37 lines
2.5 KiB
Plaintext
37 lines
2.5 KiB
Plaintext
Option Fundamentals • 7
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studies (i.e., his contractual rights had value through expiration—option
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characteristic number 4).
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This is only one example of an ancient option transaction (a few thou-
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sand years before the first primitive common stock came into existence),
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but as long as there has been insurance, option contracts have been a well-
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understood and widely used financial instrument. Can you imagine how
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little cross-border trade would occur if sellers and buyers could not shift the
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risk of transporting goods to a third party such as an insurance company?
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How many ships would have set out for the Spice Islands during the Age of
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Exploration, for instance? Indeed, it is hard to imagine what trade would
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look like today if buyers and sellers did not have some way to mitigate the
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risks associated with uncertain investments.
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For hundreds of years, options existed as private contracts specifying
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rights to an economic exposure of a certain quantity of a certain good over
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a given time period. Frequently, these contracts were sealed between the
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producers and sellers of a commodity product and wholesale buyers of
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that commodity. Both sides had an existing exposure to the commodity
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(the producer wanted to sell the commodity, and the wholesaler wanted to
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buy it), and both sides wanted to insure themselves against interim price
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movements in the underlying commodity.
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But there was a problem with this system. Let’s say that you were a
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Renaissance merchant who wanted to insure your shipment of spice from
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India to Europe, and so you entered into an agreement with an insurer. The
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insurer asked you to pay a certain amount of premium up front in return
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for guaranteeing the value of your cargo. Y our shipment leaves Goa but is
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lost off Madagascar, and all your investment capital goes down with the
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ship to the bottom of the Indian Ocean. However, when you try to find
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your option counterparty—your insurer—it seems that he has absconded
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with your premium money and is living a life of pleasure and song in
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another country. In the parlance of modern financial markets, your option
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investment failed because of counterparty risk.
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Private contracts still exist today in commodity markets as well as
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the stock market (the listed look-alike option market—private contracts
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specifying the right to upside and downside exposure to single stocks,
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exchange-traded funds, and baskets is one example that institutional
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investors use heavily). However, private contracts still bring with them a |