Pricing Money: A beginner's guide to money, bonds, futures and swaps

It benefits people who have cash that they want to invest, because they have more opportunities to do it and more visibility over which investments are safe and which ones are risky.

Therefore it benefits society by transferring cash from people who have it now but need it later, to people who will have it later but need it now. Enabling and facilitating actual socially good activity, like manufacturing goods, providing services, etc.

So there are definitely benefits to people outside the finance industry. However, in order to accept any of that you do ultimately need to believe, to some extent, in the market as a means of allocating resources. You don't need to think it's perfect, or that it shouldn't be regulated, or even that it is the fairest system, but you need to accept that it is the system we use. In a totally state-planned economy, finance wouldn't work or even make sense.

Once HFT firms started becoming more widespread, the spread lowered significantly. SPY bid/ask spreads are 1 cent on a share that costs ~$450. Some assets even have sub-penny bid/ask spreads.

The traders that create units of SPY get better spreads on the underlying stocks too, which benefits you as well by reducing asset fees and more accurately representing the NAV by lowering transaction costs. The S&P 500 is made up of 500 stocks, it is much more cost effective to assemble a basket of stocks with 1 cent spreads than 6.25 or 12.5 cent spreads.

Liquidity does the same thing for every market, it increases the speed and accuracy of price discovery and lowers transaction costs.

It allows corn farmers to grow wheat instead, because he is selling it right now and wheat is more profitable right now.

The main reason why it doesn't go astray and make people hungry is because people that isn't involved in any way can go, study the factors that make wheat more profitable to corn, do their predictions of what will be the case at the point of delivery, and if they predict correctly that the price is wrong they can go and adjust it making a lot of money on the process.

What they might be waiting on - imagine you have a business wanting to invest in something - new equipment maybe, or opening a new office. That requires capital expenditure. You might not have the free capital to be able to do that. However, if you can improve your cash position, that might be something which becomes available sooner, allowing you to grow more rapidly.

That requires that you're able to secure finance, which means you need someone to either buy something from you now, or to buy the promise of something for the future. In either case, you now have increased cash at bank, which lets you invest to generate returns (hopefully).

This is deeply rooted in the idea that money you have now is worth more than money you may have in the future.

Most of the financial wizardry you read about in the linked article is related to that aim. It's not always obvious, because a lot of it is higher-order stuff: transactions between financial market participants where payouts are linked to other transactions (or aggregations of transactions) between financial market participants, etc. It can be hard to see the link to the participants I mentioned above. But a lot of it is a means to understanding, and spreading, the risks associated with financing those participants. It is a lot easier to lend people money to finance their wants and needs if you can (a) differentiate between people who will pay you back and people you won't; and (b) share the risk of not being paid back with others.

- Commodities like wheat, barley, cows, coal, electricity and so on

- Money itself, in which case we call this lending and borrowing

- Money for other money, commonly called currency transaction

- Ownership stakes in companies, aka shares

- Contingent claims like options and futures on the above

Say you want to build a factory to make cars. That's going to cost something, and you want to share the risk with the public.

- When you IPO this company, you get a bunch of money from the buyers of your shares. The owners of the shares, why do they bother? They don't just get all the profits of the company like if they owned a restaurant. They don't control the car factory, they leave that to the management, including how much of the profits are paid out. What if they need the money, despite everyone thinking the company has good prospects? Enter the secondary market, what we normally call the stock market. Here you can find other people who want the shares you don't want, and will give you money today for your shares, even if the company hasn't made a dime yet.

- You have plans with the 10B from the IPO, but not right this day. If there were a money market you could gather some interest until the bill for the factory comes. Some other business needs to make payroll with their receivables a couple of weeks later. You just need to match with them somehow.

- When you start selling cars, you find that a lot of people don't have 50K in cash. Not to worry, you hand these people their cars anyway, and you make a financing plan where they pay for the car with money that they owe you. Now you have a bunch of loans from people, but you can't use the IOUs to expand your factory. What do you do? You find someone to forward you some actual cash on the expectation that the car buyer will eventually give you the money for the car. You just need a market to find this person with the opposite need to you.

- You might sell cars in other countries. If your factory is not in that country, your expenses will be mismatched. If only there was someone out there willing to swap all the Euros you got from selling cars in Europe for your Dollars that you use to pay your workers. It happens that there are other companies in America expanding to Europe needing Euros for their local offices, and having only dollar income. How to find them?

So what happens then? Who is going to match all these different interests? The answer is market makers. Basically people who know that there are clients whose interests match. Your basic middle man who stands there when the farmer comes in, buys the grain, and then waits for the restaurant guy to come in, and sells them. That way they don't need to meet at the same time and place, and they don't need to match exactly.

Not matching exactly brings us to contingent claims. If everyone just transacted everything in the exact right quantities, that would be nice for the market maker. He'd just take a spread on everything and sleep comfortably. But that's not what happens and supply and demand change, and prices change. In fact prices can change a lot, and you might need some sort of deal where you can buy or sell something, but only if the price is at some particular level. Or you might want to buy or sell something definitely, but not right now, only at some time in the future. This whole derivative game allows people to move risks around in order to match their changing balance of buyers and sellers.

I haven't even added speculators yet, but that's the start of a "who/why markets" answer.

EDIT. I know people will ask next. What does any of this very nice sounding imaginary world of completely explicable financial needs have to do with arbitrage?

The answer is liquidity aggregation on similar products, and liquidity spreading by interaction of participants.

Let's say there's a market to borrow money for each year in the future, eg 2024, 2025, 2026, and so on. Some guy decides he needs to borrow money for 2025 to build a factory. As a market maker, that's fine, but hey wait a minute. There's nobody I know who wants to lend in 2025. What do I do? I have this guy who wants to lend in 2024 and a guy who wants to lend in 2026. Hey, maybe I can just do all these deals, paying me a spread? My books will be slightly off balance, but don't interest rates basically move up and down together? Let's do it and deal with the mismatch later. So now these related markets are connected. They are sort of one large pool of liquidity, but still their own separate pools since there is still some difference.

This is a loose arbitrage. You're not guaranteed to make money on it, since rates can move the wrong way for you. But this is also the most common arbitrage, the one where you sort-of hedge your book against similar things and hope the imbalance falls out eventually.

Ancient civilizations invented the jubilee (loans should be repaid in 7 years) to prevent speculation on them. But unfortunately, preventing extreme concentration of wealth has fallen out of favour

Think about it this way, actors in financial markets all have various beliefs about the future, and all of these beliefs are on a scale of accurate to inaccurate. Speculation allows these beliefs to be aggregated into a single market price (which btw implies no arbitrage) for various types of contingencies and risks, and the price will rapidly update to reflect updates to reality and thus updates to everyone’s beliefs.

Let's imagine that a commercial farmer, whom we'll call Jeremy plants 100 acres of wheat on a farm. Market values for wheat (and everything else you can farm, from livestock to grains and so on) vary and move constantly, as a function of supply and demand. We saw this in an extreme form with the invasion of the Ukraine, and the droughts in Italy last year.

Now the problem with farming is your timescales are long compared to the movements of values for your product in the market, so you've no real idea as to what what you're planting will be worth by the time the bloody thing has actually grown and you've got it harvested and into barns to be sold. And once the seed is in the ground, you can't exactly just plough it all over and plant something else (not strictly accurate, but you don't want to go down that route).

So now let's fast forward. Jeremy now harvests his wheat, and let's say the price has moved up a lot between planting and harvest. Jeremy is a happy man, who's going to have a bumper time, even if his crop doesn't produce as much per acre as he might like at the minute, because it's not raining enough. Or conditions are perfect, and the price has gone up, and he makes a huge amount and can reinvest. Jeremy is a happy camper.

However, if the price falls, Jeremy is not going to be quite so chipper. As such, Jeremy can move his risk, through the use of a hedge. Let's say Jeremy hunts around to find someone to buy his wheat at the start of the season. He might sign a contract with a flour producer, stating that they will promise to buy x tonnes of his grain at £y per tonne. Jeremy now has a fixed price, which has hedged his risk profile. Now his risk has moved from financial to productive - he has to be able to provide the x tonnes. If he can't produce it all on the farm, he needs to source the difference. On the other hand, if he's a good farmer, and the farm produces well, and he doesn't over-extend his risk on what he's committing to, he now has a fixed price contract for his goods, which isn't going to fluctuate based on time (assuming the contract is honoured - if he's worried about that, Jeremy could then buy insurance on the risk of a default on the contract, but that then gets complex). This is a very good thing, but means if the market prices his wheat vastly higher than he expected, he'll miss out on that upside.

This is called a forward contract. There's other types of contract which can be used to do similar things (futures, derivatives...) but that gets a bit more complex.

Edit: Now get why it is downvoted, but it's fair to note that farmers represent a small (10% from what I gather here) portion of futures, so I don't know how reprensentative they are.

A mining company would sell gold futures under the expectation that they will mine a known quantity of gold. They trade the risk of price fluctuations to match against their known liabilities (e.g. labor or depreciation of equipment costs).

Now replace “gold” with lithium (for electric car batteries) and you can create the greenwashed story that you want to hear.

I get where you're coming from, and there's a lot which is not great in farming, but hedging values isn't one of those areas.

And technically, futures are a more standardized tool than forwards are, hence the talk about futures all the time. [1] For reference, forwards have been used forever, and used for all sorts of commerce. [2]

We take for granted that you can pull out an iPhone and buy your favorite stock in seconds, but for most of history, nobody could even imagine that. That the modern world even exists is because of forwards and futures. The ancient world was able to grow and expand because of forwards.

[0] - https://www.cftc.gov/About/HistoryoftheCFTC/history_precftc....

[1] - https://www.investopedia.com/ask/answers/06/forwardsandfutur...

[2] - https://www.encyclopedia.com/social-sciences/applied-and-soc...

On top of those primary deals, a lot of people pile up making bets on secondary deals. Those are the people going for "hey, a lot more farms are growing rice this year, I bet its price will fall". They are very welcome because they not only stabilize the prices on those markets, but they also provide short-term money to make the deals flow more homogeneously. Without them, making deals on those markets would be a profession by itself (as it was).

Now, there exist people making bets on the results of the bets of the secondary market. That is a different market. At some point it's clear that this becomes toxic, but nobody seems to agree on what point exactly.

> What about the crops they destroy because they would be less profitable?

You mean farmers getting bankrupt? You seem to be misunderstand, because the main reason farmers love the futures market is because it lowers their risks.

> How well will it work if we create unsustainable land that the farmers can no longer grow crops on?

Well, surely if you go and kill everybody, there will be nobody losing money on those markets.

They are far from the only example. Airlines use futures to hedge against fluctuations in fuel prices. Manufacturers use futures to hedge against fluctuations in the price of input materials. International businesses use FX swaps to hedge against currency fluctuations. Borrowers use interest rate swaps to hedge against interest rate rises. Investment funds (including pension funds and sovereign wealth funds) use options to hedge against drastic movements in asset prices.

I don't really understand your other questions. The use of derivatives in agriculture does not, on balance, result in fewer crops being produced. On the contrary, by allowing farmers to protect themselves against various risk, derivatives markets allow farmers to safely invest more money in production, and reduces the risk of farmers going bankrupt (bankrupt farmers don't produce many crops). Food would almost certainly be more scarce and more expensive if farmers did not have access to the financial markets.

Oil, gas, lithium, corn....

Because it was created by them, for that very purpose? Futures Contracts. Chicago Mercantile Exchange. Up until 1971 future contracts were ONLY for agricultural goods.

Other examples are _all_ commodities markets like mining, logging, etc.

Of course public company share futures are inherently abstract, but they serve similar purposes, just not to a particularly similar party, depending on your perspective (of ownership, operation).

>what about the crops they destroy

This has nothing to do with the discussion

They didn't just mentioned, they had an outsider negative take on it.

The best way is to respond with simple examples.

> What about the crops they destroy because they would be less profitable? Does the protection against monetary risk outweigh starving people to death? How well will it work if we create unsustainable land that the farmers can no longer grow crops on?

How does futures trading cause these negatives? If anything, trading reduces these risks. Countries with markets have large bounties as opposed to those that don't.

It is not a zero sum game.

Problems always appear when market participants try to affect reality to increase their odds, like shorting a position and then releasing some ugly news.

At a basic level, obviously thee needs to be someone assuming the price risk from the farmers, and those people will obviously need to be compensated.

So who is on the buy-side? Exclusively supermarkets/distributors, while exclusively farmers sell? I suppose that could work, but I assume it would quickly regress into tight relationships like we have (probably regionally variable) for smaller market's, like most vegetables (vs grain) where as I understand it it's largely a direct relationship with the buyer - you probably still sell a future contract, but it's not via a central market and it is 'farm x will deliver to buyer y', i.e. a pre-order if you will, not really a commodity.

And as others say, price discovery, liquidity. What harm does completely open (no obligation) do? And maybe you eat a lot of potatoes and want to lock in the price today. (Or more seriously maybe you're a big baker, but not big enough to be buying direct from farm, your miller is. So grain price affects you, but ypu can't directly control/choose when to take it. Secondary grain futures allow you to hedge risk of it moving against you. In turn this means lower prices or lower risk of shock price increase to your consumers.)

Loans are useful and necessary because businesses need to buy things before they get paid. It can't all be done using Kickstarter! Farming works this way.

Insurance is useful because you get paid when something bad happens to you. On a day when you're glad that you had insurance, it means someone else lost a bet.

Buying insurance you don't actually need is kind of dumb because you'll lose on average, but people do sometimes win in casinos, too. Selling insurance when you can't afford to lose is risking disaster, but sometimes people get away with that too.

Do farmers prefer that? Yes, the larger the futures market, the price of selling futures will be closer to optimal. If the market is illiquid, farmers often have to sell futures at a lower prices to market makers.

And what would you rather happen? That you were prohibited?

As others have said, your counterparty won’t know who you are: hedge fund; commercial hedger; rando — unknown.

We're already there, brother.

> if you follow the “force is only justified in response to force” principle

Ooh, ooh, do the Paradox of Intolerance next!

I know that some people knew that something was wrong with Wirecard and they short sold the stock.

You mean over-priced?

because if a company is underpriced, they cannot raise capital as easily, since each share they raise would be underpriced, and thus the existing shareholders actually _lose_ value.

An overpriced company is one where raising capital (via equity offering) is worth doing. If a company was under-priced, it would actually make more sense to do buybacks instead.

For instance, apparently the EU is currently considering a regulation that houses must be energy efficient. Getting a current house into compliance would cost on average $50k. That kinda stuff adds up.

So I could decide that I think your house is likely to burn down, so I buy insurance on it.

That's what enables the gambling. If the only people who could buy puts or calls were people who had insurable risks in the underlying; it would be a lot smaller market and less gambling.

financial markets are based on stochastic events which do matter very much, such that paying a broker is worth it. If it's not worth it to somebody, they should not participate, but in that sense they shouldn't participate in casinos either.

There are people advocating for “public banking”: https://publicbankinginstitute.org/

and credit unions also exist, which are nonprofits

The governments, on the other hand, don’t go bankrupt, so when they price the risks too low, the public will be forced to bail it out anyway, either through taxes or through inflation.

This very much is real and serious problem: consider, for example, National Flood Insurance Program, which is exactly the kind of publicly controlled insurance you asked for. It was $25B in the red by August 2017, and would have gone bankrupt if it was private. However, you (and other taxpayers) bailed it out in October 2017 to the tune of $16B. It continues to accumulate debt, and is more than $20B in debt right now. You will bail it out again, and keep subsidizing people who build their houses on flood prone areas, knowing that you will pay for their losses.

(Likewise with credit allowing people to finance ventures that they would otherwise be unable to)

For example, having fire sprinklers greatly reduces the risks from fire. However even the reduced risks are still too great for your typical homeowner, so therefore those risks are distributed (and the reduced risks are reflected in lower premiums for the homeowner).

Visit a part of the world where most people do not have access to home loans, health insurance etc. and you will not have to ask how mere redistribution of risk and capital adds to productivity ever again. (I happen to have been born one such part of the world.)

So, effectively [1], with insurance everyone can build a house nearly twice as big as without. That strikes me as productive.

[1] if the probability of a fire is sufficiently small

So without all those games, what would be substantially different?

Why? Now we have a trustless, decentralized, tech solution, why do you still want the "guys with guns" solution?

Let me offer a (partial) defense of crypto if I can:

Broadly, crypto is divided into crypto-currencies and applications.

Let's tackled currencies first, some of which some are reputable and some of which are grifts, but which viewed in their most favorable light attempt to be a form of currency or asset that is decentralized. This means that no single party may unilateraly devalue them, or restrict their trade in any way.

(No I understand if that doesn't excite a lot of people, but this is clearly valued by some people!)

As may be obvious, crypto-currencies are too volatile to serve as actual "currencies", so they are at best "assets". But it is possible to use these assets as collateral for the minting of stablecoins. I'm not sure this is quite risk transfer, but it essentially relies on the willingness of some to hold speculative assets to enable the creation of a stable assets.

In turn, these assets are not typically useless — they hold value because there is demand for them to pay for transaction costs on blockchain.

Blockchains themselves are not useless. We may not think much of the difficulties of transferring money, but it is a real challenge in LARGE swaths of the world, where people are unbanked or live under tyrannical governments. I would argue that even in the west, the need becomes is becoming more pressing (Trudeau freezing trucker supporter bank accounts, banks imposing tons of restriction on cash withdrawals and "large" bank transfers).

Beyond transfer, they also serve to run decentralized applications. People are quick to dismiss those, and true it doesn't enable to do anything dazzingly new. It simply enables you to do things you could already do, but in a way where no single party (or even colluding parties) can shut it down. This may seem silly, but I think the world would truly be better if we for instance had a YouTube where copyright trolls couldn't strike down / demonetize legimate content.

Applications then. In reality, we're still far from decentralized YouTube (but we will get there). Most applications today are financial. And I think they're quite useful. The financial infrastructure being built is genuinely novel and useful.

The problem is that it is navel-gazing at the moment: that infrastructure is mostly used to perform financial operations on crypto tokens themselves. But there is no reason that they couldn't be used for other assets.

In fact this is starting to happen: you can now invest in real estate and US treasuries on the blockchain. We're still a way from mainstream adoption, and that has mostly to do with legal uncertainties that prevents established players from diving in (though many of them are experimenting). There are also entrenched interests there, it must be said.

So if anything else, crypto helps build a better financial infrastructure.

It's somewhat ridiculous that when you buy some stock, the trade is routed through three intermediaries and is only really settled 7 days later. The abstraction on top of this is actually leaky, with each intermediary coming with some risk and some agency to throw a wrench in the works. As in fact happened between Robinhood and its clearinghouse (or some such intermediary) during the GameStop frenzy.

Where do you draw the line between (useful) arbitrage and "pure speculation"?

Much of what is commonly known as speculation is actually an important mechanism for price quality or liquidity.

Obviously there are limits, and there are ample opportunities for making a one-sided profit without regulations, but people often seem to miss the value that arbitrageurs tangibly provide to them: Being able to exchange foreign currency at very tight spreads almost 24/7; being able to buy and sell even not commonly traded stocks etc. are often a function of that.

However, while the simple discounting formulas described (likely, haven't read other than the list of contents) in the book were at the time actually used more or less as-is to value instruments in the derivative markets, nowadays they are seldomly used on their own. Two major developments there are multi curve discounting taking collateralization into account and different valuation adjustments, collectively known as XVAs.

That is not to say you do not need to understand the beginner basics, vice versa, iys just that nowadays there is much more nuance in actual valuation.

Edit: to add, I'm not sure if its useful to study these nuances in detail, unless you are going to actually work on the markets. In the big picture their details are likely not worth it, but of course it is good to try to understand why these developments have been needed/wanted by market participants.

they _produced_ more risk (by holding long maturity bonds that lose value as interest rate grows). This risk was not something that is inherent - they could've chosen not to do that with the large deposits from the pandemic money growth.

There's noone who can be the optimal holder of the risk that is produced this way, because there's no value on the other end - SVB is taking the full value already (the interest payments on said long bonds).

If someone were to hold that risk, SVB would have to pay out premiums that would surpass the interest income they receive.

The alternative is for society (aka, the central bank) to hold that risk. But this just means socializing the losses but privatizing the gains - something i'm very much against.

In the end, SVB was the optimal holder of the risk (that they produced for themselves). And they can't actually hold that risk - thus their failure.

China isn't really centrally planned. They call themselves that so that the government and previous communist ideology can avoid losing face, but anyone who's visited there or done business with Chinese companies will say that it's intensely capitalistic, just with the potential for random state interference at a whim. I suspect the same is true for Vietnam, but know less about the country.

Information asymmetry issues are exactly why certain types of financial transactions are illegal - that's why we have things like SEC disclosure and insider trading laws.

No it doesn't. He'd need to profit from that effeciency first. Idle time is not reported in GDP