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Struggling with a complex web of transactions
Financial institutions are highly interlinked and engage in huge, complex transactions with each other. No doubt you can see how many potential things can go so terribly wrong in such an environment.
The sheer magnitude of financial transactions is hard to get your head around. For some kind of idea of the enormous numbers involved, check out the nearby sidebar ‘Trading in the trillions’.
Trading in the trillions
We estimate that around $5 trillion worth of transactions are made every day in the foreign exchange market (the market for currencies, for example, dollars, pounds, euros). Around $2 trillion of this trade takes place in London alone.
Another astonishing statistic is that the notional value of all outstanding over-the-counter (OTC) derivative contracts is around $700 trillion. Putting things into perspective, the value of
everything produced in the world in a year is well short of $100 trillion (not that that’s a small number!).
As well as transactions between financial institutions being massive in size, they also vary in their complexity. Some transactions between financial institutions are very simple. For example, Bank X may sell £100 million to Bank Y in exchange for $150 million. This straightforward trade is easy to understand and not that different to when you go on holiday and purchase holiday money from the bureau de change.
Other transactions are more complex – derivative contracts (which are financial products that derive their value from some underlying asset) are a good example. Their complexity and widespread use mean that understanding them is key to understanding how and why our financial system is so complex and also how deeply interconnected financial institutions are due to their dealings with each other (in derivatives as well as in other ways). Finally, understanding how a derivative works will give you a good idea of what leverage is: the multiplying up of rewards and losses. Leverage means that even small changes in the prices of things can have a large impact in financial markets.
Derivatives themselves vary in complexity; relatively simple derivatives are described as vanilla (like vanilla ice cream, the standard version). In contrast, complex derivatives are described as exotic. People can trade derivatives on an exchange (an organised market where buyers and sellers meet to trade a standardised product) or over-the-counter (where the two parties meet and write their own contract without going through a third party).
We go through an example to help you see why a derivative is more complex than a standard financial product (like a stock or commodity). The example also demonstrates how trading in derivatives can quickly involve large losses (or gains) being incurred by different parties. Because financial institutions engage in huge amounts of derivate contracts with one another, derivatives clearly show the interconnectedness of the financial system.
A call-option is a particular kind of derivative. It gives the holder the right but not the obligation to purchase some asset in the future at some agreed-upon price (called the strike price). Imagine that you think that the price of BP shares is going to go up. You could buy BP shares now – if BP shares cost £5 each and you have £50 to spend, then you can buy 10 BP shares. For every £1 that BP shares increase in price, you’ll make £10 in profit.
But if you’re feeling more ambitious, instead of buying BP shares outright, you can buy call-options today, which give you the right but not the obligation to buy BP shares in a year’s time for £5. Obviously, if BP shares are less than £5 in a year’s time you don’t exercise your options – after all, why would you buy something for £5 that you can buy cheaper on the open market? Conversely, if the shares rise to more than £5, you’d certainly exercise your options – even if you no longer wanted to hold BP shares, you’d still exercise your options to purchase them for £5 and then immediately sell them in the market. You can see how this may be a risky option (no pun intended!) – if BP shares are below £5 in a year’s time you lose your entire stake.
Why may you prefer to buy the call-options rather than the shares directly? Because the options only give you the right to buy the shares, they’re considerably cheaper than the shares themselves. The call-option may only cost 50 pence, and so with your £50 you can buy 100 call-options instead of only 10 shares. This changes things dramatically: now for every £1 that BP shares increase in price, your profits increase by £100 instead of £10. This potential multiplication of returns is called leverage.
Does this mean that everyone should go out and start buying call-options? Probably not. First, owning the shares means that you own a part of the company and are entitled to a share of the profits. Owning the call-options gives you no such right. Second, although call-options do well when the price of the underlying asset increases above the strike price (the price at which you have the option to buy), they do terribly if, at the time of expiry, the price of the asset is less than the strike price.
This is because they’re now completely worthless – no rational person would exercise a call-option in these circumstances (so only Homer Simpson, then).
In this example, if BP shares fall in price to £4.50 (or even stay unchanged at £5) the option to purchase them at £5 isn’t worth the paper it’s written on! You’ll have completely lost the £50 you spent on them. Table 14-2 shows how the profit (or loss) from the two strategies compares as the stock price varies.
Table 14-2 Buying Call-Options versus Buying Shares
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