Exotic Poisonin HPN Blog
By Ken Dost and Vermont Trotter
The right, but not the obligation. That’s the basic concept of an option, put or call. You have the right to execute a given contract, but not the obligation. It’s the most basic of all derivatives. The value of the contract is based upon a given price for delivery on a date in the future.
This is a legitimate business tool. United Airlines wants to be able to lock in the price of fuel 90 days in the future. So they buy the right, but not the obligation to purchase a set amount of Jet A from the pipeline at date specific. They pay a small portion or premium for that right. The rest of the money isn’t due until and unless they exercise the option. If the price goes up, they are in the money because their price is lower than the spot. If the price goes down, they buy at the lower price, but are out the premium paid for the option purchased.
This is the basic idea of the derivative market. The value of the contract is derived from the underlying asset and not the asset itself. When you apply this concept to the housing and mortgage market, especially when you have an adjustable rate mortgage, changing property values and known bad mortgages, you suddenly have all kinds of derivative contracts available which you can play with.
- You now have the right to sell a future contract on:
- The price of the underlying asset at a future date
- The ability of a borrower to pay at a future date
- The date certain of a contract reset in the future
- The ability to be the one to refinance the reset (or not) at a future date
- A combination of some or all of the above – all at a future date
These are some of the derivative contracts which are available on the international market.
- Average Credit Spread Asset-or-Nothing Call Option: An option payoff that is equal to the asset’s price if the asset is above the strike price, otherwise the payoff is zero.
- Average Credit Spread Asset-or-Nothing Put Option: An option payoff that is equal to the asset’s price if the asset is below the strike price, otherwise the payoff is zero.
- Average Credit Spread Compound Option: An option on an option. Examples include a call on a call, a put on a put, a call on a put, and a put on a call. This type of option usually exists for currency or fixed income markets where an uncertainty exists regarding the option’s risk protection capabilities. Also known as a split-fee option.
- Average Credit Spread Contingent Option: An option for which the holder only pays the premium if the option is exercised. Contingent options are, therefore, a zero-cost option strategy, unless exercised.
- Average Credit Spread Double Barrier Option: An option with two distinct triggers that define the allowable range for the price fluctuation of the underlying asset. In order for the investor to receive a payout, one of two situations must occur; the price must reach the range limits (for a knock-in) or the price must avoid touching either limit (for a knock-out). A double barrier option is a combination of two dependent knock-in or knock-out options. If one of the barriers is reached in a double knock-out option, the option is killed. If one of the barriers is reached in a double knock-in option, the option comes alive.
- Average Credit Spread Double No-Touch Option: An option with two distinct triggers that define the allowable range for the price fluctuation of the underlying asset. The double no-touch option pays a fixed amount if the spot price never touches either of the two specified limits (barrier levels).
In a healthy and functioning futures market, there should be a spread of about 80% legitimate players with about 20% speculators. While this may not seem to make sense at first, when you stop to think about it, it really does. You only have a set number of producers and a set number of customers. Once they all sell to each other, the market is set. No more buyers, no more sellers. The speculators provide liquidity to the market.
As 1929 moved from summer into fall, farmers and producers began to notice that there was something wrong with the spread of real consumers of their production and the speculators who brought liquidity to the market. Instead of the ratio being 80/20 real market players to speculators, they noticed it was the other way around, 80% speculators / 20% real market players. Because of this, the real market players left the market completely and the Chicago Mercantile imploded. This led to the first series of regulations which strove to limit the number of speculators.
Today, the ratio of legitimate market players to speculators has inversed again. As you can see from the examples above, the derivative market has gotten ever more exotic to the point where mere mortals have no idea what they are buying or selling. The games sound like something which comes out of poker night with your friends on a Wednesday night while the wife is out at bible study. The chips for this casino are your life, your credit rating, the value of your home, the plant closing which threw you out of a job.
All of these are factors in this exotic casino and you breathed life into it when you sat down at your mortgage broker’s office and filled out your 1003. They didn’t even wait for you to sign the documents at closing before the games began. The players are the algorithms that close out their positions at the end of each day sweeping the table clear of chips. Who cares what the underlying value is? They just study the charts and the players have to double down on these stupid bets because they just know the other guy is bluffing.
Do these exotic financial products have a place in today’s complex market? Ask the regulators – oh, wait, there are no regulators because this is an unregulated market. And as we learned with FEDISCOPE, these games, like all betting games, are rigged in favour of the house.
This is part 4 of an ongoing series based upon the research of Ken Dost. The previous posts are: