The Art of Streetplay

Saturday, August 06, 2005

Final Thoughts on Hakansson; Implications on Differential Cost and Ability

My last post attempted to wade through some thoughts on derivatives and their value as securities. I just had a few more.

Some believe that derivatives can add value through their very existence because of their ability to lower transaction costs. While Hakansson called the transaction cost argument "weak," I still honestly don't understand why.

This is how I see it- even when dealing with derivatives that are totally redundant, the existence of differential hedging ability and cost among market participants implies individual investors (and more generally the 'less efficient') can derive value from the creation of derivatives by efficient low cost hedgers. The reason is obviously because if person A can produce a payoff structure at a cost of X and person B can produce the same payoff structure at a cost of X + e, then person A can be of value to person B by A's creating the payoff structure for B and selling that at a price greater than X but less than X + e.

As long as a payoff structure is demanded by inefficient investors (suboptimal hedging ability, higher costs, or time constrained perhaps), then from a business perspective I don't see how an efficient bank doesn't add value to the marketplace by supplying that payoff structure at a market clearing cost (a function of competition, supply and demand-- gotta account for market impact and the fact that other people may be better than you).

The above discussion is part of a more general message- differences create opportunities. The above example is an almost dumbly obvious portrayal of differences in hedging ability and cost structure. That's something one can build a business on. Differences in perception is obviously another major one, and is probably most in line with what most people consider 'investing' to be. There are other far more subtle differences. Understanding the nature of differences seems to me to be extremely important. All else is rarely equal.



  • Great blog and a thought-provoking post. After reading your previous post on the topic, 'transaction costs' was indeed the first thought that came to me in trying to come up with an economic justification for options that specifically addresses the fact that their payoff can be replicated. Dynamic hedging can become very expensive. I'm not sure why Hakansson thinks the argument is 'weak', it seems quite legitimate to me.

    By Blogger Value Guy, at 2:56 PM  

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