Everything’s a Derivative and a New Take on Crypto

By Randall Coleman, Portfolio Manager

Football is back. I’m not much of a sports fan, but I’m vaguely aware of the phenomenon. I know the basic rules of each game, the color and shape of the ball or puck or whatever it is they score with. I know when the season rolls around because the office email lights up with betting and pools. What interests me the most is the proliferation of value-creating opportunities surrounding sports. This isn’t limited to football, per se, but the timeliness of football season provides a perfect backdrop to look a little deeper and examine some of the forces at work.

In the financial world, when a security’s value depends on another security’s value, it is a derivative. It derives its value from something else. The most common derivatives in finance are puts and calls. Most simplistically, they allow investors to hedge positions in stocks, to alter their risk profile. They can be used to create certainty out of inherent uncertainty. Nobody knows for sure what price a stock will sell for in the future, but with puts and calls, investors can create a certain level to buy or sell a stock in the future based on prices today. Without getting in to the myriad of reasons why an investor would want to hedge a position, let us simply recognize that there is a vast market for financial derivatives.

The intimidating-looking Black-Scholes Option Pricing Model revolutionized options trading with math. Before its development in the early 1970s, traders had little besides gut instinct to set prices for options. With the advent of the Black-Scholes model, market participants could plug in the variables and obtain objective, quantitative values for their securities. Math enabled exponential growth in options trading.

Turning back to football, there is a vast market for derivative products based on the game. From simple bets between friends, to office pools, to fantasy football leagues, the opportunities abound. The similarity to investment derivatives is that football derivatives derive their value from events in the physical football games. Touchdowns, field goals, passes completed, yards rushed, interceptions, practically any action in a football game creates a knock-on effect in the world of sports derivatives. Statistical modeling and data analysis would be the closest comparison to the Black-Scholes model in football derivatives. Knowing a player’s past record allows virtual players to value the physical player’s abilities. These derivatives allow widespread participation and interaction in the virtual world in parallel with the physical world. Winning money, winning glory, winning fame are supposedly the main objectives. However, as evidenced by office emails, players always extract entertainment value from sports derivatives. How do you price entertainment?

Switching gears, I’ve wrestled with cryptocurrencies, Bitcoin and the like and have been stymied. I’ve been looking at them wrong. As Frank Zappa said, “Art is making something out of nothing and selling it.” To me, cryptocurrencies are art. Fundamentally, crypto currencies derive their value from math: they are solutions to very difficult math problems. The advent of modern cryptology, enabled by vast distributed computing power has led to an explosion of development in this nascent field. Parallels to the art world seem appropriate: some art is in high demand and therefore expensive. Some art is considered junk and worthless. Some art can be considered both at the same time, to different people. The point is that a market exists, a price level exists, and that price level is set by willing buyers and sellers. A market for crypto has arisen out of nothing and it has value. That, by Zappa’s definition, is art. How do you price art?

These two questions are intensely subjective. What’s of value to one person may be worthless to another. Regardless, there are public marketplaces that match willing buyers and sellers for these products. The proliferation of derivative products (fantasy sports, e.g.) and entirely new markets (cryptocurrencies, e.g.) springing up based on the physical world is a major force for economic development. The underlying theme is relentless growth in data collection, data processing, network creation and innovative thinking. ACM’s managed portfolios are well positioned to participate in all these trends.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.