Making Markets, Pawn Shops, and Farmer Joe

My first full-time job out of college was at a small (<100 employee) Chicago finance firm.

It was crazy.

The company I worked for was a market maker.

The function of a market maker is someone that publicly shares their willingness to buy or sell a given asset.

Without a market maker buyers cannot find sellers and sellers cannot find buyers.

Without market makers, markets are…

A pawn shop is a market maker.

You could bring a bike to their store and they’d offer you $50–you could ask to buy the bike and they would offer you it for $100.

In the time between buying and selling the bike (and capturing a $50 profit), the pawn shop loses money.

They have to:

• pay rent,
• pay their employees,
• pay utilities,
• and bear the stress of haggling with customers (because no one does that voluntarily!)

Another hidden cost that the pawn shop faces is that they may not ever be able to sell the bike to anyone for more than $50!

Can a pawn shop protect itself from that difficult situation?

They can buy insurance.

But what kind of insurance?

Well–what if someone didn’t really need a bike?

You could offer the pawnshop a deal:

if the pawnshop hasn’t sold the bike in 6 months, then they can decided to sell it to me for $60

but if they fail to sell it in the next 6 months for $50 profit they can at least recoup $10.

They don’t have to sell it to me–but they’ll have the option to.

This type of agreement frees individuals to take risks they would not otherwise–since they have re-assurance that their ass is covered.

This type of agreement (contract) is called an “option”.

It important to many businesses in the world–perhaps the oldest is agriculture and food production.

Farmer Joe

Farmer Joe cannot know exactly how much crops his land will yield in 6 months (if any!).

Nor can he know what the price of apples will be in 6 months.

Risk factors that can affect the price of apples 6 months in the future include:

• weather events (droughts/floodings)
• insect pests
• plant diseases
• fluctuating market demand
• fluctuating market supply (other farmers’ decisionmaking and luck)

Our farmer can benefit tremendously from being able to enter into a contract to optionally sell their apples.

It can prevent a farmer from going bankrupt in good years and bad!

I’ll be creating a follow on blogpost to share how you can evaluate an insurance contract’s price.

Interested in insurance? Manage your stress.