for a good explanation of them read this: http://www.acredittrader.com/?p=81.

Second, to assert that derivatives exist because they add value by assuming that they couldn’t exist if they didn’t is circular. In the study of rhetoric, there is a name for it: begging the question, which means, simply, assuming the point you are trying to prove.

Third, all decisions about assets reduce to buy or sell (hold is simply sell the asset at close, buy the same asset in the same quantity at open or, in a continuous market, sell and buy the same asset in the same quantity continuously). All financial innovations are variations on this choice and can be analyzed in terms of how well a particular asset reflects it. If we are rational, we buy them because we believe that we will be able to sell them for more than we paid for them or we sell them because we believe that we won’t and would prefer to buy an asset that we think we will be able to sell for more.

I realize that “everybody knows this” (sigh), but I also see people forgetting it every day (from which I infer that “everybody” “knows” otherwise). In an efficient market (even a weak-form efficient market) with rational participants, hybrid securities and strategies wouldn’t exist, even at the margins (of creditworthiness, in particular). They add no value and, therefore, have no role to play. If you are rational and have gathered all of the information available and necessary to decide whether you are sufficiently confident that the price of the asset(s) you are considering buying will increase, you should buy the asset or a call option on it (if you’re confident that you can predict the duration of the window of opportunity). If you decide that the price will decrease and you own this asset, you will sell it or buy a put option. To employ any other strategy or combination of strategies increases transaction costs, incurs greater risk without offering commensurately greater potential return or reduces risk by limiting potential returns commensurately or more.

Selling a covered call (buying a covered put) is a good, simple example of a hybrid strategy that limits return potential and reduces transaction costs, but doesn’t limit risk materially. Another example is the convertible bond. The buyer sacrifices current return (lower coupon payments) and future return (the sum of the below-strike-price segment of the price appreciation of the associated stock and the above-call price appreciation of the stock), thereby achieving the worst of both worlds—lower coupon and lower potential price appreciation. Who would buy such an instrument? The seller, on the other hand, pays a smaller premium on the bond then he would’ve on a simple bond and avoids the far greater cost of selling equity in the firm (especially if the firm’s performance is not strong). The seller does bear some of the risk of his own success. If the seller’s enterprise succeeds beyond his limited expectations, a greater share of the rewards are transferred to the bondholders when they convert. Hence, the seller installs a call provision, which he exercises when he succeeds, thereby, limiting the rewards he must share with those bondholders to the cost of calling the shares and paying for them (an increase in the coupon, really) less the cost of the interest and principal repayments he would’ve made had the bonds been allowed to mature.

No rational investor would buy such securities or employ such investment strategies. What would the financial condition of a firm have to be to offer such securities? Surely, rational investors in an efficient market would identify such firms as troubled simply because they have to offer this type of compromise (deception?) to raise money.

q, btw, is correct in his assertion that derivatives function mainly to shift risk to another player from oneself. I must say that Max’s quotes from GT provide wonderful narratives to that process, in which the unsold inventory of highest-risk assets are the Old Maid in that game. There are no hedges against holding the Old Maid when the game stops.

There is, without question, much more to this story. Nevertheless, the role or existence of hybrid securities or derivatives has not been explained by any economic theory of which I’m aware that does not include a significant role for “animal spirits” (or any other phrase you want to use to describe how people feel about events, acts and motives).

See Szymanowska, Ter Horst, Veld (2009) Journal of Futures Markets: “Reverse Convertibles Analyzed”. The authors show that the securities are, on average, overpriced by almost 6%. But they find some rational factors to explain some (but not all) of the overpricing. A must read for the quant wonks!

Click on this link, and then the SSRN button to download the paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=730543

Is this how you really think bubbles form:

“That’s exactly what happens in a bubble; everyone knows that prices are no longer related to fundamentals, but enough people think they will be able to sell before the bubble bursts that prices keep on going up.”

Bubbles are just one big conspiracy where everyone thinks they will find a bigger fool? I think plenty of behavioral finance research (Thaler, Schiller, et al.) has shown that herd behavior and other psychological reasons exist for why bubbles form.

Keynes (General Theoty Chapter 12 cont.):

‘If the reader interjects that there must surely be large profits to be gained from the other players in the long run by a skilled individual who, unperturbed by the prevailing pastime, continues to purchase investments on the best genuine long-term expectations he can frame, he must be answered, first of all, that there are, indeed, such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate in their influence over the game-players. But we must also add that there are several factors which jeopardise the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.[4] For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.’

Although you make a convincing argument about some products being less innovative than meets the eye, I think your argument gets a little twisted when it assumes that efficient markets and complete markets means the same thing. These two concepts are not the same.

The arguments (whether credible or not) given for innovations like reverse convertibles was that they were ‘completing the market’. This is not the same as saying that they were making markets more efficient. Market efficiency is more related to the idea of no-arbitrage.

In both theory and practice, we can have markets that are complete, but not arbitrage free (i.e. markets that are complete, but not efficient), as well as markets that are efficient, but not complete.

I think your arguments would be even more persuasive if you focused on the validity (or lack thereof) of whether products like reverse convertibles really were completing the market, or were just “chicken dressed up like ham”.

Alan.

Chicago is rather notorious for resurrecting discredited arguments and trying to pass them off as something novel. The reason the above argument is likely to be wrong was clearly spelled out by Keynes all those years ago:

Keynes (GT Chapter 12):

‘It might have been supposed that competition between expert professionals, possessing judgment and knowledge beyond that of the average private investor, would correct the vagaries of the ignorant individual left to himself. It happens, however, that the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps”, but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. It is an inevitable result of an investment market organised along the lines described. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.’
…

‘This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over a long term of years, does not even require gulls amongst the public to feed the maws of the professional; — it can be played by professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.

Or, to change the metaphor slightly, professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.’

I’m not saying they’re consciously doing this, but perhaps there’s a bit of deep panic over what to do with all that money (you can be close to bankruptcy and still have lots and lots of money, right?).