October 25, 2017

 Tulip mania and bubbles in general. Tulip mania was about future prices of tulips. The Dutch, by the
early 1600’s had basically your full scale modern financial market including the instruments. One class
of instruments is derivatives which can be broken down further into futures contracts. These came into
existence in the early 1600’s.
 A derivative is a financial instrument whose price depends on the price of another financial instrument
or asset. Forward contacts turn into futures contracts.
o Think about the wool in England. They weren’t just buying the wool for that year, they were
sometimes buying it for the next twelve years
 Forward contact: arrangement between a buyer and a seller, specifying that the actual trade will take
place at some point in the future at some price. Specifies that at a certain point in the future, this is the
price that will be paid for this amount of the good at a certain point in the future.
o Doesn’t eliminate uncertainty all together but it does reduce it.
o Monasteries were more certain about the amount they would get for their wool but you still don’t
know if it will be a good or bad year for their crops so it reduces uncertainty but does not get rid
of it.
o Someone who sells their crop forward is not speculating. The guy that doesn’t enter into a
forward contract is not speculating. Contract tells you how much you will be getting next year at
a price per bushel which means you can take it to your banker. Entering into this deal is very
common in agriculture.
o Suppose your growing wheat and you enter into a futures contact but in six months, the price of
wheat doubles on the spot market. You only know the spot price of the wheat when its harvest
time. This could also go the other way where the spot price tanks but you are guaranteed more by
the contract. In advance of that, neither of you know which way the market is going to go. What
you tend to get is farmers tending to sell their crop forward to dealers who aren’t interested in the
wheat but rather taking the wheat and selling it immediately on the market.
o Keynes is a good example of using spot markets to buy wheat. Keynes said that when he was
buying one of the contacts was taking the risk off of the farmers. The farmer who is selling the
crop forward is more risk adverse as opposed to someone who isn’t using forward contracts. He
saw forward contracts as a way for financial risk to be transferred for a more risk adverse
individual to a less risk adverse person. It’s almost a form of crop insurance.
o Suppose that you now have a contract that says you will be able to buy wheat at $100/bushel.
Reports come in that it will be a bad year for the wheat crop. As harvest approaches, the weather
reports say that the wheat is going to be small. This means that the spot price is going to rise to
$200. You have a contract that says you can buy the wheat at $100 but you have nowhere to
store the wheat while you are looking for someone to sell it to. There’s going to be someone who
would be willing to buy the contract from you which means you never have to take possession of
the wheat so you don’t have to store it and take it to market so you could sell the contract at
$150/bushel. The contact itself has become a valuable asset as it says you could make an
immediate profit of $100/bushel. There will be people out there that would pay you for your
contact -- $150/bushel. If they offer you the right price, you take the contract. The profit is going
to be split between you and the person you sell the contract to. As soon as you sell the forward
contract is becomes a derivative because it is a forward contract being sold on the futures market.
o Look at it the other way – if the crops are doing well and spot price is $50, no one is going to
want to buy the contract. The price that you would get for the contract is worth $0. Price that you
are able to get depends on the price of the underlying asset.
o If you are in futures contracts, there is a commitment on your end that locks you in to paying for
the wheat. If you don’t want to be locked in you move to the next stage.
 Call options: gives you the right to by the contract but does not commit you to buying it. If spot price is
below $100, you are not going to exercise your option, you are going to let it expire because why would
you buy at $100 when you could get it for $50 on the spot market. Having a call option does not
guarantee the seller money. It’s still a derivative. There is no commitment.
 Put option: gives you the right to sell at a particular price.
 When you get into options, there is more of a range of whether the option will be exercised or not which
means there is still uncertainty as you don’t know if someone will exercise their option.
 Spot market: standard, ordinary market. Hand over cash today, you get the commodity today. Exchange
is being completed right now.
 An option is a derivative because the price depends on another asset. Once you work your way through
the details, you will find that the price is linked to another asset.
 Short-selling: gets attention during financial crisis. The Dutch ban short-selling every ten years or so. It
is selling a stock that you don’t own. The way it works is suppose that the price of a share is $100/share.
Suppose that you think the price is going to drop to $80. Your view of this stock is more pessimistic as
others think it may drop to $95. If you could sell that share for $90, if the price actually drops to $80,
you are ahead. If you don’t own any shares in a company, what you do is borrow a shares certificate
from your broker who has the shares. You take the share and sell it to someone who would buy it for
$90. You borrowed the share – you have to sell it back to your broker. If you sell it to someone for $90,
they are now the certificate owner. The equivalent certificate will have to be bought on the market.
Within the next month or so, you think it will drop to $80. At the end of the month, if the share price
actually drops to $80, you go and buy the share to sell back to your broker.
o Suppose that the other guy is right, one that bought it for $90 but spot price is $95. You are going
to have to take the $90 and buy the share on the market for $95 to get a share to give back to
your broker. It’s a matter of you guessing that you can beat the market on the trade.
o The market is only efficient if a significant number of people are actually gathering information
about the shares and using that information to buy and sell. Markets are not really efficient. The
market is an entity itself. It is only efficient if the different groups within the market have
differing expertise. The efficient market price is the price when people have put time and effort
into studying the market and using the information to buy the shares. If there’s no one in the
market that has expertise, then the market is not going to be efficient.
o Efficient means that all of the information out there about the sectors that are traded on the
market makes its way into stock prices. This only happens when there is specialized information
on the market. When we say that you cannot beat the market, that’s because you will be lagging
behind the people that have devoted resources to becoming an expert.
o A market is efficient if it lets people buy and sell to people who have devoted the resources to
specializing.
o An index fund represents a market. It is a mini market. If you aren’t a specialist, you are better
off being in index funds which typically do better for those that aren’t specialist. The more
people that are in index funds, the less efficient the market because there is less people trying to
specialize. Saying that the market is efficient is a specialized statement.
 In terms of early financial markets, if you think about short-selling, you are selling something you don’t
own which has an unethical ring to it. Dutch tried on a regular basis to ban short-selling. Difficult
because you have to define short-selling in a way that you can ban it. Dutch banned things that you don’t
own but their economy relied a lot on agriculture. Can you enter into a forward contract for wheat that
you don’t own?
o What they are doing is entering into a contract for something they do not own which fits into
their ban which buggers up agriculture as farmers can no longer sell their crops forward. Selling
crops forward was a way for the Dutch to stabilize its income into the future. If it knew what
price it would get for its crop in the future, then they could get a loan from the bank to produce
the stuff. If you wipe out the futures contracts, you wipe out the collateral that the farmers used
to keep their business going.
 o Forward contracts are essential to the agriculture market. They are associated with greater price
stability over the long-run.
o Onions have never had a futures market. The price of onions is one of the most unstable in the
US. Futures trading stabilizes the price which is generally good for the producer.
o In general, if you look at commodities, trading in futures contracts is stabilizing.
 Tulip mania (1636-1637). Tulips are not native to the Netherlands, they were native to Turkey so they
were a luxury import as there were not many of them and they had to be shipped in. If you had tulips, it
was a sign that you were relatively wealthy. Tulips were stuck by the mosaic virus so the tulips were not
just a solid colour. When it is struck by the virus, the colour shatters so there were colour patterns on the
bulb. They were dramatic looking flowers when they were struck. Not every tulip was dramatic, just the
ones that were struck by the virus – these ones had a much higher price. When a tulip is struck by the
virus, the seeds are not effective. The tulips which grow from the seeds will be a standard tulip. It was
possible to propagate tulips with the pattern. When it was stuck by the virus, it weakened the tulip. You
could not get as many daughters from the mother tulip which was struck by the virus. If you were able to
get a second generation, they were smaller and they could not produce a third generation. This means
supply was restricted because you could not go into a business of producing the cool tulips year after
year.
o Supply curve will be very restricted – way over to the left. Demand curve – people were willing
to pay a high price for the shattered tulips. Traditionally, tulips were sold on the spot market as
you waited until the tulips were in bloom so you could see what you were buying. Trouble with
selling the mosaic ones on the spot market occurs because everyone can see it. So people started
buying large quantities of tulips and buying them forward because neither you or the grower
know if there will be any shattered tulips or not. There was much more of a speculative element
when people were buying them in bulk and forward. As the price of shattered bulbs went up,
people were more willing to buy futures contracts so markets in tulip derivatives occurred.
Traded in taverns and engage in trades. In England, it was coffee houses. Beer was safer to drink
than water during this time period.
o Insurance contracts allowed people to spread risk.
o Speculative bubble in tulip futures in the Netherlands. Specialized tulip dealers did not take part.
It was a short episode. November 12, 1636 to peak in February 3 which drops off all the way to
May 1st. Feb 3, there was an options in futures contracts and there was a meeting to option off
futures contracts and everyone was a seller and no one was buying so the price that day in that
particular market is $0 as the market collapsed. Comparing probability of getting a shattered bulb
to the price of the price of the futures contracts to the spot price for a shattered bulb. The price of
the futures contract was drive up so high relative to the shattered bulbs, people realized that the
prices weren’t worth it because they realized that they would not make a profit. Word got around
and the bubble burst. By May 1, your back at the Nov 12 price. This whole episode happened
during the winter when there were no physical bulbs to be seen.
o Why do they have this representation of the great bubble? We have very little information from
the period of Nov 12 to May 1. Such a small market that many weren’t interested. All we have is
a few auction prices that were recorded. Most of the information that people relied on came from
Catholics that were written after the fact. They thought that any form of speculation was evil
saying you could be ruined if you engaged in speculation which gave many the idea that who
whole lot of people must have lost a lot of money. Greatly overrated as a bubble.
o Two other bubbles around the same time. Mississippi bubble and Sea bubble.