Mort & Hank Talk Economics #4

Understanding Contracts, Derivatives, Hedges, and Options
Mort sat outside at a table in the fall sunshine when I walked up with my Americano, no room no cream no sugar.

“Hey, Hank,” he said. “I was just lookin’ at the sports section of the paper. You like the horses, doncha?”

I sipped my coffee tentatively to see how bad it would burn my tongue. “Oh, I get down to the track once in a while if I’ve got $20.00 to waste.”

“Well, Hank, that’s sure the proper attitude to take when you gamble.” Mort sipped at his coffee and went, “Mmmm.” He studied the newspaper for a moment. “Here’s what I was thinkin’ as I looked at this paper: there’s not a whole lot of difference between horse racing and modern day financial investment.”

“Whaddya mean, Mort?”

“It’s like this—when you go down to the track and place a bet on a horse, you are making an investment in that horse for that race, aren’t you? And you get a piece of paper that proves it—you get a ticket that has value, ‘specially if your horse wins.”

“Sure. If I bet $2 I’m buying a share in that horse for that race. And a $50 bet buys me 25 shares in that horse. The more I buy, the more I can win or lose. That the idea?”

“Yep, think about it Hank. You place a 2-dollar bet on a 25 to 1 horse, then you’re holding a ticket, a document, aren’t you? It has a potential 50-dollar value, depending on how many other people bet on the horse and then how the horse performs. But here’s the thing—you could also sell that document, or part of it. It’s conceivable for you to sell it any time up to when the race is almost over. All you have to do is find a buyer, right?”

“Why would I wanna do that, Mort?” I was puzzled. What was he getting at? I took a big swallow of coffee and dripped some on my jeans.

“Just stay with me on this, okay, Hank? Let’s say a guy at the track comes up to you in a hurry and says, ‘Who’s your ticket on, pal?’ and you say, ‘Fast Eddie, number 3 horse in the sixth race—just now parading to the post.’ The guy says, ‘The betting windows are closed, but I want a piece of that horse. I will give you 5 dollars right now for a half interest in your winnings. If the horse loses, you keep the fiver.”

“That sounds good to me, as long as the fiver isn’t counterfeit,” I said. “Where ya going with this, Mort?”

“Here, now, pay attention, Hank. This gets complicated because I’m gonna explain how contracts, hedges, derivatives and options are all the same as placing a bet at the race track. With some subsequent transactions, of course.”

“I’m all ears, Mort. Let’s start with contracts, then.”

“The contract is simple. As soon as you placed your $2 bet at the window, you and the track entered into a contract. Okay so far?”

“Oh, yeah. And I got a document as proof of the contract, right?”

“Yep. Now, as soon as you took the $5 bill from the fella that offered it to you, the two of you created a derivative. That is, the new contract between you and him was derived from your first contract, with the track. Make sense?”

“Sure does.” I thought for a couple minutes. “So where’s the hedge come in?”

“All right. Let’s say the other guy wanted to buy a part of your bet because he bet $20 on an eighty to one horse. Now if his horse wins, he wins $1600. But he wants to cover himself, ‘cuz his horse will probably lose. But he waited too long to make another bet at the window, so he ran around trying to find somebody at the rail with your horse, and there you were. So he gives you a fiver for an option on half your winnings. It’s an option because if your horse doesn’t win, you don’t hafta to pay him back the $5.” Mort stopped and sipped his coffee for a minute.

“Now the guy spent $20 on his original bet and gave $5 to you—so he’s out $25. But if your horse comes in first, you pay him $25, half your winnings, and he‘s even! He hedged his original bet so if his horse loses and yours wins, he breaks even, right? And he made you a $3 winner minimum—no matter what happens in the race. Your $2 bet already earned you $5. You’re like one a those mortgage middlemen who came out a winner regardless of what happened at the end.”

“I like that. What if the favorite wins—the horse that’s going off at four to one—and my horse loses, Mort?”

“Well, Hank, as the saying goes, that’s horse racing, isn’t it? But just like in financial circles, there’s always a number of people willing to bet the long odds—and they lose mosta the time.” Mort swallowed up the last of his coffee and got up to leave. “I gotta go over to the hardware store and get me a box of nails. Gimme a call Tuesday—I’ll be ready to get outta the house before Aggie gives me another honey dew list for the week.”

As I walked home I thought about how hard it is to actually win at the races or the financial markets, and how much luck plays a part in both of ‘em. But I wondered if Mort could explain collateralized debt obligations to me some time. It felt like time for a nap.