian mibunsei class system.”

1868 Chicago Board of Trade

On April 3, 1848, the Chicago Board of Trade (CBOT) was officially founded by 83 merchants at 101 South Water Street. Thomas Dyer is elected the first president of the CBOT. The first trades were offered on “arrive” contracts.

Late 1960s - Black and Scholes begin collaboration

Fischer Black and Myron Scholes tackle the problem of determining how much an option is worth. Robert Merton joins them in 1970. The problem is, it doesn’t really work outside of a campus setting. For it to work with any success, remembering of course that an option is priced according to what it might be worth under certain market conditions when it arrives to that market, there must be no-restriction short selling, free borrowing, continuous trading, along with a whole host of other, often non-existent factors in the open market.

The CBOE offers investors an opportunity at buying equities but as an option to buy. Consider this: equity options offer the investor protection of stock holdings from a decline in market price, increased income against current stock holding, help the investor prepare to buy a stock at a lower price, and last but not least, benefit from a stock price rise, without having to buy the stock outright. The CBOE explains that “If you anticipate a certain directional movement in the price of a stock, the right to buy or sell that stock at a predetermined price, for a specific duration of time can offer an attractive investment opportunity.”

It appears in the Journal of Political Economy, one of the journals that had previously rejected it. it still didn’t work in the real world but its publication gave many economist pause - which is what dismal scientists do when they are thinking about abstract stuff with no real world grounding.

At about this time, it all begins to unravel.

The hedge fund is rescued at a cost of $3.5 billion because of worries that its collapse would have severe repercussions for the world financial system.

Some traders at CSFB are sacked following allegations of illegal trades in an attempt to manipulate the Swedish stock market index.

2001 Enron goes Bankrupt

The 7th largest company in the US and the world’s largest energy trader made extensive use of energy and credit derivatives but becomes the biggest firm to go bankrupt in American history after systematically attempting to conceal huge losses.

John Rusnak uses fictitious options contracts to cover loses on spot and forward foreign exchange contracts.

The US Defense Department had thought that such a market would improve the prediction and prevention of terrorist outrages.

Four foreign currency dealers at the National Australia Bank are said to have run up the losses in three months of unauthorised trades.

Citigroup traders led by Spiros Skordos made €15 million by suddenly selling €11 billion worth of European bonds and bond derivatives, and buying many of them back at a lower price.

This loss is the largest amount a company in Singapore has lost by betting on derivatives since the case of Nick Leeson and Barings.

One of the world’s largest derivatives brokers is forced to freeze trades.

the US-based hedge fund suffered enormous loses trading in natural gas futures.

A rogue trader is blamed for the world’s largest banking fraud up to that date.