What follows is the fascinating story behind the creation of the foundation on which the entire financial markets in the industrial world rest. If also offers a lesson in the limits of empiricism, however intuitive and obvious, of the kind the central bankers routinely practice.
Let us go then together to the scene of the discovery of credit as a tradable product, where Arbitrageur has gone to Lender to borrow money for a sure-fire, cannot-miss trading strategy. For simplicity, we assume interest rate is zero. This assumption does not affect the logic of the discourse.
“What do you need the money for?” Lender inquires.
“I am borrowing money to buy a stock,” answers Arbitrageur and shows him the “technical chart” of the stock, below:
The stock is currently trading at $50. It is expected to rise to $60 or fall to $40 in one year.
“How much are you putting up?” Lender demands to know: “How much equity do you have?”
- None. Zero
Lender is surprised. What chutzpah, he thinks and sharply asks Lender: “Then what happens if I lend you $50 and the stock drops to $40? Do you expect me to risk losing $10 ‘just like that’?"
“Not at all,” Arbitrageur explains. “I have a plan. It involves creating a riskless portfolio of the stock and option that guarantees you would get your money back no matter what happens to the stock price.”
“What is an option?” Lender demands to know
Arbitrage quotes from some respected finance textbook:
An option is a right but not the obligation to buy, in which case it is called call, or sell, in which case it is called put, some underlying stock or bond or currency or index or commodity or …
“Enough,” Lender interrupts. He does not suffer fools gladly. At the same time, a new prospect need not be completely dismissed. So he gives him a lecture on fine points of credit capital:
“You speak of risklessness. Long before you smart alecs came along with your fancy terms – options, portfolio insurance, hedging, arbitrage, financial engineering, what have you – I knew how to protect my capital. I have to, because it is the source of my livelihood. If I lose it, I would be on the street. Heaven knows it is a tough world out there.”
He warms up to his speech:
“I could begin with the 4 pillars of the loan evaluation: purpose, payback, risk and structure. But that is too technical. I am going to lay it out before you in layman ’s term.
“First, keep in mind that there are different forms of capital. I have chosen to employ my money as credit capital, which stands in a unique legal and social relation to other forms of capital, codified even before the time of my ancestor, Shylock.
“Accordingly, when I give money, I lend. It concerns me not whether the borrower uses the money for personal consumption or in an economic venture. In all events, I would collect no more than what is due me based on the agreed upon rate of interest.
“Because I do not share in the upside of the venture, you must, as a fair person, agree that I should not be expected to risk my capital in the downside. So I must make sure that you have enough money to pay me back when the downside hits. The most effective way of ensuring the return of loaned money is grabbing a piece of borrower’s property and holding it – physically or contractually – against the repayment of the loan.
“Now, you want to use my money to buy a stock that could fall from $50 to $40. That would leave me – you, really – $10 short. So you have to have $10 in cash in collateral before I could lend you $50.”
Arbitrageur repeats his main point, this time adding more details:
“I do not have any equity but I have a strategy. I could guarantees payment in full of your principal regardless of the stock price. In fact that very consideration is what drives my strategy. Briefly, I plan to buy ½ share of stock. For that, I will only need $20. Now if the stock falls ..."
“My friend,” Lender again interrupts: “You must have a reason for buying 1/2 share instead of full share. But before getting there, let me tell you that by the demand of my profession, I am good with numbers. If you borrow $20 from me, you would not be able to buy ½ share of stock. The stock is currently trading at $50. Its ½ shares would cost $25. So if you borrow $20, you would be short by $5. You just told me you have no money.” He assumes a sarcastic tone: “Does your strategy show you how to create $5 out of the thin air?"
“In fact it does.” Arbitrageur responds in earnest: “I would enter into a bet with an option player for which I would receive $5.”
- Why would anyone give you $5 upfront?
- Because I will construct the bet in such a way that the participation in it will cost $5. If the bettor wins, he can collect like in any other bet. If he loses, he does not have to pay. You could say that he could choose to default. This, I must say, is the mother of the structured finance products.
- And that is this 'option thing' you mentioned?
- That is the 'option thing'.
- As long as you sell the option before coming me for money! I will have to see $5 in your hand. Only then will I lend you $20 for buying 1/2 share.
- Of course.
Lender is curious to see how the 'option thing' works and asks Arbitrageur if he could accompany him. Arbitrageur is happy to oblige. Together, they go to Option Player.