Thanks Jia Jun for the interesting posts. Btw, can the viewing area of this blog be extended? Only like half the page is utilised. Also can the fonts be bigger? Thanks.
Mr Tan
Mr Tan
William
6:26 PM
Wednesday, April 30, 20086:26 PM
The Use of Contingent Contracts
Markets, when they operate efficiently, can provide a great deal of information on the beliefs of the people who participate in that market. Prices, and changes in prices, convey a lot of information on what traders think is currently happening and what they believe will happen in the future. To see how this works, we'll look the at the pricing of a simple asset known as a "contingent contract".
A contingent contract in finance generally refers to a contract in which the amount of money one agent pays to another in the future will differ depending on the realization of some future event. A simple example of a contingent contract would be a contract which gave the bearer of that contract nothing if it rains next Thursday but one dollar if it does not rain. These kinds of contracts are more common than you might believe at first glance.
A farmer's crop may depend rather heavily or whether or not it rains. If it does rain, he has a healthy crop which he can sell on the market. If it does not rain the crop will be ruined and the farmer will having nothing. The farmer can minimize this risk by buying many of these contingent contracts. If the farmer buys the contingent contracts and it does not rain, his crop will be worthless but he will get $1 for each contract he holds. Of course, if it does rain his crop will be valuable, but he'll also have paid money for contingent contracts which are now worthless. If the farmer buys enough of the contracts, he can insure that he receives the same amount of money no matter what the weather does. This sort of risk-minimization is known as hedging and is used quite frequently, particularly in finance.
From an informational standpoint, contingent contracts (also known as "contingent claims") are very nice because they tell how likely the market thinks some event will happen. Suppose our $1 if it doesn't rain and $0 if it does rain contingent contract is selling for 70 cents. This implies that the market believes that there is a 70% chance it will not rain and a 30% chance that it will. This is because we believe that 70% of the time the contingent contract will be worth $1 and 30% of the time the contingent contract will be worth nothing. So on average, we'd expect the contingent contract to be worth 70 cents. Now suppose a number of people in the "rain" market got a new piece of information (say satellite photos) and now believed that the chance of it not raining on Thursday is now 90%. This would cause them to value the contract at 90 cents, but the price is currently at 70 cents. So they would buy these contingent contracts as they'd expect to make 20 cents on average. The increase in demand for the contracts will cause the price to rise and if enough people in the market believed the chance of a lack of precipitation was 90%, we'd expect to see the value of the contingent contract to rise to 90 cents.
To see a good example of price changes and contingent contracts, we'll look at the world of baseball.
The Baseball All-Star Game and Contingent Contracts
While often used for serious purposes, contingent contracts can also be used as a form of entertainment. An Irish based website named TradeSports.com allows people to gamble on sports events using contingent contracts as a basis. You can buy contracts on all sorts of events, from who will win tomorrow's Blue Jays vs. Red Sox game to who will win the next Superbowl. The contingent contracts work in a similar fashion as the one in the previous section. If you buy a $1 Blue Jay contingent contract and the Blue Jays win you get $1 but if they do not win the contract pays nothing. At the time of writing, the last trade price of the Tiger Woods contract for the 2003 British Open was 22 cents, meaning that the market believes that Tiger has a 22% chance of winning the tournament.
The 2003 Major League Baseball All-Star Game was expected to be a match between two equally capable teams.
Before the game begin, the price of the American League contract had been hovering around 50 cents, so the market believed that the American League seemed equally as likely to win the game as the National League team. When the game began, the price was still around 50 cents, as investors had not learned any information which would cause them to change their beliefs about the outcome of the game. After an uneventful inning and a half, the American League started to make some noise. With two out in the inning, American Leaguer Edgar Martinez was hit by a pitch, then teammate Hideki Matsui hit a single, putting 2 men on base for Troy Glaus. Although there were two out, it looked like the American side had a chance to score some runs, which would obviously improve their chances of winning the game. During the inning the price of the American League contract rose from 48 cents to 55 cents as investors felt that having 2 men on base and 2 outs in a tie game in the 2nd inning raised the American League's chances to win to 55%. Glaus struck out swinging and the price of the contingent contract fell almost immediately to 50 cents. A piece of new information (the Glaus strikeout) caused the price of the contingent contract to fall 10%, despite the fact that the game was nowhere near completion.
The National League side was unable to do much against American league pitcher Roger Clemens, but a single by Ichiro Suzuki, a wild pitch by National League pitcher Randy Wolf, and a single by Carlos Delgado put the American League up 1-0 and the price of the contingent contract up to around 65 cents. With Delgado on first and 2 outs, Alex Rodriguez grounded out to third base, and the price of the contingent contract slid to 60 cents.
Everything fell apart for the American League during the 5th inning. The first National League batter of the inning got to first base on a walk, and the second, Todd Helton, made the score 2-0 on a homerun. After the third batter of the inning, Scott Rolen, hit a single, the price of the contingent contract was down to 33 cents. The next two batters for the National League got out sending the price up to 38 cents, but a double by Andrew Jones and a single by Albert Pujols sent the score to 5-1 and the price to around 16 cents. The price did not seem to recover any after Barry Bonds struck out.
By the bottom of the 6th inning, the market believed that the American Leauge only had a 10% chance of winning. A two run homerun by Garret Anderson caused the price to double to twenty cents, but the price hike was short lived as a 7th inning homerun by Andruw Jones for the National League sent the price back down to 10 cents. Although the score was only 6-3, Fox, the network carrying the game, said that the American league did not stand much of a chance of winning since the National League's closers were unbeatable. Even a homerun by Jason Giambi sending the score to 6-4 only moved up the contingent contract price to 15 cents.
How The All-Star Game Changed Prices
Things were looking pretty dire for the American League as they had to face Eric Gagne in the 8th inning and John Smoltz in the 9th inning while they had a 2 run deficit. With one out in the 8th, Garret Anderson hit a double, sending the contingent contract price up to 22 cents. Earlier in the game a hit that did not score a run would not have had much effect on the price, but since it was late in the game and the score was close, investors knew that even a small change in circumstances could change the outcome. As a result, the price changes became more dramatic near the end of the game. A ground-out by Carl Everett sent the price down to 19 cents, but a run-scoring double by Vernon Wells sent the game to 6-5, and caused the price to rise to 52 cents. Although the American League was still losing, investors believed that with a runner on 2nd and 2 outs, they were slightly more likely to win the game than the National League side.
Hank Blalock, the next hitter, hit a towering homerun which caused the American league to take a 7-6 lead very late in the game, and caused the price to escalate all the way to 85 cents. In a matter of 10 minutes, the value of the contingent contract had increased 8-fold, and investors who bought at 10 cents suddenly had a very valuable asset. With the 8th inning over, the American League needed just three more outs to win the game. They would get those three outs and not score any runs. During the 9th inning the price of the contract rose from 85 cents to 1 dollar, the price it eventually paid to the holder.
The effect of the All-Star game was seen in other contracts. A day before the All-Star game, the contract which paid $1 if the Yankees won the World Series was selling for 20 cents. The league that won the All-Star Game would win home field advantage in the World Series. Teams win more often than not when they have the homefield advantage, so the outcome of the game was important. The Yankees, seen as the most likely American League team to make it to the World Series, were seen as slightly more likely to win the World Series by investors. A contract which pays $1 if the Yankees win the series was selling for 20 cents the day before the All-Star Game, but had climed in price to 21 cents the day after. Investors took their new knowledge about homefield advantage in the World Series, and slightly upgraded the value of all the contingent contracts for American League teams and slightly downgraded the value of the National League teams.
Next we'll look at some more practical applications of how information causes prices changes and how we can extract information from price changes.
Not Just Contingent Contracts
The effect of new information and changed beliefs are apparent in contingent contracts, but they also show up in the price of any asset. In quite a few articles, such as Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut I discuss the link between the differences in the interest rates in two countries and the exchange rate. In short, if the interest rate in country A falls and the rate in country B stays the same, we'd expect to see A's currency become less valuable relative to B's, all else being equal. As an investor, if I know that country A will be lowering its interest rate, I would expect that the A's currency would soon become less valuable than B's. So I'd do well for myself if I sold A's currencies and bought B's on the open market.
Of course, if everyone believes the interest rate drop is coming, they'll sell currency A and buy currency B, until the price of currency A falls to the level at which it would be after the interest rate drop was announced. So if we all expect that the central bank of country A will drop rates by 25 points, then they do, we should not expect to see any changes in the exchange rate at the time of the annoucement. However, if they announce they're not going to cause the interest rate to decline, we should see currency A rise back up to it's former value, despite the fact that nothing tangible has changed. To the naive observer, it may even look like the drop in the exchange rate is causing the central bank of country A to lower its interest rate a few days later, an idea I look at in length in "Do changes in stock prices cause recessions?"
By looking closely at these price changes we can also learn a great deal about what the market expects. Suppose we know that Alan Greenspan is going to make an annoucement next Tuesday. This situation is not unusual, as it is usually known weeks in advance when the Federal Reserve Chairman is going to give a speech or make an annoucement. We can tell what investors' best predictions on the content of the annoucement is going to be by looking at exchange rates. If the exchange rate drops or rises, we should expect to see a change in the interest rate, while if the exchange rate stays the same, it's likely that no change will be made. Of course this is an oversimplification as annoucements by the Federal Reserve influence all sorts of variables, not just the exchange rate. However it is apparent that if we watch how prices change we can determine what the investment community feels will happen in the future.
In a country with a free-market economy, prices are not set by a central planning bureau: they are set by supply and demand. Because supply and demand reflect the information and beliefs of investors in those markets, they contain the sum total of all the information and beliefs the investors have in a market. While we might not have the power to change people's actions or beliefs, the price mechanism gives us the power to observe those actions and beliefs. Prices are far more than just what you have to pay for something, they are also a source of great knowledge if intepreted correctly.
Cheers,
Jiajun
Markets, when they operate efficiently, can provide a great deal of information on the beliefs of the people who participate in that market. Prices, and changes in prices, convey a lot of information on what traders think is currently happening and what they believe will happen in the future. To see how this works, we'll look the at the pricing of a simple asset known as a "contingent contract".
A contingent contract in finance generally refers to a contract in which the amount of money one agent pays to another in the future will differ depending on the realization of some future event. A simple example of a contingent contract would be a contract which gave the bearer of that contract nothing if it rains next Thursday but one dollar if it does not rain. These kinds of contracts are more common than you might believe at first glance.
A farmer's crop may depend rather heavily or whether or not it rains. If it does rain, he has a healthy crop which he can sell on the market. If it does not rain the crop will be ruined and the farmer will having nothing. The farmer can minimize this risk by buying many of these contingent contracts. If the farmer buys the contingent contracts and it does not rain, his crop will be worthless but he will get $1 for each contract he holds. Of course, if it does rain his crop will be valuable, but he'll also have paid money for contingent contracts which are now worthless. If the farmer buys enough of the contracts, he can insure that he receives the same amount of money no matter what the weather does. This sort of risk-minimization is known as hedging and is used quite frequently, particularly in finance.
From an informational standpoint, contingent contracts (also known as "contingent claims") are very nice because they tell how likely the market thinks some event will happen. Suppose our $1 if it doesn't rain and $0 if it does rain contingent contract is selling for 70 cents. This implies that the market believes that there is a 70% chance it will not rain and a 30% chance that it will. This is because we believe that 70% of the time the contingent contract will be worth $1 and 30% of the time the contingent contract will be worth nothing. So on average, we'd expect the contingent contract to be worth 70 cents. Now suppose a number of people in the "rain" market got a new piece of information (say satellite photos) and now believed that the chance of it not raining on Thursday is now 90%. This would cause them to value the contract at 90 cents, but the price is currently at 70 cents. So they would buy these contingent contracts as they'd expect to make 20 cents on average. The increase in demand for the contracts will cause the price to rise and if enough people in the market believed the chance of a lack of precipitation was 90%, we'd expect to see the value of the contingent contract to rise to 90 cents.
To see a good example of price changes and contingent contracts, we'll look at the world of baseball.
The Baseball All-Star Game and Contingent Contracts
While often used for serious purposes, contingent contracts can also be used as a form of entertainment. An Irish based website named TradeSports.com allows people to gamble on sports events using contingent contracts as a basis. You can buy contracts on all sorts of events, from who will win tomorrow's Blue Jays vs. Red Sox game to who will win the next Superbowl. The contingent contracts work in a similar fashion as the one in the previous section. If you buy a $1 Blue Jay contingent contract and the Blue Jays win you get $1 but if they do not win the contract pays nothing. At the time of writing, the last trade price of the Tiger Woods contract for the 2003 British Open was 22 cents, meaning that the market believes that Tiger has a 22% chance of winning the tournament.
The 2003 Major League Baseball All-Star Game was expected to be a match between two equally capable teams.
Before the game begin, the price of the American League contract had been hovering around 50 cents, so the market believed that the American League seemed equally as likely to win the game as the National League team. When the game began, the price was still around 50 cents, as investors had not learned any information which would cause them to change their beliefs about the outcome of the game. After an uneventful inning and a half, the American League started to make some noise. With two out in the inning, American Leaguer Edgar Martinez was hit by a pitch, then teammate Hideki Matsui hit a single, putting 2 men on base for Troy Glaus. Although there were two out, it looked like the American side had a chance to score some runs, which would obviously improve their chances of winning the game. During the inning the price of the American League contract rose from 48 cents to 55 cents as investors felt that having 2 men on base and 2 outs in a tie game in the 2nd inning raised the American League's chances to win to 55%. Glaus struck out swinging and the price of the contingent contract fell almost immediately to 50 cents. A piece of new information (the Glaus strikeout) caused the price of the contingent contract to fall 10%, despite the fact that the game was nowhere near completion.
The National League side was unable to do much against American league pitcher Roger Clemens, but a single by Ichiro Suzuki, a wild pitch by National League pitcher Randy Wolf, and a single by Carlos Delgado put the American League up 1-0 and the price of the contingent contract up to around 65 cents. With Delgado on first and 2 outs, Alex Rodriguez grounded out to third base, and the price of the contingent contract slid to 60 cents.
Everything fell apart for the American League during the 5th inning. The first National League batter of the inning got to first base on a walk, and the second, Todd Helton, made the score 2-0 on a homerun. After the third batter of the inning, Scott Rolen, hit a single, the price of the contingent contract was down to 33 cents. The next two batters for the National League got out sending the price up to 38 cents, but a double by Andrew Jones and a single by Albert Pujols sent the score to 5-1 and the price to around 16 cents. The price did not seem to recover any after Barry Bonds struck out.
By the bottom of the 6th inning, the market believed that the American Leauge only had a 10% chance of winning. A two run homerun by Garret Anderson caused the price to double to twenty cents, but the price hike was short lived as a 7th inning homerun by Andruw Jones for the National League sent the price back down to 10 cents. Although the score was only 6-3, Fox, the network carrying the game, said that the American league did not stand much of a chance of winning since the National League's closers were unbeatable. Even a homerun by Jason Giambi sending the score to 6-4 only moved up the contingent contract price to 15 cents.
How The All-Star Game Changed Prices
Things were looking pretty dire for the American League as they had to face Eric Gagne in the 8th inning and John Smoltz in the 9th inning while they had a 2 run deficit. With one out in the 8th, Garret Anderson hit a double, sending the contingent contract price up to 22 cents. Earlier in the game a hit that did not score a run would not have had much effect on the price, but since it was late in the game and the score was close, investors knew that even a small change in circumstances could change the outcome. As a result, the price changes became more dramatic near the end of the game. A ground-out by Carl Everett sent the price down to 19 cents, but a run-scoring double by Vernon Wells sent the game to 6-5, and caused the price to rise to 52 cents. Although the American League was still losing, investors believed that with a runner on 2nd and 2 outs, they were slightly more likely to win the game than the National League side.
Hank Blalock, the next hitter, hit a towering homerun which caused the American league to take a 7-6 lead very late in the game, and caused the price to escalate all the way to 85 cents. In a matter of 10 minutes, the value of the contingent contract had increased 8-fold, and investors who bought at 10 cents suddenly had a very valuable asset. With the 8th inning over, the American League needed just three more outs to win the game. They would get those three outs and not score any runs. During the 9th inning the price of the contract rose from 85 cents to 1 dollar, the price it eventually paid to the holder.
The effect of the All-Star game was seen in other contracts. A day before the All-Star game, the contract which paid $1 if the Yankees won the World Series was selling for 20 cents. The league that won the All-Star Game would win home field advantage in the World Series. Teams win more often than not when they have the homefield advantage, so the outcome of the game was important. The Yankees, seen as the most likely American League team to make it to the World Series, were seen as slightly more likely to win the World Series by investors. A contract which pays $1 if the Yankees win the series was selling for 20 cents the day before the All-Star Game, but had climed in price to 21 cents the day after. Investors took their new knowledge about homefield advantage in the World Series, and slightly upgraded the value of all the contingent contracts for American League teams and slightly downgraded the value of the National League teams.
Next we'll look at some more practical applications of how information causes prices changes and how we can extract information from price changes.
Not Just Contingent Contracts
The effect of new information and changed beliefs are apparent in contingent contracts, but they also show up in the price of any asset. In quite a few articles, such as Canadian Dollar Slides Following Surprise Bank of Canada Interest Rate Cut I discuss the link between the differences in the interest rates in two countries and the exchange rate. In short, if the interest rate in country A falls and the rate in country B stays the same, we'd expect to see A's currency become less valuable relative to B's, all else being equal. As an investor, if I know that country A will be lowering its interest rate, I would expect that the A's currency would soon become less valuable than B's. So I'd do well for myself if I sold A's currencies and bought B's on the open market.
Of course, if everyone believes the interest rate drop is coming, they'll sell currency A and buy currency B, until the price of currency A falls to the level at which it would be after the interest rate drop was announced. So if we all expect that the central bank of country A will drop rates by 25 points, then they do, we should not expect to see any changes in the exchange rate at the time of the annoucement. However, if they announce they're not going to cause the interest rate to decline, we should see currency A rise back up to it's former value, despite the fact that nothing tangible has changed. To the naive observer, it may even look like the drop in the exchange rate is causing the central bank of country A to lower its interest rate a few days later, an idea I look at in length in "Do changes in stock prices cause recessions?"
By looking closely at these price changes we can also learn a great deal about what the market expects. Suppose we know that Alan Greenspan is going to make an annoucement next Tuesday. This situation is not unusual, as it is usually known weeks in advance when the Federal Reserve Chairman is going to give a speech or make an annoucement. We can tell what investors' best predictions on the content of the annoucement is going to be by looking at exchange rates. If the exchange rate drops or rises, we should expect to see a change in the interest rate, while if the exchange rate stays the same, it's likely that no change will be made. Of course this is an oversimplification as annoucements by the Federal Reserve influence all sorts of variables, not just the exchange rate. However it is apparent that if we watch how prices change we can determine what the investment community feels will happen in the future.
In a country with a free-market economy, prices are not set by a central planning bureau: they are set by supply and demand. Because supply and demand reflect the information and beliefs of investors in those markets, they contain the sum total of all the information and beliefs the investors have in a market. While we might not have the power to change people's actions or beliefs, the price mechanism gives us the power to observe those actions and beliefs. Prices are far more than just what you have to pay for something, they are also a source of great knowledge if intepreted correctly.
Cheers,
Jiajun
Edison Cheam
1:25 AM
Tuesday, April 29, 20081:25 AM
From Hannah Rasmussen
The Insider Trading Scandal - What did Martha Do?
Martha Stewart has been in the news for several months because the U.S. Securities and Exchange Commission believes that Martha Stewart was told by her friend Sam Waksal that his company ImClone’s cancer drug had been rejected by the Food and Drug Administration before this information was made public. This rejection was a huge blow to his company and the price of its stock went down dramatically. However, Martha Stewart wasn’t financially hurt because she had her broker sell her 4000 shares before this news was made public. If this is true, and it should be noted it hasn’t been proven yet, then Martha Stewart is guilty of insider trading.
What Is Insider Trading?
When most people hear the term “insider trading” they think of the illegal version. However, the term “insider trading” can also mean the perfectly legal buying and selling of stock by a company’s corporate insiders.
Insider trading is legal when these corporate insiders trade stock of their own company and report these trades to the U.S. Securities and Exchange Commission (SEC). That way the insider trading is not kept a secret and anyone can find out a corporate insider’s opinion of his or her company.
Insider trading is only illegal when a person bases their trade of stocks in a public company on information that the public does not know. It is illegal to trade your own stock in a company based on this information but it is also illegal to give someone that information, a tip, so they can trade their stock.
Why Is Insider Trading Illegal?
The SEC’s job is to make sure that all investors are making decisions based on the same information. Insider trading can be illegal because it destroys this level playing field.
Punishments and Rewards Associated With Insider Trading
According to the SEC website there are almost 500 civil enforcement actions each year against individuals and companies that break securities laws. Insider trading is one of the most common laws broken. The punishment for illegal insider trading depends on the situation. The person can be fined, banned from sitting on the executive or board of directors of a public company and even jailed.
The Securities Exchange Act of 1934 in the United States allows the Securities and Exchange Commission to give a person a reward “a bounty” to someone who gives the Commission information that results in a fine of insider trading.
The Insider Trading Scandal - What did Martha Do?
Martha Stewart has been in the news for several months because the U.S. Securities and Exchange Commission believes that Martha Stewart was told by her friend Sam Waksal that his company ImClone’s cancer drug had been rejected by the Food and Drug Administration before this information was made public. This rejection was a huge blow to his company and the price of its stock went down dramatically. However, Martha Stewart wasn’t financially hurt because she had her broker sell her 4000 shares before this news was made public. If this is true, and it should be noted it hasn’t been proven yet, then Martha Stewart is guilty of insider trading.
What Is Insider Trading?
When most people hear the term “insider trading” they think of the illegal version. However, the term “insider trading” can also mean the perfectly legal buying and selling of stock by a company’s corporate insiders.
Insider trading is legal when these corporate insiders trade stock of their own company and report these trades to the U.S. Securities and Exchange Commission (SEC). That way the insider trading is not kept a secret and anyone can find out a corporate insider’s opinion of his or her company.
Insider trading is only illegal when a person bases their trade of stocks in a public company on information that the public does not know. It is illegal to trade your own stock in a company based on this information but it is also illegal to give someone that information, a tip, so they can trade their stock.
Why Is Insider Trading Illegal?
The SEC’s job is to make sure that all investors are making decisions based on the same information. Insider trading can be illegal because it destroys this level playing field.
Punishments and Rewards Associated With Insider Trading
According to the SEC website there are almost 500 civil enforcement actions each year against individuals and companies that break securities laws. Insider trading is one of the most common laws broken. The punishment for illegal insider trading depends on the situation. The person can be fined, banned from sitting on the executive or board of directors of a public company and even jailed.
The Securities Exchange Act of 1934 in the United States allows the Securities and Exchange Commission to give a person a reward “a bounty” to someone who gives the Commission information that results in a fine of insider trading.
Edison Cheam
7:34 AM
7:34 AM
Enjoy!
Jiajun
Edison Cheam
7:25 AM
Wednesday, April 23, 20087:25 AM
Thanks Felix. An interesting analysis! =)
William
10:14 PM
10:14 PM
William
10:14 PM
10:14 PM
William
10:13 PM
10:13 PM