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Sometimes inspiration can be found in the most surprising places. Sometimes it comes from the most obvious, just when the most obvious was looking like the most despairing. It seems miraculous, almost incredible, but I’ve found something in a University of Hong Kong class that actually interests me greatly.

This miracle maker is the area of financial derivatives. Now normally financial products don’t excite anyone, except perhaps desperate insurance salesman, investment bankers who want to make partner and the individuals who share Li Ka Shing’s asset class, so it is rather dubiously that I looked initially at my own interest. The motivation is simple: derivatives are actually incredibly nifty, effective and the first area of substantive intellectual challenge that I have encountered on my course.

A financial derivative, for those who are wondering what the hell they are, are things like options, futures contracts and more complex creatures such as swaps and credit derivatives. Now the idea essentially put is that it allows low up-front cost gambling on other things such as bonds and equities, so that people can get the benefit from being invested without actually putting up the cash upfront. In market savy Hong Kong I should really have to say no further [and in some areas like covered equity warrants, Hong Kong actually has significant retail activity, unlike a lot of other countries]

The simplest to explain and the most fundamental building block of the derivative market is the option. The option is a document that entitles the holder (upon the payment of a premium) to buy a share or a bond when it reaches a certain price within a certain time frame. The idea is that you have an option to buy 1000 shares at $2 in the next 6 months. After 2 months the price rises to $3, you can then exercise the option, and be put in the position as if you had bought at $2 and sold at $3, realising a thousand dollar profit. Normally this would have required you to actually buy a 1000 shares at $2, costing you $2000. The option on the other hand would probably have traded at considerably less then that, meaning that your actual return on money is substantially higher [return rates of a 1000% are easily doable given the right share option and market volatility]. Of course the flip sides is that if the market goes down, your option [after 6 months the share is only worth $2.50] is totally worthless as you would lose money if you exercised it. If you’d bought the shares you would at least have an asset albeit one that had depreciated in value.

What I really wanted to share anyway, was the satisfaction that comes from finally having a direction to which to apply my energy, and to have a topic that encourages me to find out more by myself, and can reward endeavor with depth even if in the end its an aspect of financial products and risk management, and not really that complicated as an issue of law. It’s just good to find something that can drive that level of interest for me. Last year Public International Law and Company Law helped a great deal to drive through the year for me, and in the year before Tort played a very similar role. It’s nice to have something like that back.

Sidenote: For the one lawyer that doesn’t read my blog anyway, options were that weird thing in Vandervell (No.2) v. IRC and is how they did the mysterious vanishing act with the shares that were held by the RCS. That might not be of much help now, if it makes anything clearer, but I think I finally understand what the hell was going on there. And its probably likely as a matter of financial derivative law, that the court there got the decision abjectly wrong in its legal treatment of the option. I know, who cares.



    • Dom
    • Posted December 5, 2006 at 2:20 pm
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    Hey Mo. As someone who studied a bit of finance I want to clear something up. I think derivatives are originally created to manage risks, risks being the uncertainty of prices and interest rates in the future. So say a farm who wants to sell beef in 6 months time may worry beef price will fall below today’s price. He can take out a forward contract with a counterparty (a buyer) to lock in today’s price. The buyer will agree to this because he worries beef price will go up in the future. In this way both parties’ risks are eliminated.

    Clearly, if you take out such a contract but do not actually produce beef, then you are gambling on beef prices falling in the future. So while it’s possible to take a punt with derivative instruments I don’t think this is the intention, and I cannot encourage such behaviour.

    • Mohammed Talib
    • Posted December 5, 2006 at 10:18 pm
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    You are right that inititally they were created as risk managment instruments to avoid fluctuations in the prices of commodities and then improved so as to hedge risk in all types of financial products.

    The current market literature is actually largely warm towards speculators and those entering the market on a non-performance basis because these markets would simply not be liquid enough to function without the presence of those willing to take a stake on where the market. Often these are well informed and comprehensively regulated institutional investors (banks, pension funds & Insurance companies) and know what they are doing.

    Like I mentioned though, in Hong Kong there is a significant retail component to these products and this retail dimension is growing rapidly as more retail high net worth investors understand the utility of these nifty bits of paper.

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