Social innovations and their impact

The word ‘invention’ usually bring up image of science and technology in our mind. But there are social inventions, purists may disagree and say no they are innovations. Granted! There are social innovations. For example, innovation to manage things differently, concept of money, concept of a limited liability company, concept of family and so on. These social innovations have made human life more orderly and generally enhanced quality of life. It is generally true that necessity is mother of inventions/innovations. Born of necessity, innovations are legitimate children but born of greed and other motivations they could be ‘weapons of mass destruction’.

Financial Innovations:

Necessity: How to overcome difficulty of barter system in trade? Innovation: Imagine I have got 2 litres of milk from my cow and you have got 4 eggs from your stock of hen and the third person has got 10 kgs of wheat from her farm. We all need bit of each of these commodities. How to decide exchange rates? What if I don’t want eggs? Or you don’t like milk? So there was need for some common medium of exchange. After many trials and errors the social innovation: CONCEPT of MONEY arrived. This is a fantastic innovation if you think about it. It introduced a huge social change. It separated the production from the consumption. With money around I could now sell milk today and use part of money to buy eggs today and part to use buy eggs after one week. In other words it helped to conserve my wealth (ability to consume my income) over time. We see separation between production and consumption most clearly in form of pension fund. One saves during the working life to provide one’s pension after retirement. But what do you do with savings meanwhile? Give it to businesses who can invest in real business. But how?

Necessity: How to pool small savings to mobilise large sums to take up large scale business investments?

Innovation: Company form of organisation. There is more to be said about this in the next posting.

Necessary: How do you bring together small savers in touch with business promoters (funds deficit) who need funds?

Innovation: Several innovations made it possible. Intermediary players and rules/legislation made it possible. Collectively this is called financial system including bankers, brokers, stock exchanges and so on.

Necessity: What surety do small savers and depositors have about getting their money back and some return on their investments?

Innovation: Safety/surety depends on where one invests saving. Several innovations here.

A.For those who don’t want to take any risk, deposit the savings with government by buying certificates guaranteed by the government i.e., Treasury Notes or Treasury bills or bonds issued by government. (By the way government securities are considered ‘risk free’ because government has coercive powers to tax people. Takeaway that power, government securities are worse than junk bonds because government’s only real source of revenue is tax!)

B. For those who want little more return and are ready to take little more risk: There are deposit certificates offered by the banks not as safe as those offered by the central bank or the sovereign banks.

C. For those who want little more risk than savers in category B, they could buy the fixed income securities such as bonds issued by companies.

D. For those who want to take more risk than savers in category C, they could buy equity shares of companies.

Necessity: There is a farmer, growing potatoes, harvesting season is three months away. She is not sure of weather or attack of pests or demand for potatoes in three months time. All this means farmer is not sure how much she will realise per quintal of potatoes. Chances are that the price might be $ 20 for quintal or it could be $ 40 per quintal. She wants some certainty about her sale price in three months time. Now suppose there is a potato crisp producer who is in opposite situation as the farmer and wants to ascertain the cost of potatoes that he will have to pay in three months’ time. Both meet and strike a financial innovation.

Innovation: A contract between the farmer and the potato crisp producer that says that the farmer will sell potatoes at $ 25 per quintal to crisp producer in three months’ time is called Forward Contract. So one more innovation which is need based.

Necessity: Suppose the crisp producer thinks that the price of potato may be less than $ 25 in 3 months’ time in that case if he went for Forward Contract there is a risk that he would lose money as the market price will be less than $25 but he's agreed to buy potatoes at $25 per quintal. Is there a better way he could lock in a price of potato at maximum $25 or less.

Innovation: Suppose the farmer agrees to a contract whereby the crisp producer will have a right to buy potatoes at $ 25 per quintal after 3 months but not an obligation to buy. The contract further stipulates that the farmer will be obliged to sell at $25 if the crisp producer decides to buy the potatoes at $25. So this is a right to buy for potato crisp maker and an obligation for the farmer. Obviously the farmer is exposed to risk of losing money if price turns out to be more than $ 25 in three months time therefore, the farmer will expect some compensation for entering into such a contract.

That compensation in above situation is called premium and this contract is called an Option. The crisp producer buys an option from the farmer say for $ 0.5 per quintal. These contracts are also called derivatives. Why? Because the premium (value) of option $ 0.5 will vary with the underlying asset, in other words here the value of option is ‘derived’ from the value of potato. Valuation of options involves complex equations and the gentlemen who worked those equations out got Nobel Prize for Economic Sciences.

Options are not new though. They are as old as trade via sea or other dangerous routes but they appeared in a different form. When the goods moved by sea for example there was always a risk that they may be lost on the way due to piracy or accidents. Traders needed some protection against such losses. Some people who could understand the likelihood of such events occuring offered insurance contracts to the traders and this must have started very early on. But modern marine insurance contracts can be regarded as main predecessors of today's insurance industry. Insurance contract is nothing but an option for the policy holder. A car insurance policy for example provides a policy holder an option to surrender (a right to sell) a junk (after accident) car to the insurance company who are obliged to ‘buy’ the junk for agreed amount stated in the insurance policy.

We’ll stop with description of financial innovations here by just noting that the markets create new financial contracts to meet the varying needs of investors. Investors have different risk tolerance levels and return expectations. Financial markets thus innovate to meet those needs. Before we move on a note of caution: Never forget a simple and elegant rule of economics applicable to all the financial contracts: Higher rewards imply higher risks. There are no free lunches out there including this blog (you thought may be it is free because you are using your office computer and power connection! Well at least the time is yours and the confusion that you build up and the pain of trying to understand by reading what is written here are exclusively yours, that’s your cost, so no free lunch).

The above write up is 1291 words excluding the title. Now if you were reading to memorise it, it would take average 12-13 minutes or so, if your were reading to understand it would have taken about 5-6 minutes and if you have been skimming then perhaps you read it in about 3-4 minutes (how do I know this? well Wikipedia tells me the average reading rates). But trust me the rates for writing 1291 words will vary significantly. Anyway trivia apart, the above was written to make the readers familiar with some of the financial innovations as in my next blog posting I want to touch upon the role of options and derivative contracts and another important social innovation to discuss the financial and banking crisis. So this posting is a preparation for the uninitiated for the next posting which hopefully will be done during coming weekend. I’ll also mention what seems to me to be some of the biggest ever option contracts written after the banking crisis. Till that time ciao!

DISCLAIMER: NOTHING MENTIONED IN THIS POSTING OR ANYWHERE ON THIS BLOG SHOULD BE CONSIDERED PROFESSIONAL ADVICE. THE BLOGGER DOES NOT TAKE RESPONSIBILITY FOR ANY DECISIONS BY THE READERS AND THEIR CONSEQUENCES IF ANY WHATSOEVER.