Re: Can Tulipmania be explained rationally as the birth of options?

["Perelman, Michael" <MPerelman@xxxxxxxxxxxx>]

First of all, great pun: "spot dog."  The person whom Daniel mentions,
Garber, is an economist, who began to write about tulip mania right
after the `987 stock market melt down in the vain hope of proving that
markets were efficient.  In the end, he admitted some irrationality, but
not a lot.

Michael Perelman
Economics Department
California State University
Chico, CA
95929


-----Original Message-----
From: PEN-L list [mailto:PEN-L@xxxxxxxxxxxxxxxx] On Behalf Of Daniel
Davies
Sent: Sunday, July 18, 2004 4:26 AM
To: PEN-L@xxxxxxxxxxxxxxxx
Subject: Re: [PEN-L] Can Tulipmania be explained rationally as the birth
of options?

to be honest, not a lot.  I'm trying to track down the actual working
paper,
but my immediate reaction is the same as my reaction to Peter Garber's
previous attempt to interpret tulipomania as a rational phenomenon, and
rather similar to your own; it is a historical fact that tulipomania
diverted massive amounts of the productive output of the Dutch economy
and
led to a serious recession.  If this was produced as the result of the
operation of an efficient market, then any point one might reasonably
want
to make as a critique of efficient markets theory is made, and the
Chicago
boys have saved their theory by destroying it.

In any case, I don't think it makes sense as a piece of finance theory;
the
option tail does not wag the spot dog.  If the reinterpretation of the
contracts did take place in this manner, then that would make the
futures/options contracts themselves much more valuable to the buyers,
but
it would make no sense at all for the sellers of tulip bulbs to mark up
the
spot price of tulips.  I suspect that the authors are relying on the
assumption that it would be possible for an investor to go short of
physical
tulips, something which I do not believe was possible.

dd

-----Original Message-----
From: PEN-L list [mailto:PEN-L@xxxxxxxxxxxxxxxx]On Behalf Of Michael
Pollak
Sent: 17 July 2004 20:29
To: PEN-L@xxxxxxxxxxxxxxxx
Subject: Can Tulipmania be explained rationally as the birth of options?



[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/

    moneybox    Daily commentary about business and finance.
    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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