The Zaccaria Deal (I) : On modern finance and history

1. The Zaccaria Deal (I) :On modern finance and history Eric Briys, Didier Joos de ter Beerst Congrès AFFI Poitiers, 26 juin 2006

2. The last twenty years of Modern Finance : « again » ! • Miller (1986) enthusiastic paper “Financial Innovation: The Last Twenty Years and the Next” twenty years have gone by. It makes sense to see whether or not the optimistic views of Miller have been confirmed by the facts. • Four key areas, all revived by Option Pricing Theory (OPT): • OPT and new breed of derivative securities • Modelling of credit/default risk through OPT insights • Risk management: Var, ART • Real options and interaction with financing • Merton frames these developments in what he calls “Functional Finance” : History “ As If” = No History

3. Modern Finance: Pitfalls of the silo approach • Option pricing: Hakansson’s catch 22 paradox • René Stulz: “Telling students simultaneously that they should compute net present values using the Modigliani-Miller capital budgeting paradigm, that they should optimize the firm’s capital structure by trading off costs of distress against equity cost, and finally that they should worry about risk management amounts to pure schizophrenia and does not have the slightest intellectual foundation in modern finance theory.[…] It is a peculiarity of finance that we spend so much time on teaching about a world without frictions when everything that makes finance interesting has to do with what happens in the presence of frictions.” • Unfortunate outcome: “Happy people do not have a history”. • Well, they do have one!

4. Key messages • The framework we propose consists in core messages: • Financial and real options were explicitly contracted in Late Middle-Age, and before. • Contracts are “bricolage” of options to complete incomplete markets • Options were “bricolage” in Late Middle-Age, they still are today! • There is no universal theory but : “Proof is in pudding”

5. The original document (Archivio di Stato, Genoa, notai antichi)

6. Call Stock in key location 3000 people working for Zaccaria in Phocea Large fleet of a dozen of galleys, nave, cocha A map of Zaccaria’s route (1298-1299) 650 cantari of alum (= 35 tons)

7. Contracting constraints and supports Constrain contracting efficiency Support contracting efficiency • Limited cognitive load about the future • Lack of markets : no stock exchange, no futures, no « insurance », no limited liability • Agency risks in long-distance maritime trade • Trade-off between contract complexity and simplicity(incompleteness) • Property rights in Bruges • Usury prohibition (see under) • Cost/time of contract to deal with business and contracting risks vs benefits • Institutions : • Law • Notary, Scriba (accounting), judges, arbitrers • Standard contracting from developped mainly in Genoa : • Commenda (equity-type) • Loca (equity-type) • Societatis (JV) • Nolis (lease) • Instrumentum ex causa cambi • ... • Private-order contracting (alberghi) • Entrepreneurship, Innovation, knowledge

9. The scenario tree : a complex web of options

10. First simplified model : single venture :buyback with embedded « sea loan » 1 Short asset + long cash + Long Call with Long Put « sea loan » = (compounded options) Convention : Vz = value of the venture, z = the indicator for Zaccaria, T0 T1, departure, arrival Vz = value of the venture, P = price (with P, P *, the commodity market price in Aigues-Mortes, in Bruges), Q = quantity,

11. Scenario 1 Scenario 2 Scenario 3 Put Scenario 4 Scenario 5 Call Put Scenario 6 Call A simplified tree : a put on a call on a put on a call (red nodes = decision, white = events)

12. Timing Contract agreement in Genoa. Zaccaria receives 3,000 G £. Arrival in Bruges, if no casualty, and decision to buyback alum 6 month waiting deadline 3 month trip Aigues-Mortes - Bruges 3 month trip Bruges - Genoa 1st November 1299(t = 3) 1st August 1299 (t = 2) 1st May 1299 (t = 1) 1st November 1298 (t= 0) Starting date of the venture, or repayment of 3,250 £ if Zaccaria does not leave Genoa Arrival in Genoa, if no casualty. Payment of 3,780 G £ to Suppa & Grillo

13. Full model (2) : Zaccaria ’s payoff 2 P = price (with P, P *, P **, respectively, price in Aigues-Mortes, in Bruges and Genoa), Q = quantity, a = alum, d= drapery N = transport cost for back-and-forth , G = galley (s), aN = market price of transport (nolis) S = exchange rates p(1) = Decision to buyback in Aigues-Mortes [1-p(1)] = Decision to Start the venture p(2) = Casualty before Bruges (full loss) [1-p(2)] = Safe arrival in Bruges p(3) = Decision to lease galleys (no buyback in Bruges) [1-p(3)]= Decision to buyback p(4) = Casualty before Genoa (way back) [1-p(4)] = Safe arrival in Genoa

14. Sea loan (indemnity) Payoff from drapery Buyback price Galley recovered Rent cash Upfront Investment Casualty No-Casualty on the way back Decision to buyback Decision not to buyback Decision to start No-Casualty on the way back Zaccaria ’s payoff (scenario 1, …, 6) 2 Payoff no-departure

15. Decision 1 : Start the venture [1-p(1)] 2 Galley recovered in case of safe arrival Cash in Nolis (transport) if galley arrives in Bruges Up front Expenses in transport (invest Galley + pay salaries, food) Payoff no departure Start if(Scenario 2 +Scenario 3 +Scenario 4) - (Scenario 1) > 0

16. Decision 2 : buyback [1-p(3)] 2 Galley recovered in case of safe arrival Defalult up to 3,500 Tournois in case of casualty Payoff from drapery in Genopa Buyback price of 3,780 £ Cash in Nolis (transport) if galley arrives in Bruges Buyback if(Scenario 5 +Scenario 6) - (Scenario 3 +Scenario 4) > 0

17. Put/call parity Accetped by the Church Prohibited by the Church The Zaccarias Protective Put Fiduciary Call = Long Put Option + Long Asset + Borrowing * Cash + Short Asset (Sales) + Long Call Option = Short Put Option + Short Asset + Lending - Cash + Long Asset (Sales) + Short Call Option Suppa & Grillo

18. Back to the First model : the venture as a « sea loan »: Loan + default Long cash + short debt + Long Put on debt with Long Put « sea loan » (compounded options) Prohibited by the Church

19. Conclusion : Empirically we have crunched numbers : Buyback option = always out-of-the-money in Bruges • Pooling funds : 3,000 £ were gathered jointly from Suppa and Grillo • Transfer funds: Zaccaria has received cash for a venture to and from Bruges • Complete incomplete markets: innovative solution that completes market gaps • Manage Risk.The contract spreads, through transfer and financing, the various risks among the parties to it. • Control agency risks. agency and informational issues. • Screening/monitoring: quality of alum accounting books and scriba on board. • Incentives : ex ante selection and ex post control of parties: The option to start (“find and reveal information”, no “cheap talk” • Increase asymmetry of information with Competitors. • Fostering family and business networks. • Create Legal arbitrage (State, Church).

20. Conclusion : contracts as context-specific bricolage to exchange The institutional context Debt Leasing C O N T R A C T I N G C O N S T R A I N T S C O N T R A C T I N G S O L U T I O N S Sales Contract = Options Equities Insurance Management The business model