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Options & Futures

“I’ll gladly pay you Tuesday for a hamburger today,” cartoon character Wimpy Wellington repeatedly offers. If he worked as an options trader he’d probably say “I’ll gladly pay you 1/10th the price of a hamburger today if I can buy a hamburger, sometime in the next year, at the price they are today.” You’d answer: “but don’t you want to taste the hamburger?” “No,” he’d reply. “I’m a vegetarian but plan to sell my hamburger option to a meat-eater at a profit: I don’t really care about the burger except to the extent somebody will eventually want it.”

The options and futures market is where speculators agree to buy or sell a stock or commodity in the future, at a price set today.

Tulip Mania

The introduction of options and futures almost immediately created the most famous market bubble in history. Tulips were a popular crop from the Netherlands. They’re a perennial plant, grown from bulbs. Prices began to rise when speculators realized they could use options and futures to profit. Most traders purchased options for tulip bulbs, not actual bulbs. Because there was a limited number of plants, others repurchased the options at higher prices.

Eventually, the price of some tulip bulbs was at ten-times the annual wage of a skilled worker. Options and futures fueled the prince increases enabling traders to increase prices far faster than tulip bulbs could be produced. Eventually, the bubble burst and caused enormous losses.

Utility Value

Options and futures were originally created, and are still used, to spread the risk of crop failure. Farmers would sell an option to purchase a crop in the future at a set price.

When the crop matures, the agreed-upon price might be lower than the market price and the farmer is forced to sell at a loss. Conversely, the agreed-upon price might be higher and the option buyer then does not purchase the crop but loses the price they paid for the option. Finally, the crop might fail in which case the farmer received at least some revenue – the price of the option – rather than nothing.

In many ways, options function similar to insurance.

Futures or commodities contracts, or derivatives thereof, make up the bulk of trading today.

Traders don’t want and wouldn’t know what to do with, for example, thousands of tons of wheat, aluminum, or pork bellies. They wouldn’t know what to do with one pork belly, much less a truck full. However, they theoretically bring stability and predictability to those who actually grow and consume various products, except when they don’t.

Multinational Corporation

A Nightmare, in Real Life

Picture the entire Fortune 500 combined into one large company.

The company manufactures everything imaginable with monopolies in cotton, silk, dyes, salts, spices, and tea. Not only do they have near-monopolies in gunpowder but also weaponizes opium, giving away free samples to encourage dependency. Basically, their only moral is to make money.

Government and the company intertwine at the highest levels. Comparatively, their owners make Russian oligarchs look like market stall merchants in wealth and influence. Indeed, the company effectively dictates government policy.

The company raises its own army. It is twice the size of the official army with no legal constraints. They outright colonize other countries and start and fight wars. If they prevail in war then the company keeps the spoils. However, when they lost then government absorbs the losses.

The British East India Company worked exactly like this.

The company was enormous, openly influencing and dictating to the government. Eventually, they controlled half of all trade in Britain.

The East India Company colonized and ruled India. Subsequently, they started and fought the opium wars with China in the name of Britain.

Other East India Companies

There was also a Dutch East India Company that was not entirely dissimilar. That business colonized South Africa, literally enslaving the locals. The Apartheid government is a direct result.

The French East India Company was not nearly as successful, due more to a lack of capital than higher morals. They tried and failed to colonize Madagascar but did create small outposts around the world.

France dissolved their East India Company, which never earned a profit, in 1769. The Dutch East India Company was dissolved in 1799 and all assets and territories became the property of the Dutch government. In 1858, the British government assumed control over the soldiers and territory. The British East India Company dissolved in 1874.

Modern Management (Wedgwood)

Modern management, marketing, and high-end sales to ordinary people make pottery company Wedgwood a management innovator.

Pottery dates back to ancient times. Fragments of pottery in China date back 20,000 years. Since then, for the most part, wherever archeologists find people they also find pottery. Therefore, opening a pottery manufacturer, especially in the 1700s, intuitively seems like a terrible idea.

Josiah Wedgwood decided to try something different, creating a pottery business built on high-quality management techniques and top-tier customer service.

Built in 1769, the Etruria Works factory spanned 350 acres. Employees, managers, and Wedgwood – along with their families – lived and work at the site. The company focused on “ornamental pottery,” pieces meant more for display than use. Although advertised as Etruscan his pottery more typically appeared in a Grecian style. The factory utilized division of labor, assigning different workers to a single specialized task. This was unusual before the introduction of standardized parts and the assembly line.

Wedgwood created a high-end showroom in London with well-dressed and knowledgeable staff. Each piece of pottery was beautifully showcased and packaged. Customers who changed their mind later could return a piece for full credit.

The quality of Wedgwood pottery was above average potters, but the company really differentiated by the highest quality purchase experience. They were also apt technology innovators, creating stoneware called Jasper. Like most English potters, they also manufactured local bone china.

More importantly, Wedgwood innovated modern marketing techniques, going so far that he obtained royal permission to brand a line of his pottery “Queen’s Ware.”

Wedgwood is the first known use of artificial scarcity, making his pottery attractive for collectors and investors.

The company

Broadcasting

David Sarnoff

David Sarnoff is the father of broadcasting. Sarnoff was a Jewish immigrant who became his family’s breadwinner at age 15. He worked as a Morse Code operator, rising up the ranks to become a supervisor. Eventually, he transitioned to radio to transmit messages over long distances.

Early radio technology was for point-to-point communications, like a long-distance walkie-talkie. AT&T used it for long-distance telephone calls and companies communicated with ships. Sarnoff saw radio as a one-to-many technology, beaming entertainment and news directly into houses. The idea was a breakthrough.

GE acquired Sarnoff’s employer, American Marconi, and renamed it the Radio Corporation of America, RCA. Sarnoff proposed that RCA focus on broadcasting. They ignored him until his broadcast of a boxing match, in 1921, proved wildly popular. Interest was strong and drove the sales of radios. Other RCA executives then understood that content would drive radio sales.

Early Radio

There were early sporadic radio broadcasters but most were banned during WWI on national security grounds. After the war ended, in 1919, broadcast networks began to spring up all around the US. The US issued commercial broadcast licenses throughout the 1920s.

One of the first uses of radio voice broadcasts was education. Tufts College professors broadcast lectures in 1922. Other colleges followed.

Commercialization began in earnest when RCA spawned the first real network, the National Broadcasting Company, NBC. They began broadcasting in 1926, using telephone lines to connect multiple stations. William Paley created the Columbia Broadcasting System (CBS) the following year. In 1939, antitrust regulators forced NBC to spin off the “Blue Network,” a second network they owned. The spun-off company renamed itself the American Broadcasting Company (ABC).

These three networks dominated radio and television broadcasting for about 50 years until cable television became popular.

Radio Goes Global

Radio manufacturers in the United Kingdom recognized the need for content to drive radio sales. There were radio stations but they were sporadic low-quality affairs. To encourage high-quality content they formed the British Broadcasting Company (BBC).

Around this time, radio broadcasts popped up in major cities in the world. Radio Paris launched in 1922. German radio went online in 1923 but was seized by Nazi propaganda minister Joseph Goebbels a decade later. Goebbels created modern electronic propaganda and his core methods are still in use today. Furthermore, Germany broadcast propaganda to neighboring countries who responded by broadcasting their own anti-fascist messages to Germans.

In the US, broadcast networks were primarily advertising supported. Radio manufacturers benefitted from the availability of content paid for by businesses advertising goods and services. In contrast, radio sales drove manufacturers to fund the BBC. Advertising was seen as a nuisance and eventually dropped. The first head of the BBC, Lord Reith, declared that radio broadcasting is a public service, not a commercial product. Most countries throughout the world started with the European public service model but, to some extent, transitioned to the US commercial model. Conversely, the US government-funded and launched a television network, the Public Broadcasting Service, in 1970.

Television

Eventually, RCA moved into television (see the television entry) and NBC, CBS, and ABC became national US television networks. A smaller network, DuMont, tried unsuccessfully to compete. It was shuttered as a network in 1956 though the surviving stations recreated a new broadcast network, Fox Broadcasting Company, in 1986.

Computer Game

Background

Early computers used punch cards to load programs and data into computers. The software was a stack of cards, each card one line of a program. Data input were cards on the top of the stack. Eventually, then the entire thing fed into a card reader. The reader read the stack, processed the data, then printed results.

This process left the computer idle for a large amount of time since the computer did little to nothing while reading the stack of cards.

Computers in the 1950s and 1960s were extremely expensive. However, even with the lag-time and cost, using the computer was vastly faster, and thus less expensive than doing computations by hand. Therefore, companies and governments did not especially mind: the reduction in cost, even with the waiting, was still enormous.

However, this model did not work well for University’s, where many students shared a computer and needed to wait in line to try running their programs. In response, researchers created a new type of operating system, a timesharing operating system, allowing multiple people to use a computer at the same time.

As a side effect, these timesharing operating systems enabled input and output to terminals rather than through punch-cards and printouts. That is, the computer could read keyboard inputs from multiple people, sharing the time required to focus on each, and also run programs.

One side effect to timesharing is that computers became interactive. People could do something, then the computer could respond, then the user could do something else based on the response. This was a dramatically different use for computers which, until that time, functioned more like powerful calculators.

Spacewar!

In 1962, using an interactive DEC computer with circular monitors, Steve Russell created the first modern interactive computer videogame, Spacewar! Two players flew around in ships, with a star in the middle, trying to blast one another. The ships obeyed the laws of physics. The and the sun acted like a gravity well and would destroy ships. Earlier experimental interactive games were dull: tic-tac-toe and mazes.

Computing legend Alan Kay, the inventor of object-oriented programing and the laptop among other things, remarked: “the game of Spacewar blossoms spontaneously wherever there is a graphics display connected to a computer.”

Eventually, Nolan Bushnell and Ted Dabney created a coin-operated knockoff, Computer Space. That game did well and the two went on to create the first computer gaming company, Atari.

Peer-To-Peer File Sharing (Napster)

File sharing allows one computer to connect anonymously with others, sending and receiving files. Most files were single-track MP3s of copyright music.

Background

The original theory was that because mixtapes were legal then noncommercial “sharing” of any music was legal. The legality of mixtapes, a collection of songs from other tapes, stems from a US law, the Audio Home Recording Act of 1992. As long as the tapes were noncommercial, Americans were able to share them with friends.

However, creating a mix-tape took time and each was customized for the recipient: young lovers often created tapes for one another. Furthermore, they contained a collection of songs. In contrast, MP3 “file sharing” took little time to create or download. The songs transferred between strangers and were almost always single-tracks.

Napster

The Napster software itself resided on a centralized server but connected computers directly together to actually transfer the files. That is, the files did not exist on the Napster servers. They were on the sender’s computer which the Napster software, in effect, turned into a server for the purpose of transmitting files.

Then teenager Shawn “Napster” Fanning wrote the Napster software. His goal was circumventing hosting MP3 music files on a central web server. MP3 websites were quickly shut down by the music industry.

Fanning and co-founder Sean Parker came up with the peer-to-peer file “sharing” scheme. Napster put an easy to use interface on this system that looked like music shopping and facilitated the uploading and downloading of MP3 music files for those without technical skills. It became wildly popular.

To Every Action…

The music industry freaked out.

On Dec. 7, 1999, the empire struck back. Countless music industry participants sued Napster the company, the founders, their investors, and even many users of the system. The lead lawsuit was captioned Metallica v. Napster Inc. Altogether, the Recording Industry Association of America (RIAA) filed over 30,000 lawsuits against Napster users and even one of the music publishers, Bertelsmann, that leant Napster money.

Napster eventually shut down and sold. However, the “sharing” technology continued to evolve.

Eventually, Kazza, another music sharing technology, took its place. Rather than rely on individual servers, Kazza connected ordinary computers to one another leaving no central server or company to shutter. The RIAA continued to fight the myriad of file “sharing” services.

The launch of Napster was also, not coincidentally, the peak of revenue for the music industry. The industry refused to accept their former business model, selling entire CDs to users who wanted a single song, was no longer viable. Furthermore, the lawsuits alienated an already feisty audience.

Related image — Music Industry Revenues Peak with Launch of Napster

Eventually, starting about 2016, music industry revenues reached a bottom and started increasing thanks in large part to streaming music. Additionally, many bands reoriented their commercialization plans away from music sales and towards live concerts that could not be pirated.

Parker would go on to work as an early employee of Facebook. In 2019, Fanning remains unrepentant. The makers of Kazza eventually created Skype.

Virtualization

Virtualization enables the separation of an operating system and the physical device, the chips that it runs on. An imperfect but close enough metaphor is auto rental. Rather than purchasing a car, that may be too big for many tasks and too small for others, a user can rent just the right size car or hail a car-sharing company. Virtualization reduces overall computing costs.

Summary

In virtualization, one CPU/RAM/disk stack may run multiple operating systems concurrently, with each separated from the others. In another example, multiple CPU’s are tied together and virtualized as one seemingly enormous computer.

Separating the computer from the operating system enables end-users to rent only the computing power they need for a given task lowering overall costs. It also enables the fast cloning of extra computers.

For example, if a class needs 30 identical computers for 30 students for an exercise, they could use 30 virtual machines with students using only physical screens and other input/output equipment. After completion, the push of a button deletes 30 computers. The school pays only for the time used.

Similarly, if a researcher needs one enormous computer for a large data project they could rent one for the time required that consists, somewhere, of many CPU’s tied together. This is far less costly than purchasing the machine and leaving it idle.

Most virtual input/output devices connect to the physical machines via the web. However, some applications, especially banking or the military, might use private networks. For example, a bank might offer employees virtualized computers where the physical machine isn’t much more than a screen and keyboard. This saves space, a premium on the trading floors of investment banks, and is also more secure.

History

Virtualization is similar to the large centralized “timeshare” computers dating back to the 1960s. Those were rented on an as-needed basis by businesses who did not want to purchase or maintain the large, expensive, and finicky machines. However, the ability to string together multiple parts of a computer, not just one big central computer itself, make virtualization different. Virtualization is key to “the cloud” – a computer that exists only “in the ether.”

Husband/wife team Diane Greene and Mendel Rosenblum co-founded VMWare, the inventor of virtualization.

Open Source Software

Open-source software allows anybody interested to see and contribute to the creation of software, including the ability to spot bugs or security flaws. Dashiki wearing wild-eyed (and hair) Richard Stallman is the father of open-source.

Richard Stallman

Stallman’s theory is more eyes reduce the risk of quality problems. Consequently, people vote or reject changes to the software. Evidently, this community-based system counterintuitively reduces the risk of bugs and security flaws. Defects are spotted and fixed early before hackers can find and take advantage of them.

Stallman argued that software source code should be open. He holds an undergraduate degree from Harvard but dropped out of the MIT Ph.D. program. However, he all but continued to live in the MIT AI lab: he listed it as his legal residence for years.

In 1983 Stallman created GNU’s Not Unix (GNU). The name is recursive, an insider joke for computer programmers. GNU Unix is a free and open-source version of Unix. He also wrote many programs to go along with it, most notably EMACS and the GNU compiler. Stallman created the Free Software Foundation in 1985 along with the “copyleft” General Purpose License (GPL), the first open-source model software license.

GNU Varients

In 1987 developers from Berkeley created a different open-source Unix variant, called Berkeley Software Distribution, or BSD. In 1991 Finnish student Linus Torvalds and others created the popular Unix variant, Linux.

Stallman’s open-source ideas have become mainstream software companies releasing the source-code for inspection, albeit not for free. His GNU system is still widely in use, though not as widespread as Linux. Stallman remains an open-source advocate and activist.

Stallman maintains that Linux should be called GNU/Linux though, ironically, because nobody owns Linux (due to Stallman’s philosophy), there is nobody that can officially change the name. Torvalds himself was always uncomfortable with the name Linux, insisting it masked the team effort needed to create the system; since he did not name it he cannot change the name.

Personal Portable Music Player

Battery operated portable personal music players are fun, enabling users to build a cocoon of their own music.

Portable radios and stereos date back to the invention of the transistor. Over time, these grew in size and power. Enormous stereos run from batteries, “boom boxes,” were commonplace. However, boom boxes played music from speakers and one person’s music is another person’s noise.

Walkman

Eventually, on July 1, 1979, Sony introduced the Walkman TPS-L2, the first portable modern music player. The system featured high-quality headphones and played cassette tapes. Unlike boom boxes, the Walkman was small enough fit in a (large) pocket. At $150 (about $500 USD in 2019). Sony predicted they would sell 5,000 units per month and subsequently sold 50,000 in the first two months. Initially introduced in Japan, the Walkman migrated to the US in June 1980.

Sony dominated portable music in the 1980’s, first with their cassette player and later with a DC version. However, due largely to inter-company conflict, Sony lost the market with the introduction of MP3 technology and digital music. In addition to their electronics business, Sony owned a music and movie studio. Unlike prior technology, MP3’s could make an unlimited number of music copies. Executives at the studio reviled MP3’s due to piracy and refused to release a Walkman that supported the popular MP3 format.

iPod

There were many MP3 players, the vast majority of them underwhelming. Eventually, on Oct. 23, 2001, Apple released the iPod which supported MP3’s. It was not the first portable MP3 player but was substantially easier to use than competitors. Arguing that piracy was out-of-control as people “shared” pirated music tracks over the internet, Apple convinced the studios to allow the company to sell individual songs for $.99.

Quoting articles from the time:

“The iTunes Music Store may be just the thing to get Apple rocking again too. As everyone knows, it’s been a tough couple of years for the computer industry as well. Apple swung back into the black in the first quarter of 2003 after two quarterly losses, but its profits were only $14 million, compared with $40 million a year ago. And as popular as Apple’s iPod portable MP3 player may be, it contributed less than $25 million of Apple’s $1.48 billion in revenues last quarter. So Jobs is betting that by offering customers ‘Hotel California’ for 99 cents, he can sell not just more iPods but more Macs too.”
Songs In The Key Of Steve Steve Jobs may have just created the first great legal online music service. That’s got the record biz singing his praises. Fortune Magazine. May 12, 2003. (emphasis added)

On Apr. 28, 2003, Apple opened the iTunes Music Store for use with the iPod; in the first week, iTunes customers purchased over a million songs. By 2018, Apple’s quarterly revenue was about $60 billion per quarter.

Patents

Andreas Pavel filed patents for a portable music player, called the Stereobelt, in 1977 but failed to sell the idea to any music company. After protracted litigation ー where Sony won and lost various rounds in different jurisdictions ー Sony paid him a substantial settlement in 2003. Kane Kramer held the first broad patent for portable digital music players but lacked funds to renew it and allowed it to elapse before digital music players became popular.

Securitization

Securitization enables income streams of pooled loans, reducing overall risk to lenders. This spreads the risk of both prepayments and defaults, lowering the cost of credit.

Background

Denmark created pooled mortgages, called covered bonds, in 1850. Switzerland followed in 1930.

In 1970 US government pseudo-agency Ginnie Mae (GNMA) created the first securitized pool of home mortgage loans. GNMA pooled home loans explicitly backed by the US government; typically loans for military veterans, farmers, or other public-policy types.

Another pseudo-US government-owned company, Fannie Mae, issued the first collateralized mortgage obligation in 1983. Louis “Lou” Ranieri, who started his Wall Street career in the mailroom, famously enabled that first bundle of loans.

These early securitizations existed to manage prepayment risk. That is, banks rely on payments over a long period at a set interest rate. If interest rates decrease, and many people refinance and pay off their loans, the assumptions prove incorrect. Pooling the loans lowered overall prepayment risk.

Michael Milken

Subsequently, Michael Milken, an employee with the Drexel Burnham Lambert investment bank, reworked securitization to diversify default risk, not just prepayment risk. Pooling enabled Milken to sell otherwise high-risk “junk” debt because the risk of default was spread. Ranieri followed up w/ MBS’s that diversified both prepayment and default risk.

Milken’s securitizations enabled financiers to purchase businesses with debt eventually assigned to the business. Oftentimes, existing management opposed these purchases, called colloquially “hostile takeovers.” New management, burdened with the new debt required to acquire the company, thenslashed costs by laying off workers and selling assets. Notable hostile takeovers include Pan American World Airways (Pan Am), Revlon, RJR Nabisco. Bankers engaged in hostile takeovers were known as “raiders”. Over time, the name evolved to the more tasteful “private equity.”

Louis Ranieri Mortgage-Backed Securities

Mortgage securitizations grew steadily larger and more complex over time. Eventually, bankers believed they could mitigate virtually any risk of prepayment or default, extending credit to virtually any borrower no matter the risk. Subsequently, this led to irresponsible lending (and borrowing) which, combined with a type of derivative insuring the securitizations (“credit default swaps”) caused the Great Recession of 2008.

Modern securitizations encompass an enormous amount of the world banking system. They manage prepayment and default risk for every imaginable rent stream and also recapitalize early lenders. The securitization market is so large it been labeled a “shadow banking system” due to the immense amount of capital involved.