Can Tulipmania be explained rationally as the birth of options?

[Michael Pollak <mpollak@xxxxxxxxx>]

[Does this argument make any sense?  I can't see any upside for the 
planters in this arrangment.  It seems they would be better off doing all 
their deals on the spot market.  And it doesn't seem to provide any 
explanation for the collapse.  It seems they are just in love with the 
ratio and are bending the facts to fit their chosen conclusion.  I was 
wondering if people who know more about option pricing might see merits 
that I'm missing.]

   URL: http://slate.msn.com/id/2103985/

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   Bulb Bubble Trouble
   That Dutch tulip bubble wasn't so crazy after all.

   By Daniel Gross
   Posted Friday, July 16, 2004, at 2:05 PM PT

   During the dot.com bubble and its collapse, economists and historians
   increased their study of market crazes of the past, particularly the
   most ludicrous one of all: the 17^th-century Dutch flower bubble. The
   classic description of Tulipmania appeared in Clarence Mackay's 1841
   classic Memoirs of Extraordinary Popular Delusions and the Madness of
   Crowds, "In 1634, the rage among the Dutch to possess them was so
   great that the ordinary industry of the country was neglected, and the
   population, even to its lowest dregs, embarked in the tulip trade."

   The normally sane Dutch bourgeoisie got carried away and bid up prices
   of tulip bulbs spectacularly in winter 1637, only to see them crash in
   spring. One bulb was reportedly sold in February 1637 for 6,700
   guilders, "as much as a house on Amsterdam's smartest canal, including
   coach and garden," and many times the 150-guilder average income. As
   Earl A. Thompson, an economist at the University of California at Los
   Angeles, and Jonathan Treussard, a graduate student at Boston
   University, note in a working paper, "the contract price of tulips in
   early February 1637 reached a level that was about 20 times higher
   than in both early November 1636 and early May 1637."

   Sounds like a bubble. But it wasn't, asserts Thompson, who is working
   on a history of bubbles. Tulip-bulb investors were neither mad nor
   delusional in 1636 and 1637. Rather, he says, they were rationally
   responding, in finest efficient-market fashion, to overlooked changes
   in the rules of tulip investing.

   As European prices for the dramatic flowers rose in the 1630s, many
   burgomasters--local mayors--started to invest in the bulbs. But in the
   fall of 1636, the European tulip market suddenly wilted because of a
   crisis in Germany. German nobles were big fans of tulips and had taken
   to planting bulbs. But in October 1636, the Germans lost a battle to
   the Swedes at Wittstock. Then German peasants began to revolt. The
   German demand for tulips sagged, and princes began digging up their
   own bulbs and selling them, say Thompson and Treussard.

   The sudden glut caused prices to fall, and Dutch burgomasters began
   losing money. They were in a bind. Trade in tulip bulbs was conducted
   through futures contracts: Buyers agreed to pay a fixed price for
   tulip bulbs at some point in the future. With prices having fallen in
   the fall, leveraged burgomasters were tied into paying above-market
   prices for bulbs to be delivered in the spring.

   Rather than take their lumps, these politically connected investors
   tried to change the market rules--and they succeeded. First, they
   threatened to abandon their contracts and leave planters in the lurch
   entirely. But ultimately, they ironed out a deal whereby the
   obligation to purchase bulbs at a fixed price would be suddenly
   converted into an opportunity to do so. In current parlance, they
   aimed to transform tulip-bulb futures contracts into tulip-bulb
   options.

   Under the new deal, the investors wouldn't have to pay the high
   contract prices in the spring unless the future market--or
   spot--prices of tulip bulbs were higher. (To compensate the planters
   in case market prices were lower than the contract prices, the
   investors agreed to pay a "small fraction of the contract price" to
   get out of the contract, Thompson and Treussard note. Ultimately, that
   amounted to about 3 cents on the dollar.) On Feb. 24, 1637, the Dutch
   florists "announced that all futures contracts written since November
   30, 1636 and up until the opening of the spring season, were to be
   interpreted as option contracts," Thompson and Treussard write. The
   action was later ratified by the Dutch legislature.

   The news of these discussions began to filter out into the market in
   November 1636. Now, when it becomes clear that a contract is to be
   transformed into an option--the ability to buy something rather than
   the responsibility to do so--you would expect prices to rise. Why? If
   the investors in existing future contracts were only going to have to
   pay a small percentage of the contract price in the end--as was
   becoming apparent--then tulip planters would have to jack up contract
   prices significantly in order to recover sums that reflected the spot
   market prices. And people would be willing to pay the higher prices.

   Why? In the worst-case scenario, investors would lose 3 percent of the
   price of the contract. In the best case, prices would rise above the
   strike price, and they could make an instant profit while assuming the
   minimal 3 percent risk.

   So, the market exploded. In November 1636, when the burgomasters'
   plans to screw the tulip planters took effect, traders began to
   process the impending changes into their thinking. By late November
   1636, "buyers had already begun treating the contract prices as option
   strike prices set at around 10 times the actual prices." As a result,
   "contract prices soared to reflect the expectation that the contract
   price was now a call-option exercise, or strike price rather than a
   price committed to be paid for future bulbs." By February, the price
   had risen 20 times. "That's what caused the tulipmania," says
   Thompson.

   So, the swift rise in prices for contracts on tulip bulbs in late 1636
   and early 1637 was less a speculative frenzy than a market rationally
   responding to rule changes.

   If they're correct--and it'll take someone with far more economic and
   data-crunching expertise than Moneybox to ratify or debunk their
   argument--then business writers will have to delete Tulipmania from
   their handy-pack of bubble analogies.

   Daniel Gross (www.danielgross.net) writes Slate's "Moneybox" column.
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