My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
In the final part of Chapter 7 last week we closed by looking at some of the many markets available to investors and their tendency to be manipulated under the present system. Here is the link to last week: Issue 39
We now enter a new part of the Jigsaw at Chapter 8 after having placed many Jigsaw pieces so far and gained a good grounding in the most important ones as they fit with each other and which begins to form the completed picture.
One of the most important developments in recent years has been the use of technology combined with complex mathematics which many claim to have completely changed the nature of trading, especially in financial markets. HFT or High Frequency Trading has been in place for many years but has now become more and more efficient and faster over time; so that currently we find that the bulk of trading takes place automatically using computer algorithms alone – which makes the market vulnerable to sudden changes and ‘black swan’ events.
Here is a quick overview of HFT for reference: https://www.investopedia.com/terms/h/high-frequency-trading.asp HFT is but one small facet of ‘financial engineering’ which the following Issues will address.
CHAPTER 8
Financial Engineering
“Something hit me very hard once, thinking about what one little man could do. Think of the Queen Mary — the whole ship goes by and then comes the rudder. And there’s a tiny thing at the edge of the rudder called a trim-tab. It’s a miniature rudder. Just moving the little trim-tab builds a low pressure that pulls the rudder around; takes almost no effort at all”.
Richard Buckminster Fuller
Richard Buckminster “Bucky” Fuller was an American architect, systems theorist, author, designer and inventor; he developed numerous inventions, mainly architectural designs, including the well-known geodesic dome. His observation, quoted above, indicating the effect of ‘leverage’ on a ship’s rudder is classic engineering theory and practice.
This principle applies equally to financial systems where the application of ‘leverage’ has extended, in recent years, the ingenuity of ‘financial engineering’ beyond reasonable limits and into the financial stratosphere.
In the financial world ‘leverage’ or ‘gearing’ is an euphemism for “borrowing money to invest in risky assets or securities”; it is synonymous with that of a lever, with which most people will be familiar, allowing a lesser effort to apply greater force. A screwdriver is a good example of this type of leverage where the work effort applied at the hilt is magnified several times at the head in contact with the screw.
Financial engineering is a multi-disciplinary field involving financial theory and refers to someone educated in the full range of tools of modern finance especially the use of ‘leverage’ as a major part of their tool set and who are often mathematics graduates and PhDs involved in the financial world in general.
These ‘engineers’, known sometimes as ‘Quants’, are often associated with the invention of exotic new financial products and strategies which are used by bankers and financial institutions to improve their profits on investments although they do have other objectives which will become clear as this Chapter unfolds.
For those who would like to know more there is an excellent book, especially for those uninitiated into the weird world of financial engineering, which describes the work of these people titled: “The Quants” (The maths geniuses who brought down Wall Street); by Scott Patterson.
https://www.amazon.co.uk/Quants-maths-geniuses-brought-Street/dp/1847940595
The stock market as an example of simple financial leverage
One way to illustrate ‘financial leverage’ is by using an example in the stock market. Instead of an investor buying so many shares of a company directly, a contract may be made with a broker to agree to buy the shares, at a date in the future, at an agreed price for a small percentage (premium) of the prevailing share price, usually around 5-10%.
This is known as an ‘option’ and literally allows the investor to take a gamble on the share price appreciating over a period, say six months, during which time the investor has the option, but not the obligation, to exercise the purchase of the shares at the option price and thereby make a profit.
Of course, if the shares stay the same or fall in price there is no profit, maybe even a loss, then the investor will allow the contract to expire without any further liability; the loss is restricted only to the original premium paid. It can be seen that, in its simplest form, by investing, say, £100 in an option contract to buy £1,000 worth of shares which go up in value to £1,200 during the option period; a gross profit of £200 is made for the risk of losing only £100, or a one-off, 100% return; nice work if you know how!
All these financial instruments are known collectively as ‘derivatives’ because their value is derived from some underlying financial product such as a company share. They are the most prevalent of all financial instruments and globally are estimated to be valued at over USD 800 trillion, twelve times the estimated total GDP of the world!
There are many and varied derivatives traded on exchanges around the world which, in London, is the ‘London International Financial Futures and Options Exchange’ (LIFFE). LIFFE was taken over by the NYSE in 2002 and effectively leaves this exchange under the influence of the American model. Five of the biggest U.S. banks — JP Morgan, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley — account for more than 90% of derivative contracts. Regulators estimate that nearly half of derivatives are traded outside the United States; more on this will emerge later in the Chapter.
Futures contracts are another example of derivative products
We have already met a ‘futures exchange’ in the first Chapter when commodity trading was discussed and how it assists farmers and producers in selling their produce ‘forward’. There are many markets and exchanges for this kind of derivative, even for trading currencies, but one is of particular interest, because it has an influence on the ‘price of money’ , will enable a deeper understanding of money markets in general; it goes to the heart of financial engineering, first though a reminder about futures and spot prices.
“Futures contracts” (futures), are standardized contracts for delivery (the seller delivers) or receipt (the buyer receives) some fixed quantity and quality of a commodity. Futures contracts are available for each month of the year; thus a contract for delivery of December wheat can be purchased in, say, May. The “Spot Price” is simply the price of the ‘futures contract’ of the most active month which is generally the current month, that is, the price of the product in the present. The market for gold metal (bullion) serves as a useful example.
A gold future’s price should be the price at which bullion can be purchased, at some time in the future, because a ‘futures contract’ is a legally binding agreement to deliver the actual, physical metal. Exchanges, an example of which is the ‘COMEX’ as reviewed in the last Chapter, have registered warehouses where physical gold is stored prior to delivery should the buyer ask for delivery at the appropriate time.
It is important to note that exchanges allow traders to buy or sell contracts at a fraction of the commodity’s price, just like the options we discussed earlier, which is known as ‘trading on margin’ – the margin being the small percentage or premium paid by the buyer – and so only a fraction of the actual contract value is required to trade, whether buying or selling.
This system works well but can be manipulated by unscrupulous traders, mainly massive American and European banking cartels, for example J P Morgan et al, who have the financial muscle to distort prices and have an insider’s advantage by working in conjunction with the exchanges and their regulators.
When the price of gold rises, through normal market demand to own the physical metal, it signifies a declining value and confidence in paper money generally in the form of the US dollar in which gold is generally priced.
Gold has always been considered valuable by mankind since time began and unlike paper money it has no counterparty, as explained in the first Chapter, therefore it is in the interests of the issuers of paper money, the Fed for example, to ensure a devaluation of the dollar is minimised to maintain a reasonably stable unit of currency. They do this by forward selling large quantities of ‘paper gold’ contracts which causes the physical spot price to fall as both the prices are linked and affect each other.
A thought experiment describes the use of derivatives in the market
Most traders, banks and financial institutions dealing in futures end up not taking delivery of the metal because most are simply speculators interested only in profiting by gambling on price movements and trading on margin; they are dealing with paper contracts much like the example of the ‘apples trader’ in the last Chapter to which I promised to return.
It is possible for the ‘apples trader’ to increase his profits by extending his dealing to create a futures contract which becomes a derivative of the original contract to purchase apples. This is how it would work bearing in mind that the supply of apples is seasonal and we assume that the original trade deal in the last Chapter was closed during a time of abundant apple supply; in UK it might be September, when the wholesale prices are low, (in economics: if supply exceeds demand the price falls and vice versa).
Remember, the trader at the top of the street has a good supply but less demand for his apples so the retail price is lower than that at the bottom of the street where there are many more buyers and demand is high.
You could strike a deal with the trader to buy, say, 10 tonnes of apples for delivery in December when there is likely to be a shortage of apples. The forward price will generally be higher than spot price to reflect the cost to store, insure and transport the apples until delivery.
The spot price had already been agreed at £2.25/kilo so you agree a futures contract to buy at £2.50/kilo knowing that the trader at the bottom of the street is likely to pay more for apples in December when his stocks are low. Also you have inside information that the apples crop has suffered a partial failure due to poor weather and therefore the chances of higher prices next autumn are increased. You pay the trader 10% premium (£2,500), trading on margin for the contract.
Note that a significant risk arises if investors do not have the balance of the funds (£22,500) available to pay in full at delivery time; they will have to borrow the money (‘leverage the contract’) and in order to do so they will need to ‘post collateral’ (deposit the contract as security) with a bank or trade lender.
If, in the meantime, the price of apples moves against the investor (the contract is worth less now) he will be required to ‘post more collateral’ which is known as a ‘margin call’. This can cause traders to become bankrupt in extreme cases if additional collateral cannot be found, however we will assume that all goes well.
In the following months the market for apples moves in your favour and you note that the trader at the bottom of the street has increased his prices to £6.00/ kilo with the likelihood that prices will increase further. You can now offer the trader your contract at £2.75/kilo for 10 tonnes deliverable in December which he finds attractive and closes the deal.
You have now made a profit of £0.25/kilo on 10,000 kilos or £2,500 and doubled your money. This principle applies to all the markets throughout the world although they become extremely complex when financial instruments are involved.
Next week find out how it works in the gold market in real life.
To be continued next Saturday
If you are going to gamble your money in Las Vegas, at a Horse or Dog track, the Lottery, or on Wall Street, why not pick up a cute young lady from a corner somewhere and take her to a motel where you might at least get screwed before you are robbed.