UK: A HISTORY OF TRADING - HOW HEDGING BECAME SPECULATION.

UK: A HISTORY OF TRADING - HOW HEDGING BECAME SPECULATION. - The use of derivatives can be traced to around 400BC, when olive growers in ancient Greece wanted reassurance about what the market would pay for their produce at the end of the season. Today,

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Last Updated: 31 Aug 2010

The use of derivatives can be traced to around 400BC, when olive growers in ancient Greece wanted reassurance about what the market would pay for their produce at the end of the season. Today, agreements of this kind are known as commodities-based future contracts or 'futures' for short.

The forward contract dates from the Renaissance. This is like a futures contract except that the buyer is not expected to pay up front. Payment is settled when the contract expires, usually after three, six or nine months. As world trade developed in the 17th and 18th centuries, forwards and futures were applied to gold, silver and other minerals, and later to perishable commodities like coffee, cattle and wheat.The objective was always to hedge against future risks.

In 1973 the Chicago Board of Trading became the world's first securities exchange to trade in a new product called an option. This offered the opportunity - but not the obligation - to buy or sell at some future date. In the following decade trading of options and other derivatives spread to Philadelphia, London, Paris, Frankfurt and Tokyo.

Also in 1973 came the first mathematical formula which permitted some pricing accuracy. The Black & Scholes formula arrived at a price through variables such as the contract's time to maturity and the value and volatility of the underlying security.

In the 1980s derivatives became vehicles for speculation. George Soros and Michael Steinhardt became famous running their multi-billion dollar 'hedge funds', erroneously named since their whole purpose was to reap maximum yield through leverage and risk taking.

Complex over-the-counter (OTC) derivatives emerged in the 1980s and 1990s. Investment banks make fortunes developing and placing these customised products and usage increases every year.

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