Here is another post inspired by the book "Ascent of Money" written by Niall Ferguson. You will probably get better information on hedge funds and hedging from Wikipedia, but here is my take on the subject and what I saw as important in Ferguson's presentation of the matter.
Hedging and hedge funds have their roots in agriculture. For a farmer there are two things that affect his income: first one is the amount of crop and second one is price of the crop. The amount of crop depends on the weather and there is not much you can do about it. The price the farmer gets paid depends on the market price. The farmer pretty much knows what his expenses will be when sows his seeds. What he does not know is how much he will be paid at harvest. The farmer could protect himself against price fluctuations by making a deal with, for example, bakery that it will by all of his wheat with certain price. At harvest the market price may be lower than the price the farmer and agreed upon, in this case the farmer wins. It also could be that the market price is higher than agreed in which case the bakery wins, because it gets it wheat at a cheaper price than if it would by the same amount of raw material with market prices.
The first standardised future contracts that were traded in after markets were created in Chicago. The Chicago Produce Exchange was the first permanent place for trading futures.
Since this type of elimination of risk requires a speculator as a counter part trading in futures has been viewed as nothing more than a casino. Partly because of that only 1970s trading of interest and currency futures was permitted. In 1982 the future contracts were allowed to stock trade.
Since all futures contracts are derived from the value of the property the contract is based on all futures contracts are so called derivatives. Here are some derivatives that Ferguson presents in his books. There is a good list of derivatives on Wikipedia.
Options are form of derivative financial instrument closely related to futures contracts. There basically are two types of options selling and buying options. The option grants the owner of the contract the option (not an obligation) to buy/sell a certain amount of goods at a price agreed in the contract.
Swaps are a form of derivative where two parties basically bet on, for example, the development of interest rates. Someone who receives income from loan where interest is fixed can swap the interest rate to floating rate.
Credit default swap is a contract where the buyer of the CDS makes a payment to the seller and receives a pay off if a instrument goes default.
There are also weather derivatives which enable you to insure against natural catastrophes and extreme weather patterns. In 2006 the nominal value of weather derivative was 46 billion dollars.
Nowadays most of the derivatives are no longer standardized but tailor made and sold in so called over the counter (OTC) trade outside the stock exchanges. Banks are the usual seller of OTC derivatives and majority are temporarily arranged between two parties.
The problem with derivatives and future contracts is that it has divided world into those that have money to protect themselves to those that don't. It usually takes a seven-figure-sum of money to protect against unexpected fluctuations in interest rates or in commodity prices etc.
Showing posts with label niall ferguson. Show all posts
Showing posts with label niall ferguson. Show all posts
Wednesday, September 21, 2011
Wednesday, August 31, 2011
Rothschilds
This the second post related to a book I am reading. It is written by Niall Ferguson and it is titled "Ascent of money". This post will quickly summarize the story of how the rise of Rothschild's is represented in the book. It may or may not be entirely accurate but I found it very interesting.
Let it be reminded once again that this post is more of a mental note for myself.
Rise of Rothschilds'
The story of Rothschilds is very fascinating. For centuries the family has had significant power in the financial world. It was quite fascinating to find out that their success was preceded by a gigantic miscalculation. Any way let's start from the beginning. Or not all the way to the beginning, but to the wars Britain fought against Napoleon.
Britain had been fighting against Napoleon for several years without much success. The war efforts were financed by issuing war bonds. The problem was that the only universal currency at that time was gold and the wars where fought in regions were it was impossible to use pounds. In 1814 Britain needed gold fast and they turned to Nathan Rothschild to procure the gold. Nathan had brothers and relatives running banks in the major financial centres. This network allowed him to buy gold from all over Europe quickly. He actually was able to buy double the amount that he asked to acquire. British government paid Rothschild's commission on the gold he delivered, but there was another way how Rothschilds made money during this operation. They were able take advantage of the differences of gold prices in Europe. For example, if price of gold in Amsterdam was lower than in London Nathan would sell gold bonds (is this the right term in English, don't know) send the money Amsterdam where the money was used to buy gold. The gold was then sent back to London, the bond was redeemed and the gold that was left over was kept as profit. In April of 1814 the Coalition forced Napoleon to surrender and sent him to exile to Elba.
In 1815 Napoleon escaped because of rumours that he would exiled to a remote island in the Atlantic Ocean. Napoleon managed to gather a sizeable army and decided to go in to offensive. Nathan Rothschild thought that this meant that there would be another lengthy war and started to gather gold so that he would ready when the governments came to him asking for gold. The battle of Waterloo was a success to the Coalition. Napoleon was crushed and sent to exile in Saint Helena. To Nathan Rothschild this was a disaster he was sitting on a pile of gold that nobody needed.
Nathan decided to bet on the government bonds of Great Britain. He evaluated that since there was no longer a state of war the government would need less money and government would not release as many bonds. That would decrease the supply of government bonds on the market and according to basic principles of market economy if the supply decreases the prices should go up. Not to mention that Nathan drove the price up by hoarding government bonds. After one year the price of government bonds had risen by 40%. At this point Nathan started to sell and made profit of 600 million pounds in todays money (figure from Ferguson). This move basically secured Rothschilds' as the one of the leading banks in the financing sector.
I'll write more about financing if I find anything else that interest me in Ferguson's book.
Let it be reminded once again that this post is more of a mental note for myself.
Rise of Rothschilds'
The story of Rothschilds is very fascinating. For centuries the family has had significant power in the financial world. It was quite fascinating to find out that their success was preceded by a gigantic miscalculation. Any way let's start from the beginning. Or not all the way to the beginning, but to the wars Britain fought against Napoleon.
Britain had been fighting against Napoleon for several years without much success. The war efforts were financed by issuing war bonds. The problem was that the only universal currency at that time was gold and the wars where fought in regions were it was impossible to use pounds. In 1814 Britain needed gold fast and they turned to Nathan Rothschild to procure the gold. Nathan had brothers and relatives running banks in the major financial centres. This network allowed him to buy gold from all over Europe quickly. He actually was able to buy double the amount that he asked to acquire. British government paid Rothschild's commission on the gold he delivered, but there was another way how Rothschilds made money during this operation. They were able take advantage of the differences of gold prices in Europe. For example, if price of gold in Amsterdam was lower than in London Nathan would sell gold bonds (is this the right term in English, don't know) send the money Amsterdam where the money was used to buy gold. The gold was then sent back to London, the bond was redeemed and the gold that was left over was kept as profit. In April of 1814 the Coalition forced Napoleon to surrender and sent him to exile to Elba.
In 1815 Napoleon escaped because of rumours that he would exiled to a remote island in the Atlantic Ocean. Napoleon managed to gather a sizeable army and decided to go in to offensive. Nathan Rothschild thought that this meant that there would be another lengthy war and started to gather gold so that he would ready when the governments came to him asking for gold. The battle of Waterloo was a success to the Coalition. Napoleon was crushed and sent to exile in Saint Helena. To Nathan Rothschild this was a disaster he was sitting on a pile of gold that nobody needed.
Nathan decided to bet on the government bonds of Great Britain. He evaluated that since there was no longer a state of war the government would need less money and government would not release as many bonds. That would decrease the supply of government bonds on the market and according to basic principles of market economy if the supply decreases the prices should go up. Not to mention that Nathan drove the price up by hoarding government bonds. After one year the price of government bonds had risen by 40%. At this point Nathan started to sell and made profit of 600 million pounds in todays money (figure from Ferguson). This move basically secured Rothschilds' as the one of the leading banks in the financing sector.
I'll write more about financing if I find anything else that interest me in Ferguson's book.
Tuesday, August 30, 2011
Quick note on government bonds
I am reading a book by Niall Ferguson titled " Ascent of Money". The book so far has been a bit of a disappointment, but still I have learned quite a bit about government bonds and general topics related to financing. Again this a posting that is more of mental note for myself. The majority of the material here is from Ferguson's book. I've made the illustrations myself and condensed and added some ideas of my own.
Basics of how government bonds work
In this section I'll try and explain what government bonds are and how they work as I understand them. These days virtually every government needs to borrow money from the market. In the early days government bonds where used to collect money to pay for wars but today they are used to finance government expenditure.
The basic idea behind a government bond is that the state sells a piece of paper with nominal value of 5000 and promises to pay 5% interest(paid from the nominal value) per annum for the next 10 years to the holder of the bond. This means that the buyer can sell the bonds at market price if faced with a acute need of money or if the owner sees that the money can make better profit when invested differently.
The concept of effective interest is something worth discussing. It is calculated like this:
What this means that if you purchase a bond from after market at price of 4500 the effective interest rate is higher than the one marked on the bond. But there is catch. As we all know there is no such thing as a free lunch. Why has the market price of of Brutopias 10 year bond declined? Well it means that the consensus on the market is that Brutopias ability to take care of it's debts has decreased. This means that investors may not get their money at the end of the ten year loan time, or the payment might be delayed.
This means that really big profits can be made when the governments financial situation is some compromised. Also when investing to government bonds of foreign nation you must take into account the changes in exchange rates and the inflation rate in that country as it may quite quickly eat up any profit you expect to make.
In general government bonds are safe investments as it is usually quite impossible for country to go bankrupt, because it can always tax it's citizens. However the profits are not that big either.
Basics of how government bonds work
In this section I'll try and explain what government bonds are and how they work as I understand them. These days virtually every government needs to borrow money from the market. In the early days government bonds where used to collect money to pay for wars but today they are used to finance government expenditure.
The basic idea behind a government bond is that the state sells a piece of paper with nominal value of 5000 and promises to pay 5% interest(paid from the nominal value) per annum for the next 10 years to the holder of the bond. This means that the buyer can sell the bonds at market price if faced with a acute need of money or if the owner sees that the money can make better profit when invested differently.
The concept of effective interest is something worth discussing. It is calculated like this:
What this means that if you purchase a bond from after market at price of 4500 the effective interest rate is higher than the one marked on the bond. But there is catch. As we all know there is no such thing as a free lunch. Why has the market price of of Brutopias 10 year bond declined? Well it means that the consensus on the market is that Brutopias ability to take care of it's debts has decreased. This means that investors may not get their money at the end of the ten year loan time, or the payment might be delayed.
This means that really big profits can be made when the governments financial situation is some compromised. Also when investing to government bonds of foreign nation you must take into account the changes in exchange rates and the inflation rate in that country as it may quite quickly eat up any profit you expect to make.
In general government bonds are safe investments as it is usually quite impossible for country to go bankrupt, because it can always tax it's citizens. However the profits are not that big either.
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