The 3000 Year History of Options, Derivatives, and Futures Trading

Posted by Bigtrends on May 16, 2013 1:28 AM

The 3000 Year Brief History of Options, Derivatives, and Futures Trading

A History of Derivatives : A 3,000 year History

1700 BC - The history of derivatives is very long, there is even a reference in the Bible - Genesis 29 where Laban offers Jacob an option to marry his youngest daughter Rachel in exchange for seven years of labor.  After seven years Laban reneged and only offered his eldest daughter Leah.  Luckily for Jacob, polygamy was allowed in those days so he was able to marry Rachel as well later on.

580 BC - The History of Derivatives goes back to ancient times.  Thales of Milesia, a pre-Socratic Greek philosopher and considered one of the seven sages of Greece, was thought to have bought options on olive presses.  His prediction was for good weather and a bumper crop, which ended up making him a fortune.

1637 - One of the celebrated events in the history of derivatives is the Tulip Bubble, which was facilitated by forward contracts on Tulips.  As the price of tulip bulbs increased Dutch dealers also started tulip bulb options trading, so that producers could sell the rights to owning tulip bulbs in Call Options. This means of hedging risk turned into speculative frenzy, as the price of tulip bulbs skyrocketed between the end of 1636 to February of 1637.  The contracts were OTC and in the absence of legal enforcement personal reputation was what the trading was based on.

1697 - Dojima Rice Exchange was the first to to trade standardised futures in the history of derivatives contracts and had two types of rice markets - the shomai and choaimai (spot and futures respectively).  Different grades of rice were contracted with standardized agreements.  No cash or vouchers were exchanged; all relevant information was recorded at a clearinghouse.  The contract period was limited to four months at a time and had to be settled prior to contract expiry.  Settlement of the differences in value between the current spot price and the contract had to be done with cash or an opposing contract position.  With a few interruptions and updates, the rice exchange operated until 1937.  Participants in the exchange were required to establish lines of credit with a clearinghouse.  The clearing house assumed the risk of the various counterparties - very similar to today.

1720 - South Sea Bubble - The South Sea Company was a trading concern with interests in South America, and was important also as an important marker in the history of derivatives.  They had a monopoly on trading in this region after the War of Spanish Succession.  In return for this concession the company assumed some of the national debt of England.  Enthusiasm for the share led to the price moving from $100 to $1000 in under a year.  It also fell back equally quickly when expectations about the company became more realistic.  Options and Futures were used widely during this era in London.

1848 - Chicago Board of Trade created, marking a really important date in the history of derivatives.  Chicago was a hub for the storage and transport of grain from the Midwest.  Grain prices rose and fell sharply seasonally.  Storage was also often at a premium following the harvest.  To cope with all these vagaries the "to-arrive" contract was created.  The idea was that the farmer could lock in the price and the deliver the grain at a future date.  This allowed farmers to hedge against price moves and protect themselves.  The contracts became standardized in 1865 and by 1925 a clearinghouse was formed to take away the credit risk element.  That is pretty much the modern commodity future that we still use to this day.

1872 - Russell Sage created the first OTC options in New York, and is a major figure in the history of derivatives.  His business model relied on using the principles of Put-Call Parity.  He would buy the stock and a put from the customer and then sell them a call back - while fixing the put, call and strike prices.  In effect he was creating a synthetic loan, which allowed him to charge much higher rates of interest that the prevailing usury laws allowed.  What is interesting is that he had in 1867 been convicted and fined for usury, so he had just found a very clever way around it.

1972 - The collapse of the Bretton-Woods System and the advent of free floating currencies meant that currency futures became very quickly a necessity.  This was another step in the development and history of derivatives.  This is when the Chicago Mercantile Exchange created the IMM in 1972.  These were the very first time futures were traded on non-physical commodities.  By 1975 there were Interest Rate Futures, initial attempts (based on the Ginnie Mae) did not succeed until one was created based on a Treasury Bill underlying.  It was not till 1982 that an Index Equity future was introduced (on the S&P 500).

1973 - The Chicago Board of Options (CBOE) was created.  This was the first time standardised options were traded through a central clearing house and the prices were listed in the press.  On the first day of trading there were 911 contracts across 16 underlying stocks.  This could again be pointed to as one of the seminal events in the history of the derivatives markets.

1973 - Fisher Black and Myron Scholes introduced a mathematical framework to price options.  This is what we know today as the Black-Scholes equation and this formed the basis for much of the financial engineering that would happen in the next few decades.  In 1973 the first equity Index Options was introduced following hot on the heels of the equity index future.  Without a doubt, the introduction of the Black-Scholes was one of the crucial points in the history of derivatives as it introduced a more scientific framework for the pricing of options. This was the starting point for further developments in the academic and practical study of options.

Courtesy of http://risklearn.com/

 

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