Archive for April 9th, 2009

In the period 1972-73 there was a fateful coincidence. Three developments happened in a short span of time, and together they spawned a revolution in corporate finance. The pressures on corporate financial managers until that time were intensifying, but the events of 1972-73 ratcheted up the intensity.

The events began when Black and Scholes published a formula for valuing the price of an option. This formula used more advanced mathematics than the three breakthroughs that preceded it. Time might have elapsed before the formula would have come into widespread use, but the other two events put the formula to work almost immediately.

Hewlett Packard began marketing a high-end hand-held calculator that could find solutions to the formula quickly. The calculator was expensive, and many scientists did not buy it because they could solve formulas on their mainframe computers. But the third event was that the Chicago Board of Trade launched a new category of product, options on common stocks. These were different from futures contracts, which were what the Board of Trade had offered before. These options on common stocks were difficult to value, and the young traders who acted as market makers knew that. Some of them found the Black-Scholes formula and the new Hewlett Packard calculators, and as soon as they had those two tools, they were able to buy options that were underpriced and sell options that were overpriced.

Other market makers who did not use those two tools were trying to do the same thing, and their methods were less accurate. Option trading is a fast-moving game, and a market maker can make hundreds or thousands of trades a week. The people who used the formula and the calculator had an advantage, making fewer errors and higher average profits on each trade. In a very short time the formula and the calculator were absolute requirements for survival.

Trading volume in options grew rapidly. Portfolio managers and individual investors found ways of using the Chicago Board of Trade options. The options allowed them to alter the risk characteristics of their portfolios and to stabilize the rates of return their portfolios delivered. By using the options correctly, a sophisticated investor could buy risky securities with high expected yields but high volatility and convert them into a portfolio that was quite stable. The options added stability to portfolios that had already been made as stable as Markowitz’s and Sharpe’s techniques could make them.

Corporate treasurers saw what was happening, and some of them began to investigate ways of applying the new options to improve the financial stability of their companies. For them, the new options were another kind of hedging product. There had been hedging products before the new options came along. For example, foreign exchange hedging products had existed for centuries, and corporate treasurers had used them extensively. There had also been a wide range of insurance policies, and corporate treasurers had bought those to protect their companies.

Corporate treasurers as a group were slow to take advantage of the new options. They faced restrictions and had to wait until new hedging products appeared. The success of the Chicago Board of Trade options showed that there is demand for new hedging products, and financial institutions began to offer innovative products. The result has been called the Derivatives Revolution.

The term derivative is a catch-all that includes options, futures contracts, and swaps. All these products have some common elements, despite having evolved separately. They all protect against one risk or another. In that sense they are all like specialized insurance policies that pay off when some specific event occurs. A company can buy them individually or in combinations, or it can sell one and use the proceeds to buy another. As these products began to appear in large numbers and variations, corporate treasurers had a complicated but potentially rewarding task. They had to choose which ones to use, and they had to keep reviewing the ones they were using, and replacing some of the ones that expired. The name of the task is risk management.

Companies that are good at risk management show steady growth despite the volatility of the industry sectors they operate in. They use risk management products to smooth the ups and downs of the underlying commodity cycles. In that fashion they deliver stable, growing returns to shareholders. Among investors there is always a strong demand for shares that do not fluctuate violently, but instead rise steadily, with few bumps along the way. The companies that are able to deliver that performance succeed, and their shares rise in the market. The companies quickly gain leadership status and often are able to raise enough capital to buy their competitors. Stock market performance gives them the advantage they need to acquire dominance in their industry sector.