Oliver Foote, Author at Oliver Foote

Plans for Canada. When Will The Recovery Begin?

What in the World?

Not to sound agist (that’s how any great conversations with that one uncle starts eh), but who uses the word “Tariff” these day, what happened to duties, or just taxes? Also we’d be at least 10 states, if not 13. If it was 10 all the stars would still fit on the flag.

Backstory:

If you’re reading this in the future, you might have no idea what I’m alluding to. Well it’s the year 2025, May has just started and I think I’ve heard the word Tariff more than I ever thought possible. Canada’s federal liberal party had possibly the worlds quickest U-Turn to an election victory after facing sure defeat, and the guy running the US is convinced Canada should be “the 51st state”, among about 500 other things. What a weird timeline. I think I’m going to come back to this in 10 or 20 years and be so confused. At least I hope that’s the case and all the worlds problems get solved, one can at least dream. But for now this is the world we live in and there are some pressing problems facing Canada and the new Prime Minister.

Mark Carney:

Arguably, one of the best moves of Trudeaus political career was knowing when to bow out. With the snap election being called by the new leader of the liberal party Mark Carney. Who really seemed to come out of nowhere, although looking at his resume he’s been quite involved in government prior to this. Against all odds, a seemingly defeated liberal party, he managed to come 3 seats short of a majority government. In this article, while there are so many things going on in the US and Canada, and as we’re all learning the links are extremely deep and trade policy is very important to not only the price of goods, but consumer confidence in spending money and keep jobs. While I’d love to chat about all of it, my main focus is going to be talking about what plans Mark Carney has for Canada and what things might look like if he is able to follow through on some of his party’s platform. A lot of the things he’s been touting on the campaign trail, I’ve addressed as problems in my prior posts related to trades education, cost of housing, and investment and innovation in Canada. I’ve also been focusing a bit more of my time on video format content on my YouTube channel youtube.com/oliverfoote. So let’s see what we can find shall we.

One Economy:

This is an idea that has come up ever since the start of the trade war. The idea of one Canadian economy. Many of the provinces are on board with this idea, and now that there is the political will to find a way to remove our own trade barriers (thanks Trump, I guess), I think it’s likely that this will get done between Carney and the premiers. There have been some numbers quoted that if we are able to do this it would return around the same amount of economic activity to Canada as a 25% tariff from the US would cost Canada. I believe that pretty much everyone is in agreement that more labour mobility, easier flow of goods, and accepting credentials across provinces is just a sensible thing to do. This could help provinces that need workers, and provinces that have an oversupply of workers balance out their supply dynamics a bit. We’ve already been seeing an outflow of people from provinces like Ontario to provinces like Alberta and the Maritimes. This in theory is a win-win, takes pressure off Ontario employment and housing and provides much needed workers to places that are having a hard time finding them.

Build Baby Build:

There was one line that stood out to me on building and that was “we need to build homes on a scale not seen since the Second World War”. They outline how they will do this by creating a new agency with the goal of investing in new home building technology, providing low cost financing for affordable units, tax incentives for multi-residential unit construction and conversions, and importantly cutting governmental charges on building homes. Of all the development costs, government charges (taxes) have gone up the most in percentage terms of any development cost in the past 20 years, for a variety of reasons. They claim on their website that cutting development costs in half, will spur $8 Billion of private investment (every year!), let’s bookmark that to see how that pans out 5 years from now. They also said they will work with cities to speed up approvals and try to systematize things across Canada so builders can work anywhere, again I think this is a positive thing. Toronto’s approval timeline is around 30 months right now, that’s just approval! The actual construction of a high rise takes about 2-3 years, but the approvals and delays at 7 years on average to that timeline. So if we are able to even cut down the delays by half, it would immensely improve affordability. Businesses are all about systems, and the systems of many municipal governments are way to complicated and exclusionary when it comes to getting things built. I really hope that municipal governments across Canada are able to get on board with the provinces and federal governments and start rubber stamping thousands more units per year.

Innovation and Investment:

I heard a business owner say and I think this goes for builders and housing developers, that they are running their businesses in Canada “in spite of” the local government. I do believe strongly in oversight, making sure workers are safe, making sure that monopolies don’t prevent competition, supporting and championing local businesses. All levels of government should work hard to be partners with business, not roadblocks. Another great line from the platform was lets change “why are we doing this” to “how can we get this done”.

When it comes to housing, when it comes to business, when it comes to trades, innovation and re-investment. We really need to start asking how we can enable things to happen, not why they should or shouldn’t be allowed in the first place (while being smart about the investments obviously). I’ve made videos and spoken about Canada’s declining business investments in the past and how a lot of our big business investments have instead moved into residential housing and inflating asset prices, this has been somewhat of a trend across many western countries lead by the US. There are points in the liberal platform that address this as well and point to specific plans for increasing investment in Canadian companies and businesses. I read a very interesting piece from the BoC where they mentioned that global capital flows historically went to the US and their “Superstar” firms which also tends to attracts global talent. Canada needs to invest and encourage a larger start up and entrepreneurial culture that can potentially create multiple global superstar competitors that will make Canada a more attractive place for global capital. One problem with the ultra ambitious, is that they frequently run into market size and somewhat fragmented, or limited markets in Canada. Naturally, at some point every company will expand internationally, and finding success in the US is the ultimate victory because of the liquidity of the market, start up culture, and global capital flows, wealth in general, can make companies grow exponentially.

The Future of Canada

There is so much to talk about here and the layers go very deep. I don’t know how much the Carney government will be able to accomplish, but I really hope that at least some of their ideas get through and I think as a nation we’ve reached a point in time where everyone is on board to try and resolve some of these bigger issues and people are united in the idea of doing so. I feel a positive national spirit building in Canada and I hope that this will be the catalyst towards helping Canada become a real player on the world stage. If there has even been a moment in time where the country and all levels of government seem willing to make massive changes, it’s right now, and I really hope that they are able to do that, and that they have enough runway and political pressure to get some of these major projects through. Amidst all the chaos of the past 5 years, first COVID, now a trade war, I actually find myself feeling optimistic about what the future of Canada might hold, and I no longer feel this imminent urge to pack my bags and leave for better opportunities elsewhere in the world. Only time will tell what ends up happening and what doesn’t, but I have a lot more hope than I did a few months and years ago. There will be a lot of bumps in the road along the way, but I have faith now, which is not something I could say 5 years ago. Let’s see what we can do.

Buy The Stock Market Drop? Tariff Mania.

Let the Games Begin:

As someone who likes to purchase stocks when the markets are bleeding, I wanted to do a quick discussion since the stock market is basically in freefall after Trumps “Liberation Day”, I think he meant he wants to liberate the US from it’s money.

After doing a bit of reading the net tariffs the US has imposed are around 22% overall, which is 19% higher than it was last year. After reading this Motely Fool article, they point out that every time there have been small increases in the tariff rate, 0.5-2%, the markets tend to fall around 20%-30% from past peaks, this has happened countless times in history. These “Liberation Day” tariffs are 19% higher, so it’s likely this will be one of the largest stock market declines potentially ever seen, (assuming Trump’s administration keeps these in place, who knows).

Missed the Boat:

I’m quite highly indexed in the US market as a Canadian, around 80% of my holdings, so this has been somewhat painful (well not really since I tend to ignore the market day to day). But as far as my investments go I don’t really like to sell my stocks, and I haven’t. I’m planning to ride this painful fall all the way into the pits of despair, as I don’t have the time or conviction about the timing of the bottom to sell on the way down and then hope to buy at a lower price. Generally selling while a market is falling means you’ve already missed the boat.

My Covid Market Strategy:

Last time, during covid, I took out some loans to invest in the market near the bottom. Then the recovery started because the central banks made it very clear they would cut interest rates. The economy bounced back as it learned how to manage this unknown event. Yes there were supply chain disruptions, but the fundamental hyper-globalization of the world economy wasn’t put (as much) into question.

Should I Do It Again?

Since I don’t have much cash on hand right now, the question I want to answer for myself, is it a good idea this time to take out loans to invest? Is this a prudent financial plan? As of writing, prime rate is at 4.95%, so I’d have to make above a 5% return in the stock market each year I’m borrowing money, in order to justify this plan. I’d also have to try to evaluate the risk of rates increasing. I’d also have to come up with a somewhat reasonable estimate of the length of time the stock market will be in the dumps and when it will start to recover. With these questions in mind I began researching.

Bank of Canada Thoughts:

I started with what the Bank of Canada has to say about tariffs and interest rates, as well as the speed of the recovery. This paragraph from an event in Feb 2025 does a good job of summarizing the discussion and the problem.

Initially, they are expecting excess supply in the economy as exports fall, this will likely lead to a short term jump in inflation. Assuming this jump isn’t too bad. We will then have the problem of a lack of demand, due to job losses and lack of business investment in the economy, which Canada has already been suffering from for the past decade or so and this trade war will only make worse.

“Smooth the Decline”:

As Tiff Macklem said, they cannot restore lost supply, but they might be able to “smooth the decline in demand” a.k.a. cut interest rates, which they’ll try to balance with upward pressure on inflation, a.k.a. don’t cut them too much.

Projections from the federal reserve were sitting at 3 further 25 point rate cuts as of a week ago, but today economists are projecting 4 cuts. Additionally, while the Bank of Canada said itself that they would have liked to hold rates prior to all the tariff nonsense, the projections from all the large Canadian economists were an additional 2-3 cuts for the Bank of Canada in 2025. I think it’s possible we also see 3 cuts bringing the benchmark rate down to 2% by the end of 2025 given this tariff shock. There are risks to the upside that inflation does get somewhat out of control due to the tariffs (which inherently increase prices), and the bank is forced to hold or even slightly increase rates, although I think the bigger risk comes to lack of productivity and output, rather than serious increase in prices.

Pandemic Inflation vs. Tariff Inflation:

The reason prices increased so much during covid was that people were unable to work leading to supply chains getting backed up, then governments and central banks pumped trillions of dollars into the economy. This was a perfect recipe for higher inflation. Fewer goods to go around, but citizens with more spending power for various reasons. This time around the dynamics are different, people don’t have as much money floating around, savings rates are in the gutter, people are already stretched, there aren’t as many good jobs around as there was in 2019. What this means is that higher prices will likely just result in less demand for goods, leading to contracting economies and drawn out recessions. Covid wasn’t really a traditional recession, the recovery was unprecedented. This time is going to be different, this is going to cause long term, painful economic damage.

S&P 500 P/E Ratio:

Looking at history, what will likely happen to the stock market is a big drop, followed by years of slow climb as the economy adjusts to this new reality. The only question is how far it will drop. Another thing to consider is that looking at the Price to Earnings ratio of the S&P 500, it’s hovering at around 23.5 as of writing and earlier this year it was close to 27. Even at a P/E of 23 this is still on the higher end of an “expensive” stock market, something closer to 20 would be considered reasonable and a good buy. Since these tariffs will likely decrease consumer spending and cause companies earnings to fall in the short term, it easy to see that the stock market might have a ways more to come down based on this alone.

Here’s a good chart of where the stock market was right before the dot com bubble, and where our 2025 market was. Really it looks like the tariffs were the catalyst the market needed for a bit of a correction.

Q1 Just Ended (safely), Q2 Will Hurt:

The earnings part of this ratio is yet to be updated as we await company earnings, since we just closed out Q1, earnings hits won’t show up in financial statements until Q2. It’s hard to say if the market will be able to properly price this in, or if Q2 earnings season this summer will lead to another large leg down in the market as we see the real tariff reality reflected in earnings. As the market continues to try and price in the absolute worse case scenario, it’s likely going to overshoot to the downside, which is when the buying opportunity should present itself. Only warning I have is be prepared for a very long and slow climb back up, and be prepared for multiple short term drops as the market begins to get more information and a more complete picture.

Short-Term 4-Year Plan:

At minimum it will likely be at least 4 years before things change (again, unless Mr. Orange changes his mind). Factoring in a 4 year bleed, I somewhat hesitate to recommend the plan of borrowing money to invest. The state of our economies were already stretched quite thin prior to this, and this will completely shake up global trade. Another potential wrinkle in this policy is that this ends up being a temporary 4-year (or shorter) policy, and in 2029 everything goes back to pre-tariffs. I would consider this a very likely scenario.

Unfortunately, this being the case would arguably make things even worse in the short-term for Americans as companies will be reluctant to onshore production and invest in long-term plans to build in the US. Which will just result in these companies trying to find other partners to trade with and cut the US out entirely, and overall reduce economic activity in the US.

Guns and a Foot:

The US will almost certainly see high inflation and job losses due to companies inability to be competitive globally and export at reasonable prices as countries start to put reciprocal tariffs in place. It’s equally possible in my view, that this “Liberation Day” ends up being very short lived. Once the US begins to feel the impacts, markets falling. It’s possible that everyone, including those around Trump in the next 6 months to a year start calling for him to revert these policies. If he does reverse course prior to the end of his term, the markets will likely react positively, although they probably won’t return to their highs of January 2025 due to a lack of trust in Trump.

Passing of Time:

As an investor you have to balance the possibility of both these things happening. It’s likely this will be long and drawn out, but it is equally likely things will change sooner than later. In either scenario, the US *should* return to a more free trade policy at some indeterminate date in the future. Since this is almost a certainty, whether in this administration or the next. The length of the downturn doesn’t necessarily matter if you are a long-term investor buying with cash you can afford to dump into the market. This is likely going to be viewed in the future as a stellar buying opportunity. I think it is a safe bet to say that for the next 4 years, the US will no longer be viewed as a safe haven for capital. The long term impacts on US economic dominance due to this policy, lack of trust with trading partners, intangible things, will be harder to quantify.

Modern Era Volatility:

Something you might notice looking at a chart of the S&P 500 is that in recent years volatility has increased significantly. This is partly due to the speed at which information travels these days. Reactions to world events tend to be more instantaneous than they were 25 years ago. The decline from the dot com bubble was a 2-3 year long protracted fall, whereas the covid decline was, I’m not kidding, 3 weeks. Then the fed stepped in to “save the market” and the recovery began, within about 6 months it returned to where it left off in Feb 2020. Between 2020 and 2024 there were some ups and downs, with a period of a 20% drop from 21-22, but on the whole things were more stable.

I wanted to point this out because I think the modern era will play into the speed and severity of the decline. I don’t expect the recovery to be nearly as quick as the covid recovery, but I think the sharp declines in the market will continue for a couple of weeks at most, then things will stabilize once all this tariff stuff plays out globally. This makes predicting the bottom a challenge, so the general advice would be to buy in slowly in chunks on days when the market is down over the coming weeks and months. I hesitate to think this decline will be as fast as the covid decline, but the “big” one time shock of these blanket tariffs, the “main event”, has occurred. Whereas during covid, the main event was when everyone realized the speed of the spread of the virus and then governments around the world telling people to stay home. This time it’s Trump telling America to… Well, insert your favourite expletive here.

US and China:

Importantly, to much of the high tech industry. Chips from Taiwan will become more expensive. Ton’s of supply chains are located abroad, especially in China, and lots of consumer electronics are manufactured in Chain or Taiwan. With the additional US tariffs, projected lack of consumer spending, you might see companies like Apple drop significantly (which it has already). I’m not going to be buying individual stocks, but my suspicion is that consumer spending will basically halt for a while as people worry about what the tariffs mean for their jobs, and as many people begin losing their jobs during Q2 they won’t have money to spend.

To Borrow or Not To Borrow:

On balance, I think borrowing money right now to invest holds a good amount of risk. I don’t really see a guarantee that things will improve. When we had the covid downturn, the action of the central banks and governments supported economies rather than taking a chainsaw to them. There are many more uncertainties this time around. That being said, every time in history that the US market has fallen, things have eventually recovered. On top of this, there is an limit to the amount of time that Trump will be in office (for now).

US Global Dominance in Question:

The only assumption that hasn’t had to be questioned for the last 80 years, is if the US remains the dominant economic force once all of this is over. They were riding the high of being one of the most innovative and powerful economies in the world. The competitiveness of the US on cutting edge tech, and top talent from across the world being attracted to the economic machine is genuinely put into question thanks to this move. China was already on pace to surpass the US as the largest economy, it’s currently at #2. I suspect this will just accelerate the US decline in competitiveness.

I am still somewhat naively hopeful, that the US will come out of this and be able to resume somewhere near where they left off. There will be people within the country that will continue to be on the cutting edge, entrepreneurialism is still going to be at the heart of the US. They will still export a lot of media to the rest of the western world.

More Room to Fall? China Hits Back:

I think there is still room to fall. The market is down about 15% from it’s January peak. Considering these numbers are only starting to bring the market back to realistic valuations, I’m not even sure the tariffs have been priced in yet.

On the “pricing in” tariffs front, today China announced reciprocal tariffs on the US, which caused the already down market to drop even more today. The US imports over $450 Billion of Chinese goods which now have a 34% tariff slapped on them as of this morning. Stocks with large exposure to the Chinese market such as Nvidia, Apple, Tesla saw more severe drops than the market overall. Over the weekend, and starting next week, it is likely that other countries will retaliate against the US as well, namely the European Union. Which will lead to more pain and further drops in the US markets. Each time another large economy decides to fight back against the US tariffs, it will continue to hurt the US markets more and more. As this builds up I suspect it will become more and more likely that Trump will backpedal. Even if he does no one will trust his word anymore and the market may just continue its freefall.

Timing:

With the small amount of cash on hand I have right now, I’m likely going to start buying in slowly. I won’t buy in all at once, I’m going to buy chunks in the next week or two once the drop is nearer to 20%. With a clearer picture now in my mind, I may also take on a small amount of loan risk that I feel I’d be able to pay off successfully should that turn out to be a poor decision. It’s also important to consider your stage in life when deciding how much risk to take. I’m 25, I don’t enjoy taking on huge amounts of risk, but I’m young, so taking on a bit more risk than someone who is retired isn’t a bad move. Regardless, prudence is also important when we’re talking about entire economies getting hurt and people losing jobs. If you’re not in a recession proof job, be careful. I don’t really have all that much to lose right now, but I also don’t want to be an idiot and lose for no reason. So calculated risks are important, and I think this is a good time to take action and calculate some risks.

That’s my analysis of the scenario, only time will tell what the outcome is, but I’ll leave you with the age old saying of “buy low, sell high… And hope the US comes to it’s senses”. We may not be at the eventual low yet, but buying on the way down has proven to be a winning strategy time and time again, timing the market is a fools errand, so just be sensible. Trump can do a lot of damage, but I believe the US will still come out of this as a top player on the world stage, even if it takes 4 years for all this to blow over, and even if there are some irreversible problems caused, only time will tell. This time, the decision isn’t as easy as it was during covid, but if you drown out a bit of the noise. Buying in while things are looking bad, and understanding that this is all (most likely) temporary, is how success stories are built. As always.

Keep Investing,

-Oliver

End Note:

Dividend Stocks vs. Interest:

I wanted to add a bit of an endnote here. Last time when I borrowed money to invest, I did it relatively safely. I mostly purchased stocks that had over a 100-year history of paying out dividends, in a country with a stable economy (which is a bit harder to quantify this time), and I made sure that the dividends they paid out would at minimum cover the interest on my loan, effectively reducing my risk to near zero. Beyond that any increase in the share price was “free” appreciation. Just wanted to throw that out there as something to consider, obviously be careful about the industry you choose, but this is just an idea to mitigate risk while increasing your position in the market.

What is Hedging?

Hedging and Derivatives

Recently I have been taking some accounting courses and through some of the courses I’ve been learning about things that I think many people would find rather dull, but that I have found quite interesting. I’ve been learning about accounting for Agriculture, accounting for stock based compensation or other employee share based compensation (SAR, share appreciation rights). We also had a section talking about financial derivatives and what they might be used for. The goal of my discussion to today is to talk a little bit about hedging, what is it? Why do people care? Who is hedging good for? Is Hedging complicated? You get the gist. Hedging was not something I learned about directly, but it is something that I think carries a bit of a “mistical air” about it, so I wanted to try my best to explain how it works and get into the weeds of financial derivatives.

What Are Derivatives?

Let’s start out by talking about what a financial derivative is, what does that scary word mean. Well to someone who has done calculus, it means that x²=2x’. In the financial world a derivate is adding another layer onto the underlying asset, and generally that layer can be traded and has value on it’s own, without impacting the underlying asset. You can think of it like this, in a non-derivative transaction you almost always are trading some form of money for something else. It might be money for grain, gold for a donkey depending on your mood. A derivative is derived from an exchange like this. We might create a contract that on a future date we’ll buy something for a set price, we might also exchange interest rates on our loans, or provide an option for someone to buy or sell something. In these examples the contract for a future price, or the “option” to purchase something in the future has a value. Generally, the value of a derivative would be the difference between todays price and the price someone agreed to buy/sell at, plus a “premium” for the timeline risk. The longer the timeline the larger the premium. By creating these options to purchase, or contracts into the future, we have created something that has value on it’s own, without affecting the value that the underlying thing will ultimately get sold at, thus we have a financial derivative. These derivatives are frequently used to “hedge your bets” against price changes (lock in a good price today), or just to speculate on price changes.

The Forward Contract

As a good starter example take the forward contract. A forward contract is a contract between two parties, where they agree to purchase or sell something to the other party at a certain price on a certain date in the future. Basically, a forward contract locks in a price today regardless of the fluctuations of the market. This is frequently done on commodities (agriculture and oil, for example), which can be somewhat volatile price wise depending on supply and demand, prices at the gas pump change almost daily. In order to avoid these daily price changes, you are agreeing to a certain price now, and the other party takes on the risk of the price changes. The “seller” has the potential to earn a profit or loss on the contract based on the price they agreed to and the price at which they’d be able to normally sell the same goods on the open market. As the “buyer” of one of these contracts, the price of the asset no longer matters to you since you’ve already locked in your price and you can now account for it as an account payable with no variability. In essence, a forward contract is just a way to try and remove pricing uncertainty from the equation for one party. If it’s important to your business to know the input costs of raw materials because you’re trying to manufacture something at a certain price, a forward contract might be useful. If there’s an unpredictable world event (which seem to be happening more and more these days), you can reduce the risk of volatile pricing, at least for a while. This type of contract can be considered a “hedging” tool. In this case the goal is to reduce the risk of a price fluctuation. Generally, a forward contract is not sold once it is created, in which case it wouldn’t necessarily be a financial derivative since there’s no way to make money on the contract itself if you so desired. That’s where our next type of contract comes in.

The Futures Contract

An extension of the forward contract is a futures contract, which you may have heard of as a financial derivative. A futures contract is again giving the rights to someone to buy or sell a certain commodity in blocks of 1000. The difference between this type of contract and a forward contract is that the futures contract itself can be publicly traded on markets up until the date the contract needs to be fulfilled. Again, many firms might use this as a hedge depending on what they are selling or buying. However, this type of contract can also be open to speculators, as the value of the contract fluctuates with the market price of the underlying commodity. This contract can then be sold over and over again at various prices until its due date. The risk from the speculators point of view is that 1000 of something is a relatively large amount. If the pricing of the underlying commodity changes by $1, you can be up or down $1000 relatively quickly. Multiply this by the number of contracts you bought and the volatility of the price, you can risk quite a bit of money, while also potentially profiting quite a bit of money. Most speculators aren’t using futures contracts as a hedging mechanism. But there are large firms out there who want to buy “insurance” on the price of a certain commodity, and might use this as a tool to lock in a certain price, not worrying about the value of the contract in the interim. Bored yet?

The Option Contract

Our next financial derivative to take the stage is going to be the option contract. This one get’s very meta very fast. An options contract can be a hedge against stock that you own in a certain company, or a speculative tool. Each option contract represents 100 shares of stock. Suppose that you think Nvidia stock price is going to be much higher 1 year from today. You can purchase a “call” option contract that gives you the rights to purchase 100 shares of Nvidia stock at $100 per share 1 year from today. However, someone else will be taking the other side of the bet, and due to the popularity of Nvidia stock or sentiment of the likelihood of the entire market being higher next year than it is today. You’ll likely have to pay a hefty premium to obtain that option contract. As time goes on and market sentiment changes, the “premium” you paid will start to decay and the option contract itself will lose value the closer you get to the specified date. On the final date of the contract, the only value is the “intrinsic value” of the contract. Which is the price the shares are trading at on the open market minus the price written on the contract. If the stock price is lower than stated on your option contract, it would be a better deal to buy the shares on the market, so your option contract is worthless. If the stock price is higher than your option contract, you might be able to make up for the premium and earn a profit on top of it buy buying the shares at a cheaper price than you can purchase them on the open market right now. The higher the stock price, the better our option to purchase the shares “cheap”.

Put Options

You can also purchase a put option if you believe the stock price of a company will go down. The put option allows you to force the company to purchase your shares at a certain price. Let’s again use the Nvidia example. We buy a put option at $100, 1 year from now. At the expiry date, lets say that Nvidia is trading at $80. But we have the option to sell our shares at $100. So on expiry, we can make $20 per share by selling 100 of our shares using our option and repurchasing them at the lower price (or not). Without getting too much into the details, I do want to point out that speculating on single stocks is known to be a bad idea. If you’re reading this you are unlikely to be someone who found an arbitrage opportunity in the market, or who built a model on weather patterns in Idaho in order to figure out potato yields and trade on that information, which is what you have to do to get an edge in financial markets. So this is my PSA not to speculate. But options can be used as tools to avoid fluctuations in the financial markets themselves. You don’t even necessarily have to exercise the option. For the sake of argument, let’s say that something about Tesla future stock price is worrying, and you’re the proud owner of 100 Tesla shares. You decide to “spend” a bit of money on a put option contract in order to be able to sell your Tesla shares at a good price in the future. The year comes and goes and it turns out that you’re completely wrong and Tesla doubles in value and your put option is worthless. Well you should still rejoice because your Tesla shares a worth more than they were last year! What you’ve effectively done is spent a bit of money to prevent loss, which has resulted in reducing your overall gain. You’ve essentially reduced the volatility and the risk built into your shares, which is how options can be used as a hedging tool.

Interest Rate Swaps

Now we’re going to get into the really whacky and fun stuff. Interest rate swaps. Why might someone want to “swap” an interest rate? Take Company A that has a bank loan for $1,000,000 with a variable interest rate, currently sitting at 4%. Company B also has a $1,000,000 loan, but with a fixed rate of 5%. If Company A, who has a variable rate, believes that the central banks lending rate will go higher in the future, and Company B believes the opposite, they might want to swap their interest rates on half their loans. This would result in Company A and Company B having a blended rate, where $500,000 of the loan has a variable rate of 4% and the other $500,000 has a fixed rate of 5%. They can both save money on interest if the variable rate drops, and they’d both have part of their loan guaranteed at the fixed rate if the variable goes up. It’s a good way of reducing interest rate risk. You can also do many different variations. Maybe Company A wants 75% variable exposure and 25% fixed exposure. I think this is a pretty cool tool that I didn’t really realize you could use before a couple weeks ago. But it makes a ton of sense. I wonder if you might be able to do something like this on residential mortgages? Let me know if you have any intel.

Credit Default Swaps

As my final financial derivative, I want to talk about Credit Default Swaps. If you’ve read or watched The Big Short you probably have heard about these. As a brief explanation, if someone, or an entity has some debt, you can create a “credit swap” for the underlying obligation. As the purchaser of a CDS, you are hoping for the entity or person to default, or go bankrupt, or fail to pay their debt in some way. If the entity does completely go under, their debt is then auctioned off and the CDS purchaser would receive their payout. The rate which you pay for the privilege of owning a swap is around 1% to 5% of the value of the debt per year to the entity. The part that is somewhat hard to wrap your head around on these kinds of swaps, is that you are buying the debt of a bankrupt entity. I’m not entirely sure how one would use a credit default swap as a hedge, unless you wanted to hedge against a large credit crisis, which if you look at consumer borrowing rates right now, isn’t as unlikely as it was a few years ago. I would have to put this in the category of highly speculative and quite frankly, I’ve still got some reading to do on it. That’s about all I got for this week, just wanted to get some ideas on the page about derivatives and their potential uses, as well as hedging and risk reduction tools. As always thanks for reading.

Keep Investing,

-Oliver Foote