The Magic of Paper

The Magic of Paper

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Are you ready to know what my frequently asked question is? It is quite unique. Bada Bing Bada Boom!! It is "What do you do?" But seriously, isn’t that the most commonly asked question for most of us? I work as a Quantitative Researcher for a principal trading company, and we trade commodity derivatives. I get diverse responses from people the moment I declare my profession. “What exactly do you do? I am not familiar with this field, could you elaborate?”. This article is my attempt to answer that question. But let me tell you a story first.

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A few years ago, while visiting my sister in India, I spent an afternoon watching my nephews play. They created a “make-believe” train station, and we took turns transporting from one corner of the room to another. What fascinated me was the specificity of the paper tickets. The area of the paper was proportional to the distance you could travel. This frivolous game actually incorporates one of the foundational aspects of finance, the idea of attaching value to paper. As long as we can agree and believe that a particular piece of paper has value, the game continues. Money is nothing but a piece of paper issued by a country. As long as we believe it has value, we can use it in  exchange for goods and services. But paper can also serve as more value than this. (brief summary here)

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Derivatives

Imagine a wheat farmer who has to decide how much seed to plant for the upcoming season. He decides based on the forecast of what the wheat demand will be in six months, when he will harvest the crop. This uncertainty presents a potential risk for the farmer. Similarly, imagine a wheat bread manufacturing company which needs a constant supply of wheat and is at risk of fluctuating wheat prices. Both the farmer and the bread company have a certain risk associated with their businesses.

Can we magically make this risk disappear? Abraka-Dabra! Enter the magic of paper! The farmer and the breadmaking company sign a document declaring that the farmer is going to sell a certain amount of wheat for a certain price on a specific date in the future to the bread company. With this declaration, the farmer knows in advance exactly the price he will get for his wheat and the bread company is no longer at the mercy of wheat prices.

Whoever holds this document has the right to take delivery of wheat from the farmer and, just like that, we have turned a piece of commodity into a representative paper that can be traded. This is called a derivative, a contract that derives its value from a financial asset. In this case, it is wheat. Now one can come up with similar examples of crude oil manufacturers and airline companies, or coffee farmers and coffee shops. They all deal with commodity derivatives. These commercial entities (farmers, bread manufacturers, airline companies) are called hedgers. Let’s look at another important market participant called market-makers.

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Market-Makers

Now that we’ve developed the concept of representing a good or service as paper, let us talk in terms of paper. Have you ever wondered how paper gets its price? The value of anything is literally the amount of money one is willing to pay to take possession of it.  So, if there is no one available or willing to quote a price, then that paper has no value.

Let’s say you are taking a day trip to London from New York. At the London airport, you convert 100 dollars into pounds hoping to shop. However, you end up not buying anything, so you want to convert your pounds back into dollars. You go to the exact same foreign exchange stall to do that, but would you get back your 100 dollars? The answer is a definite NO! You may get something like 98 dollars back, because the stall takes a commission for providing the service of “financial immediacy”.  Financial immediacy refers to the ability to take the other side of the transaction instantly.  If there were no foreign exchange stalls, one has to wait until they find someone who is probably going to New York and wants pounds in exchange for dollars, also exactly 100 dollars, or multiple people that add up to 100 dollars. Such cosmic coincidences are difficult to find. Hence, we need foreign exchange stalls. Such stalls are needed not only for currency exchange but for any paper marketplace we create.( more explanation here) These operators who act as foreign exchange stalls in the market are called market-makers, essentially ensuring you always have a price for the particular paper at all times. And that is how paper gets its price.

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Shoppers Stop: The Marketplace

Now that the marketplace is bustling with Hedgers and Market-Makers, the two essential participants of any market, my primary job is to go out there and shop for risk. Some people call it “trading”.

We have established that derivatives or fancy paper can be used as instruments for de-risking (financial term “hedging”). Indirectly, it means that you are paying a price to de-risk.  In a marketplace, one gets paid for taking a risk and one needs to pay to get rid of a risk. But the market participants have different risks and different assessments of the same risk. My goal is to create models to evaluate a given risk at, and at the same time try to understand how other participants might be evaluating that risk, with the sole intention of being a better shopper. It is an interesting place to be, where you do not spend while shopping, and accumulate money instead.

Conclusion here