In finance, a derivative is an agreement based on an underlying asset. Instead of exchanging the actual asset, agreements are made to exchange cash or other assets for the underlying asset within a specified timeframe. As the value of the underlying asset changes, so does the value of the derivative. Following the definition, we find that our lives are filled with derivatives. Credit cards, service agreements, and many other everyday contracts promise a service now in exchange for cash within the billing period - the specified period. Rather than being the boogey man of financial destruction, derivatives are financial tools that if used properly make our lives easier. History shows that these financial instruments were developed to solve real world issues that needed to be solved for business.
Although generally thought of as a high tech trading tool, derivatives have been around for a quite a while. Over 100,000 years ago, it is known that people bartered for goods and services. The problem with bartering is that it is hard to trade between items that are harvested at different times of year. Items that perished quickly are difficult to trade. The solution was to begin utilizing a less or non-perishable commodity such as wine, grains, or other objects as an intermediary. For instance, we could trade a perishable item for wine, which we could then use to exchange for another crop harvested later in the year - our currency being effectively wine. These types of trades eventually led to the development of commodity money, an intermediate store of value that expanded the number of trading opportunities. Almost every civilization would develop a commodity money basis for trading.
Around 8,000 B.C. writing and mathematics had developed in Sumer, located in the Tigris and Euphrates river region, to a point they developed a unique method for accounting. Clay tokens were used to represent the different commodities and quantities (See Picture 4.1 1). To keep people from tampering with the tokens, they baked them into a hollow vessel. Pressed into the exterior of the vessel - prior to baking - would be markings similar to the tokens inside and a witness mark to make it official. The beauty of this system is the way it resolves disputes. If there were any disagreement of the values on the exterior of the vessel, they would break it open to count the tokens inside. Eventually the tokens and vessels would become a promise to deliver a quantity of goods by a certain date - all baked on the vessel. Now instead of wine, we would accept a vessel and give the other party (counterparty) our product. Then based on the quantity and time of delivery pressed into the vessel, we would receive the counterparty's goods. By 3,500 B.C., new forms of writing and math enabled the Sumerians to replace the vessels with clay tablets. These trades are similar in behavior to forward contracts.
A forward contract is an agreement where a seller agrees to deliver an item by a certain date to a buyer at an agreed price. Typically, forward contracts are settled upon the delivery of the item at the expiration date. Profits are only realized if the buyer had purchased the item at a reasonable price. If the buyer overpaid they would lose money.
In ancient Greece, the Athenians used shipping contracts for trading which resemble forward contracts, with a twist. The buyer would borrow the money up front. Prior to a trading voyage, an entrepreneur (buyer) looking to profit on a trade of commodities would make an agreement with a merchant who would finance the voyage. They would draw up a contract. The contract would state the amount of money loaned and required interest the entrepreneur would pay the merchant upon return. Since these voyages were risky, the merchants demanded a high return in the rage of 30%. After all, there were many ways a ship could disappear; pirates, unfriendly nations, and storms to name but a few. Further stipulations would name the commodity to be purchased, state where it was to be purchased, the ships route, and a time limit for the voyage. To make sure the entrepreneurs' would not cheat them, the merchants had a trustworthy acquaintance or employee accompany the voyage. Upon reaching the agreed upon port of call, our entrepreneurs' would purchase the commodity - or sell in the case of exports. In either event, the merchant now had an effective ownership of the commodities until they were paid back. The similarity to a forward contract can be seen since the factors of price, commodity, and time are stipulated in the shipping contract. Profits for the entrepreneurs' would only be realized if they could sell the commodity at a high enough price to cover the merchant's loan and interest. If they could not cover the loan, they would end up in court and may find much of their collateral, and perhaps their freedom, in jeopardy. Because trade was so important, laws and regulations would develop to ensure each party would be justly treated in disputes.
Around 1100 European merchants developed the "fair letter" that acted like a letter of credit between the buyer and seller. These letters would then be settled at regional trade fairs such as the Fairs of Champagne; an annual cycle of trading fairs held in town located in the Champagne and Brie regions of France, which were the main markets for Northern Europe. The seller would have the merchandise ready for pickup at a fair, and the buyer would give a "fair letter" for payment. The Fairs of Champagne started out as mainly agricultural events, but evolved into major trading markets for many commodities. Italian moneychangers at the fair would settle the letters for the merchants. The Fairs of Champagne became international clearinghouses for paper debt and credit. The seller would receive another "fair letter" or letter of credit that could be settled in or near their hometown with a local goldsmith. Back in these times, the local goldsmith is where merchants held their money. The goldsmiths would eventually evolve into banks. Over time, the fairs began to lose their dominance in trade. Many of the trade routes to the fairs were over land. War and political issues would cause over land routes to fall from favor - traders turned to sea routes. The fairs would move from the Champagne region to the port city of Burges.
Bruges is interesting because of the impact natural changes in the environment had on the city and its economy. Bruges is located near the North Sea in modern day Belgium. Prior to 1134, the natural water channels that provided access to the sea had silted up. That year a large storm hit the coast and reopened the natural channels near the city. Soon, because of the over land trade issues for the Fairs of Champagne, merchants started using the port city as their main trading location. Ships would begin to arrive from as far away as the Mediterranean. By 1309 Bruges became one of the most sophisticated money markets and trading cities in Europe. Growth and prosperity seemed abundant until around 1500. The channels that had been the reason for Bruges success began to silt in. Trade would move to another port city - Antwerp. Bruges would decline.
In1515, the city of Antwerp opens the Bourse, a dedicated building where local and international traders could gather to conduct business. Before the Bourse, traders generally met at a specified place and time to conduct their affairs. Now there was a dedicated marketplace year round. Soon, the town of Antwerp grew dramatically as the Bourse became the preferred place of trade in Northern Europe. Textiles from England, spices from the Portuguese, and metals from Germany all were traded in Antwerp. Due to its success, by 1531 a new and larger Bourse was built outside the city in a planned development specifically with trade in mind. Away from the port and warehouses, the new facility is where contracts and other financial instruments were traded. Traders were not purchasing commodities directly; they were buying and selling rights to commodities - intangibles. A true financial market had been established.
Antwerp was generally prosperous until 1648. Antwerp is located on the Scheldt River. The river provided access to the ocean and allowed the city to become an international trading post. Recall that the region was in the middle of the Eighty Years War, which ended in 1648. Antwerp was located in the southern provinces of the Netherlands that remained under control of Spain - the Spanish Netherlands. As part of the Treaty of Munster, the peace treaty between Spain and the United Provinces (Dutch Republic), the Scheldt River would be closed to navigation. Antwerp's trading activities were effectively shut down. Amsterdam would become the new leading trading hub for Northern Europe.
For the next two hundred years the trading of commodities in the western world will utilized agreements that are similar to forward contracts. Several civilizations would have similar type of agreements or arrangements for trading not only for ship voyages, but for caravans as well. However, the agreements are still generally between parties that must deal with each other directly, sort of an ancient over-the-counter (OTC). Each party must trust the other party in order to trade. The next revolution in trading would occur in the East.
In Feudal Japan around 1700, many rulers in agricultural regions taxed their subjects in rice. For currency, they would bring the rice to cities such as Osaka where it was stored and sold at auction. Only authorized wholesalers were allowed to bid on the rice at auction. The winning bidder would receive a rice voucher that would be settled shortly thereafter for cash. The vouchers eventually became transferable; a new market in the buying and selling of vouchers would develop among the merchants.
Around 1730, the Dojima Rice Exchange is established with the full support of the government. At the exchange, there are two types of rice markets; the shomai and choaimai. The shomai market is where actual rice trading takes place. Here traders buy and sell different grades of rice based on the spot price. Rice vouchers are issued for each transaction and would be settled within four days. At the choaimai the first future market was operating. Choaimai roughly translates to rice trading on books. In the spring, summer, and fall different grades of rice were contracted with standardized agreements. No cash or vouchers were exchanged; all relevant information was recorded in a book at a clearinghouse. The contract period was limited to four months at a time. All contracts had to be settled prior to the closing of the contract period, and no contract was allowed to carry over to another period. Settlement of the differences in value between the current rice spot price and the contract had to be done with cash or an opposing contract position. With a few interruptions and updates, the rice exchanges would operate until 1937.
To be able to participate in the exchange, traders were required to establish lines of credit with a clearinghouse. Trades were done through the clearinghouse, and if the trader defaulted on a trade, the clearinghouse was responsible for payment. Similar to today, the clearinghouse acts as the intermediary and guarantees payment on trades. Hence, the Dojima Rice Exchange is considered by many to be the first futures market. The final metamorphosis in commodities trading and derivatives would be over a century after the establishment of the rice exchange in the New World.
Receiving its city charter in 1837, Chicago had grown to over 4,000 inhabitants. Soon four events would lay the groundwork for this small city to become one of the world's largest. The year is 1848 and the Illinois and Michigan Canal has just been finished to connect the Great Lakes to the Mississippi River and ultimately the Gulf of Mexico. That same year the telegraph is introduced - within two years Chicago would be connected to most major East Coast cities. Also in 1848, railroad companies install lines for commerce; the city will become a large railroad hub. Lastly, the Chicago Board of Trade (CBOT) was founded.
Prior to the exchange, commodity trading operated similar to earlier centuries. Buyers and sellers would need to locate each other then make an agreement - similar to a forward contract. The problem was if the prices fluctuated too much the other party would back out of the deal, there was significant counter-party risk. As earlier fairs and markets, the CBOT was founded to make it easier to trade and bring order to the process. Initially the CBOT was a voluntary association with little active trading activity. By 1850, the exchange had developed rules and product standards, which allowed the grain market to operate more efficiently, but forward contracts were still in use. Since contracts were assignable, speculators began to play the commodities markets looking to cash in on price movements. In 1855, France moved its grain purchasing from New York to Chicago; CBOT had become a very popular place to trade in grains. The Illinois State Legislature incorporated the exchange in 1859. The true revolution in commodity trading for the CBOT would not take place until 1865. That year standardized agreements were introduced with the exchange as the counter party - futures agreements. This is similar in nature to what the Japanese were doing 130 years earlier.
1898, The Chicago Board of Trade spun off the Chicago Butter and Egg Board, which would evolve into the Chicago Mercantile Exchange by 1919. Over time, each exchange would begin trading a broad range of product types from agricultural commodities to metals. Major advances in trading derivatives would not come until 1970's. Perhaps not so coincidentally, this period also gives birth to the microprocessor and personal computers. It is the beginning of the Computer Age.
The 1970's is when derivatives gained widespread use. Several factors were at play to propel derivative markets. First, many governments began to deregulate pricing and controls in markets introducing higher volatility. Tedious calculations were required utilizing probability theories to help predict future price movements. Luckily, at this time the computer becomes more wide spread allowing the complex models and computations to be solved quickly and efficiently. Then in 1973, Fischer Black and Myron Scholes would publish their paper, "The Pricing of Options and Corporate Liabilities", which established methodologies to help determine option prices. The paper also shows using options on equities that it is possible to create a hedged position - something fairly well known in agricultural commodities. That same year and coincidentally, the Chicago Board of Trade opens the Chicago Board Options Exchange. With a methodology to price options, computers to crunch the numbers, and a market to trade- things boomed. Over the next few decades, there would be derivatives on almost anything with a market willing to trade.
The next big development for derivatives would be electronic trading. Launched initially by the Chicago Mercantile Exchange in 1992, electronic trading has gained wide acceptance. Benefits have been greater liquidity, reduced transaction cost, and higher transparency. Today, trading in virtually any derivative, commodity, or security can be done from one's living room.
The tools we utilize for synthetic real estate are property derivatives (aka. real estate derivatives ). Similar to forward agreements in concept, property derivatives have been around for millennia. In fact, a simple contract to buy a home is a forward agreement - buyer and seller agree upon the price and period for delivery (due diligence period). The due diligence period could be equated to determining if the property's "grade/quality" meets your contract requirements. As we sometimes learn most painfully, the price we pay may not be what the true value of the real estate is. Real estate, unlike many other commodities, comes in many prices, sizes, and locations. Before efficient markets develop, there would need to be a reasonable "standardization" of property values - an index. Looking to fill the information gap, several institutions, businesses, and academia worked on developing indices for their interests. The results of these efforts would yield indices for commercial and residential real estate with the first indices appearing around 1980.
With the development of reliable property value indexes, the first early attempt of a property derivative market began in London around 1994. Focusing on commercial real estate, the market for property derivatives never really caught on with investors. In 2005, property derivatives came back to life in the U.K. with trades on commercial property. Although many various derivative types were available, the most common type of transaction would be in swaps and eventually forward agreements.
The United States would not really get started in property derivatives until around 2005. Very similar to practices in London, the market is for the most part an over the counter affair although a market for pricing does exist. Different derivative types, but mostly forwards on the index, are available for residential and commercial indices. A bright spot for residential investment came in 2006 with CME/Chicago Board of Trade establishing a market for housing futures based on the S&P/ Case-Shiller Index - although trading is light, it is really the only market where real estate futures can be electronically traded.
Most recently, June 2009, equities (stocks) had been developed to allow traders to effortlessly invest or hedge real estate risk - allowing even greater access to property derivatives for small investors since equity-trading accounts have smaller deposit requirements. Known as MacroShares, they had great potential. Unfortunately, they suspended trading in January 2010. Trading did not take off as expected. Perhaps they were an unfortunate victim of timing; trying to launch a real estate investment product in the middle of a depression.