Commerce -> Math -> Science ->Trade -> Boom

We live in interesting times 

The financial crisis is just beginning according to some finance insiders, economists and journalists. One of the reasons for this crisis is the high amount of leveraged trading done by banks and other institutions. 

Leveraging means using tools to amplify your action. In a physical lever, we need to apply small force at one point to achieve a multiple of that force at some other location by pivoting on a fulcrum point.

Leverage in Physics

So to have the effect of X times a force F, you just have to apply a force F at another suitably chosen point. This is a powerful idea but has been around for millenia most notably used by Archimides in many of his inventions. Infact, he is said to have remarked that give me a fulcrum strong enough and I will move the world.

But the downsides of this is that if you make a small change in F, there will be X times the change on the other side. So a small error propogates multiplicatively in leveraged scenario. 

Though this is a crude analogy, but even in finance people started doing something similar. They did leveraged trades so as to need to only invest a small amount but hoping to get a bigger return. They failed to see the downside which is that their risk also balooned and also the fact that if everyone took such extremely leveraged position, the whole system becomes extremely fragile due to a small shock even though the chances of that shock occuring might have reduced.

Many of these financial instruments were results of using complex mathematical tools and methods which were traditionally developed to help in solving scientific and engineering problem. But primitive mathematics like number system and algebra were developed to facilitate trade and commercial activities. 

It is funny that first math developed from commerce, then it is used and developed spectacularly well in the field of science and engineering, but then the advanced math when applied back to the field of commerce seems to have backfired. 

Buffet on derivatives

Financial sector attracts a lot of brilliant talent nowadays. In India, I guess, the brightest people of any batch go to finance from the MBA program. No doubt, there is the lure of the lucre, but aside from that there is also the thrill and the intellectual pursuit involved in growing money.
I guess one cannot distinguish a lot of trading which goes on now from a gambling game. In a gamble, people take risks and they get rewards in proportion to that. If I bet on a horse in a derby which has very low odds of winning and if it wins then I get much more than if I would have on betting on the favorite. In the same way, in the markets people take risks and make huge profits when they are right. The attraction of instantaneous gratification and the thrill of knowing that you outwitted the rest of the competitors can be a very powerful motivating factor for someone to do finance.

Derivatives are an instrument of trade, where the trade is done on a contract. These are derived from some asset like commodities, energy etc. But when one buys derivatives we are not buying the asset but usually we are buying a commitment from someone that he will give us that asset at a certain time at a certain place and at a certain rate. There are a lot of other combinations of these kinds and they require a lot of imagination and creativity to be designed and also to avoid into their trap!
What these instruments do is that they reduce the risks of doing business. For example, a farmer may hedge(technical term) his yield of crop next year by entering into a contract at the exchange for someone to buy it at a fixed rate. Now if the next year, there is a shortage and the price rise then he loses since he has to pay the fixed amount. But if there is an abundance and the price fall, he benefits and he gets the price of the hedge. For the buyer too, its a win-win since he knows beforehand what the price he has to pay and if it falls he does lose but he insures himself against the case where the price rise.
Derivative trading has grown phenomenally in recent years. But not all people are very happy with this. One prominent critic of this is the wizard of omaha, Warren Buffet. Here is what he thinks about this.

A century!

This is my 100th post. Whew! Never thought I would be so regular in doing anything every. My first post was in 2004 and then I had a really long hiatus and then last year had been good. Probably lot of time in hand while doing (nothing in) my PhD.
Its also my last day in Delhi and India and this trip was really great. For the first time, having a full one month spent with family and really enjoyed it. But all good things end so that other good things can start!
Another new thing in this trip is my budding interest in finance and money. Am not expecting this to last for too long though.

Only a fool and the wise are always optimistic, and I am both.