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What are the roles of derivatives in the real economy?

Starting from the basics: What is an economy? Financial vs real economy. How derivatives are used in the real economy and a bit of history of Brazilians coffee market.

We all hear this word all the time “ economy” but what does it really mean? Well, my view of the economy is different from most mainstream economics books simply because mainstream economics(also known as Keynesian economics), simply put, is a theory that believes that as former president of the FED Alan Greenspan famously said, we can always print money to solve our risk of default problems. You don’t need a major in economics to be suspicious of that statement, just look at the reaction of the second journalist.

But don’t get me wrong, Keynes was a genius, when he developed his theory it was desperate times which of course requires desperate actions. In 1929 great depression, life was hard, unemployment at 25% , total chaos, but after Keynes juiced the economy with cheap credit and things got better, politicians liked the idea of printing money, this temporary solution could become a permanent one, which is basically saying that the “future generations will pay our debt” and by then, we will be long dead.

Well, Mr. Keynes, the long run is here and it’s time to get sober, we now have more debt than we can ever pay and judgment day will come, the world’s total debt is $258 trillion in the first quarter of 2020 while the current world’s GDP is $87.69 trillion:

Current worldwide GDP in US$:

There are many other issues why I dislike mainstream economics, if you read macroeconomics by Paul Samuelson, one of the best references in the subject, it does not mention the possibility of negative interest rates which recent countries like Japan, Sweden, Switzerland, Denmark are starting to “experimenting” because they have no choice, if interest rates rise, the trusted based credit relationship between borrowers and lenders collapses as the lenders start to doubt the capability of borrowers to pay up. The whole system collapses, people start to question whether their deposits in banks still exist. Central banks are “forced" to print more money by lowering interest rates or issuing more bonds and by other mechanisms because if people stop borrowing they cannot pay the debt created with the credit they shouldn’t even receive. Is just like a party that you can’t stop drinking to avoid a hangover.

High paying respectful economists are more likely to be data scientists, mathematicians/statisticians, portfolio managers, due to hard skills, most models of economic literature use linear equations to explain complex phenomenons, this makes no sense to me.

The concept of nonlinearity is very important if you want to understand the dynamics of price fluctuations, studying derivatives changes your world view in how the real economy works and how little we understand the reasons behind people’s choices and decisions. Macroeconomics is not a subject you can master in college and thinking otherwise is a pretense of knowledge.

I like to view the economy from the Austrian perspective:

The problem is, while money is created and controlled by the central banks, credit is not, credit is created out of nothing. This is the business of commercial banks. but every once in a while, inevitably, a recession strikes in and people run to the banks to withdraw their money and just can’t because banks lends more money than they receive in deposits. this is called a bank run. The given credit is just a trust-based transaction that the lender(financial institutions) will receive the money in the future from the borrower with some additional interest while bankers cross their fingers hoping that everybody won’t need cash at the same time.

As said before, interest rates are controlled by central banks which create credit by lowering it to incentive investments, supposedly growing the economy, and then restricts it by rising it to incentive savings after growth generated by the investment cycle. But in real life, not all people are rational businessman and entrepreneurs, many people take cheap credit to buy a nice car, or a nice house or many other things that they surely can’t afford, this effect creates a Boom in the economy sending false price signals to producers of goods and services, making they produce more than we as a whole economy need. People feel rich for a while as the spending of an individual is an income of another, but this doesn’t last long, the boom is followed by the Bust when interests rates rise, the debt created with credit offered gets bigger and this is where the borrowers get in trouble, they are forced to cut back on spending and even selling their own assets like the nice house or car they bought and again since individual spending is another individual income it creates a chain reaction causing a recession.

Here is a list of bank runs from 17th to 2010 :

Nowadays central banks enforce laws for banks to maintain a certain percentage of deposits to prevent a bank run but it’s a slippery slope, eventually, banks still need some “help” from the government with bailouts because they are just too big to fail.

The real economy concerns the production of goods & services, this is the real world where normal people live: doctors, engineers, teachers, farmers…

The financial economy deals with transactions of fiat currency and financial assets, this is where bankers, financial engineers, brokers, traders lives, and since 1971, the financial economy took over the real economy, big corporations preferred buying financial assets over hiring more people to grow their own business because they were making more money this way. The derivatives market reached an outstanding notional value of $640 trillion in the first half of 2019, more than twice as much as total debt in the whole world! and the reason for this starts after World War II.

In 1960, with a surplus of U.S. dollars caused by foreign aid and military spending of the United States in the War, they just didn’t have enough gold to cover the volume of dollars in worldwide circulation at the rate established by the Bretton woods agreement(35$/ounce). In 1971, president Nixon made an announcement that changed the world, he ended the Bretton woods system and the dollar become a fiat currency, which is just money without intrinsic value. But it was supposed to be just a temporary action, well, it is temporary till this day.

The financial system was flooded with fiat currency, the printing machine never stopped because there was no real asset behind it to back it up, the dollar becomes the world’s defensive currency reference, and the United States was established as the most powerful country in the world.

Dow Jones 1916–2002:

It seems great, but there is a small problem. Fiat currency never works in the long run! Since Roman times, fiat money has failed spectacularly throughout history due to the same pattern of rapid devaluation and then total collapse. 97% of the Western money is printed randomly as needed and people are starting to realize that now. The financial market already expects the “mother of all crises” in the next few years and cryptocurrencies are on the rise because it serves as the same purpose as gold did.

Since the 19th century we used the gold standard, this had a simple logic, if a country suffers from hyperinflation, people will buy metals which is a sure thing that anyone will agree to make a transaction because the last a check, you can’t feed children with paper money.

Metals are a scarce resource and you can’t just create out of thin air, so it was considered a reliable asset for storage of value, cryptocurrencies follows somewhat the same logic, it is bounded to a mathematical impossibility, which seems more interesting than gold that had prices affected when gold mines were discovered. Cryptos are very easy and reliable to make a transaction and it doesn’t actually exist in the physical world, so no need to buried treasure or taking risks of carrying around in your pocket.

In the first book of politics by Aristoteles(320B.C), he describes briefly how Thales of Miletus(500 B.C) came um up with a plan to make a profit with his knowledge in astronomy, which at the time was attributed to his wisdom, but Aristoteles saw as a business strategy, a tool that could be used for universal application:

Politics Book I, Aristotle pg: 55

In ancient Greece, olive oils were a highly valued commodity. During cold winter, Thales observed with his astronomy skills that it was going to be a large crop of olives as winter ended, then he came up with a little sum of money(premium) to rent olive-presses at a very cheap price because such a tool is useless in non-harvesting seasons, so it made sense for the owner to make some profit renting it. But with the passing of time, winter was over and there was a huge demand for olive-presses and Miletus made a huge profit. this may be the first transaction of derivatives in recorded history. he bought a call option.

The boring definition above often confuses most readers but let me illustrate what it means from the Miletus example, the image below is the payoff function (all the possible values for the call option at the end of the rent agreement) given a random future process, because nobody can actually know if, in the future, crops of olives will grow.

Miletus rented de presses which are represented by St, an asset that changes the value in time due to different circumstances (seasons). Let’s say that the owner it’s willing to rent for a C price at a T-t period of time. Is easy to see that Miletus has a loss of -C if there are no crops or the winter doesn’t pass as he expected, for whatever reason he will pay a periodic rent until the expiration date T which has a maximum loss of -C.

The other scenario is that winter has ended, harvesting season for olives arrives and tools like olive-presses are in high demand. It is easy now to see that Miletus has an asymmetrical exposure towards risk, he can measure how much he is willing to lose if he is wrong but he cannot know how high the demand will be, thus theoretically, infinite profit.

If you find this confusing don’t worry, I will address this many times, the figure above is in Portuguese, I’ll translate it to English because I got it from my Bachelor's dissertation in binomial option pricing.

Derivatives have a bad reputation, but like any tool, if you don’t use properly it can hurt you.

Example: Imagine you are a producer of corn. A very important commodity because most corn produced it’s used to feed animals we eat and for biofuel cars, the current market price for bushel is about $4.20.

Scenario1: at the harvest day corn prices reaches maximum historical price at $8/bushel due to a rare plague in corn plantation, then you will sell the corn for a much higher price than expected.

Scenario 2: Due to favorable climate conditions, there is an overproduction of corn and the offer is just too high, lowering prices to 2$/bushel which does not compensate for storage and transportation of the product. The best solution here is unfortunately to destroy the corn to reduce costs. This is the risk that a corn producer has to take in order to continue with his activity, and there are many more risks involved

Now let’s look at the buyer of your fresh produced corn, let’s say a cow’s farmer.

In scenario 1 the prices can rise dramatically and reach a higher level than his activity allows it, affecting other markets like milk and meat, biofuel. this is the risk of the cow’s farmer.

But in scenario 2 it's very favorable for the buyer because prices will be much lower than expected.

It is easy to see that both producers risks cancel out each other if they reach an agreement, in the present, to make a transaction of the commodity that will exist in the future, for a fixed price, that makes both of them in activity despite the uncertain future of corn prices. let's say $5,50 is a good price for both of them. This can be done with a forward derivative contract. both parties do not care about the speculation in future prices, their job is to produce and make a profit by this activity.

Now let’s see what can happen in both scenarios:

Scenario 1: prices rise to 8$/bushel the cow's farmer is satisfied, now he can buy corn for a much lower price then the market is pricing while the corn farmer has a loss of 2,50$/ bushel, but it can still keep his business running buy selling his crops by 5.50$.

Scenario 2: If prices drop to 2$/bushel the corn producer is satisfied because he can sell at 5,50$ when the market value is 2$/bushel, the cow's farmer is obligated to buy at a higher price, but still can continue with his activity.

To wrap it up, another example of how a derivative could help an entire nation: during the 1929 great depression, the most important commodity in brazil was coffee. Brazil produced enough coffee per year to supply the entire world market. During the meltdown of the international financial system and reduction of world commerce, it became impossible to negotiate new loans, and prices were in free fall all around the world. There was so much coffee leftover that they thought about using it as firewood for locomotives. President Getúlio Vargas stepped in, and order that coffee reserves were to be burned in order to raise prices.

70 million bags of coffee were burned in the country — enough to guarantee the worldwide consumption of the product for three years.

I will leave you with this question: Should we fear Derivatives?

Hitting the Reset Button

What are the roles of derivatives in the real economy?

Starting from the basics: What is an economy? Financial vs real economy. How derivatives are used in the real economy and a bit of history of Brazilians coffee market.

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