Dinosaur Derivatives and Other Trades. Josse Jeremy

they purchased gold on Wednesday in anticipation that they could sell at a higher price on Friday. The ‘greater fool theory’ was at work, some of these buyers may have realized that the increase in price was a bubble and anticipated that they would be able to sell at a profit before the bubble imploded.”1

      Actually, liquidity also goes to the concept of managing the “uncertain” future. In the next chapter, we'll take a look at this concept – the Genesis story of how Joseph made a killing in a market where God apparently removed the element of uncertainty entirely. But for most of us in finance, uncertainty is a constant, and hence “risk” is always an element in decision making. Liquidity does not remove the element of risk – far from it. But it signals something to an investor. Liquidity says to the investor, “Even if this investment does not turn out how I thought it would – that is, no Megalodon actually appears – well, I can still exit the asset.”

      There is an element of trust embedded in liquidity: “I will pay value for this asset now because I trust another will take it from me, for value, in the future.” And indeed this is not fundamentally different from the trust we hold in a dollar bill. After all when we are given a dollar for our work or our goods, we blithely trust that we will be able to exchange that dollar – that is exchange it in the not-too-distant future, for the goods or services provided by others.

      Interestingly, also, mainstream financial theory recognizes pure "liquidity" as something that has value in and of itself. There are many analyses showing the increased value of a stock that is listed with an active market versus a private, “illiquid” stock (not offered on any market). The former is commonly identified as having a "liquidity premium." In fact, just adding liquidity can increase a stock's value by as much as 20 or 30 % over a private (illiquid) stock that is identical in every other way.2 These liquidity premia are regularly used in professional valuation work by investment banks, accountants, and the like. In other words, investors and traders recognize that there is additional value in something purely because it is exchangeable, and they are willing to pay a premium…even at risk of ending up greater fools for doing so.

      But now we come to the next factor. We have arrived at the curves in the road where “greed” and “fear” create rapid acceleration and deceleration. With the establishment of the ability for any asset to go up and down in value, the potential arises to make money buying cheap and selling dear (arbitrage). When these factors come into play, there's a new compelling logic behind investing in Megalodon options. How appealing these are to anyone who wishes to speculate! Fear is the quintessential human emotion that arises from financial uncertainty. Greed – well, I think we're familiar with its appetites. In any event, note for now how often greed and fear do generate precisely the type of mania seen among the Megalodon bidders in our story.

      And then there is a final piece in the puzzle – that is “habit” or “conditioning.” As more people trade in the option, the reality of its value seems to be confirmed daily by the ongoing patterns of behavior of the crowd. Like a religion or a credo, the more often certain ideological concepts are repeated, the more we become conditioned to accept what appears to be an independent truth. Now, instead of “high priests,” think “brokers.” As brokers repeat their buy/sell mantra to eager investors, they continually promulgate and perpetuate the dinosaur dictum. Repetition of this credo can take the market value of assets to levels that are way, way beyond anything that can be connected with the underlying economic utility of the asset. Sound familiar? Yes, we call these run-ups of the market based on fervid beliefs “asset bubbles” and “market mania.” What occurs is a sort of financial religious ecstasy as each new zealot experiences his or her own epiphany.

      1

      Manias, Panics and Crashes – A History of Financial Crisis, Sixth Edition, 2011, Charles P. Kindleberger and Robert Z. Aliber, pp. 43–44.

      2

      Likewise there can be as much as a 300–500 bps incremental yield premium (i.e. additional cost) on private debt as compared to publically listed, liquid debt for an identical issuer/creditor.

1

Manias, Panics and Crashes – A History of Financial Crisis, Sixth Edition, 2011, Charles P. Kindleberger and Robert Z. Aliber, pp. 43–44.

2

Likewise there can be as much as a 300–500 bps incremental yield premium (i.e. additional cost) on private debt as compared to publically listed, liquid debt for an identical issuer/creditor.