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Once upon a time - Views on News from Equitymaster
 
 
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  • Oct 15, 1998

    Once upon a time

    Once upon a time there was a farmer who grew wheat. Some of the wheat was consumed by his family but most of it was to be sold. With the money that he got from selling the wheat, the farmer bought tractors and fertilisers (to help him grow more wheat) and soaps, shampoos, and shaving blades (to keep all the analysts excited about the prospects for companies that manufactured fast-moving consumer goods). The farmer was concerned about the quantity of wheat that he could grow year after year, the amount that would be left over for sale after his consumption, and the price that he would get for every bushel of wheat he sold. To ensure a good wheat crop, the father voted for a government that claimed to have a direct communication channel with god.

    To make sure that his family consumption was not too high, the farmer made sure his family watched all the television shopping channels that glorified the virtues of being slim and the cute government films on family planning. But the farmer still had a problem about the price that he would get for his bushel of wheat. You see, the farmer may not have done an MBA (which gives you the knowledge to overbid for telecom licenses and then the dress-code to seek a government bailout) but he understood the concept of costs and profits.

    Today, he was buying subsidised fertilisers and tractors and using free water and free power to grow his wheat. Tomorrow, if the price of wheat declined - how would he make money to buy all the shampoos that research analysts were projecting he would buy? Or the mobile phones that those MBAs had put into their telecom license valuations? Sure he could always ask those chief ministers to bail him out and forgive him all his loans, but most of them were in jail these days and contacting them was getting difficult - those promised cellular phone lines were yet to be built.

    And then the farmer was introduced to Eureka - the financial genius, winner of the Nobel prize, rebel with a cause. Eureka said that the farmer could do a forward sale of his wheat to a party that needed the wheat as a raw material for an end product and wanted the price fixed in advance. Brilliant, thought the farmer, these capitalists are geniuses. So, he sold his surplus wheat output to Roti Dhoti - the largest manufacturer of packaged chappatis. Everyone was happy: the farmer got his guaranteed price and Roti Dhoti got a steady supply of raw material at a fixed price and our good friend Eureka got his fee for the transaction.

    Eureka, having tasted success on this transaction, felt the urge to get more fee income. He contacted more farmers and more companies like Roti Dhoti. They all were sold on this idea of forward contracts and they all became clients of Eureka who, needless to say, got more fees. A specialised exchange was set up to trade these forward contracts and specialised broking firms were set up to deal in these. But after all the farmers had been matched with all the Roti Dhotis of the world, Eureka stopped getting any growth in fee income.

    So, he invented options. Here there was no need to have a real farmer with real wheat to sell to a real company like Roti Dhoti. Instead, any two people with no need for any wheat could take opposite views on the price of wheat. One sattawalla may feel that wheat prices were going up, so he would buy a call option on wheat for delivery in December, 1998. The other sattawalla may feel that wheat prices were going down so he would write a put option on wheat - the right to sell wheat to you in the future at the lower price. The beauty of this was that no wheat really exchanged any hands: only contracts that were issued and then cancelled - and the money that had to be paid or received by the person who got the correct "prediction".

    Eureka and his clan had never had it so good - every important commodity in the world was now being traded in the forward, futures, and option market. People who would never have the need for wheat or sugar were buying and selling hundreds of tonnes of the product through the options market. One estimate had it that the amount of currencies traded in the world was over 100 times the actual need for currencies to pay for all the goods and services in an increasingly inter-connected world! This was capitalism at its best: all risk and all reward where the means to an end, became an end in itself.

    The farmer who grew wheat and Roti Dhoti that needed the wheat had little say for they were all small players - prices on the options market began to dictate what crop would be grown next year. The servant had become the master. And the central bankers of the world - protectors of the faith - did nothing to stop this bandwagon. Many times they helped in sustaining this free-market myth. Currencies were battered, economies pulverised, millions thrust into poverty by the actions of a few, but it did not matter - the market was right. Once upon a time, there was a real farmer with real needs and fears about the price he would get for his wheat crop - but that was a long time ago.

     

     

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