Acid-Test: Derivatives Trading

Many outside observers view derivatives trading — as undertaken by hedge funds such as the George Soros fund, or Long-term Capital Management (LTCM) — as the epitome of the ugly face of global capitalism: it appears to be an activity premised purely on the short-term acquisition of material wealth through the creation of complex and artificial financial instruments. But, as is usually the case, on closer scrutiny things are not so simple.

Although outright speculation undoubtedly explains much derivatives trading activity, it does not explain the whole market. Take, for example, two of the most popular trading strategies employing derivatives, namely portfolio insurance and index arbitrage. Without getting into the technicalities, the essential objective behind portfolio insurance is — as the name implies — to insure a portfolio against heavy losses. This is generally achieved by entering into derivatives positions that become profitable if the portfolio to be insured loses value. Similarly, the objective behind index arbitrage is not to maximize profits ad infinitum but rather to lock in a modest risk-free return. This is achieved by exploiting the 'spread' between the value of a futures contract and the corresponding spot value.

Rather than simple wealth maximization, therefore, such strategies are better described as risk management. Furthermore, they involve the application of a substantial body of sophisticated knowledge that evolves through time. There is an excellence to pursue here, namely the development of a trading strategy that successfully meets some risk-management goal. The activity is also communal: traders work in various groups that pursue certain common goals. For example, the traders in a 'pit' on the London-International-Financial-Futures-Exchange (LIFFE) share the common goal of maintaining as liquid a market as possible for their particular contract; or the traders in a trading room of a financial institution share the common goal of meeting performance targets and designing contracts that meet the risk-management needs of clients. But could this activity be reasonably viewed as what MacIntyre defines as a practice?

There are three basic characteristics of derivatives trading that define it as a practice within virtue ethics:
– First, it establishes its own standards of excellence in the design and successful implementation of the various trading strategies summarized above.
– Second, there are particular internal goods specific to derivatives trading. As always with the concept of internal goods it is hard to find words to define them. In After Virtue, in the context of chess, MacIntyre defines the internal goods as analytical skill, strategic imagination and competitive intensity. All these would seem to be eminently applicable to derivatives trading.
– Third, derivatives trading is undoubtedly organic. These markets are continually changing as new strategies and contracts are being developed all the time.

In short, there is no reason why the tenets of a practice-based community cannot be applied to even the most cold-bloodedly technical of business activities, namely derivatives trading. Such a derivatives trading organization would be one in which its members viewed themselves as engaged in the pursuit of the internal goods unique to the practice of derivatives trading; e.g., the successful application of the theoretical tools of option-pricing theory, or the ability to design a portfolio insurance strategy that meets as closely as possible the stated risk-management objectives.