Convertible Arbitrage. Thought of the Day 108.0

A convertible bond can be thought of as a fixed income security that has an embedded equity call option. The convertible investor has the right, but not the obligation, to convert (exchange) the bond into a predetermined number of common shares. The investor will presumably convert sometime at or before the maturity of the bond if the value of the common shares exceeds the cash redemption value of the bond. The convertible therefore has both debt and equity characteristics and, as a result, provides an asymmetrical risk and return profile. Until the investor converts the bond into common shares of the issuer, the issuer is obligated to pay a fixed coupon to the investor and repay the bond at maturity if conversion never occurs. A convertible’s price is sensitive to, among other things, changes in market interest rates, credit risk of the issuer, and the issuer’s common share price and share price volatility.

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Analysis of convertible bond prices factors in three different sources of value: investment value, conversion value, and option value. The investment value is the theoretical value at which the bond would trade if it were not convertible. This represents the security’s floor value, or minimum price at which it should trade as a nonconvertible bond. The conversion value represents the value of the common stock into which the bond can be converted. If, for example, these shares are trading at $30 and the bond can convert into 100 shares, the conversion value is $3,000. The investment value and conversion value can be considered, at maturity, the low and high price boundaries for the convertible bond. The option value represents the theoretical value of having the right, but not the obligation, to convert the bond into common shares. Until maturity, a convertible trades at a price between the investment value and the option value.

A Black-Scholes option pricing model, in combination with a bond valuation model, can be used to price a convertible security. However, a binomial option model, with some adjustments, is the best method for determining the value of a convertible security. Convertible arbitrage is a market-neutral investment strategy that involves the simultaneous purchase of convertible securities and the short sale of common shares (selling borrowed stock) that underlie the convertible. An investor attempts to exploit inefficiencies in the pricing of the convertible in relation to the security’s embedded call option on the convertible issuer’s common stock. In addition, there are cash flows associated with the arbitrage position that combine with the security’s inefficient pricing to create favorable returns to an investor who is able to properly manage a hedge position through a dynamic hedging process. The hedge involves selling short a percentage of the shares that the convertible can convert into based on the change in the convertible’s price with respect to the change in the underlying common stock price (delta) and the change in delta with respect to the change in the underlying common stock (gamma). The short position must be adjusted frequently in an attempt to neutralize the impact of changing common share prices during the life of the convertible security. This process of managing the short position in the issuer’s stock is called “delta hedging.”

If hedging is done properly, whenever the convertible issuer’s common share price decreases, the gain from the short stock position should exceed the loss from the convertible holding. Equally, whenever the issuer’s common share price increases, the gain from the convertible holding should exceed the loss from the short stock position. In addition to the returns produced by delta hedging, the investor will receive returns from the convertible’s coupon payment and interest income associated with the short stock sale. However, this cash flow is reduced by paying a cash amount to stock lenders equal to the dividend the lenders would have received if the stock were not loaned to the convertible investor, and further reduced by stock borrow costs paid to a prime broker. In addition, if the investor leverages the investment by borrowing cash from a prime broker, there will be interest expense on the loan. Finally, if an investor chooses to hedge credit risk of the issuer, or interest rate risk, there will be additional costs associated with credit default swaps and a short Treasury position. This strategy attempts to create returns that exceed the returns that would be available from purchasing a nonconverting bond with the same maturity issued by the same issuer, without being exposed to common share price risk. Most convertible arbitrageurs attempt to achieve double-digit annual returns from convertible arbitrage.

Synthetic Structured Financial Instruments. Note Quote.

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An option is common form of a derivative. It’s a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation to perform a specified transaction with another party (the option issuer or option writer) according to specified terms. Options can be embedded into many kinds of contracts. For example, a corporation might issue a bond with an option that will allow the company to buy the bonds back in ten years at a set price. Standalone options trade on exchanges or Over The Counter (OTC). They are linked to a variety of underlying assets. Most exchange-traded options have stocks as their underlying asset but OTC-traded options have a huge variety of underlying assets (bonds, currencies, commodities, swaps, or baskets of assets). There are two main types of options: calls and puts:

  • Call options provide the holder the right (but not the obligation) to purchase an underlying asset at a specified price (the strike price), for a certain period of time. If the stock fails to meet the strike price before the expiration date, the option expires and becomes worthless. Investors buy calls when they think the share price of the underlying security will rise or sell a call if they think it will fall. Selling an option is also referred to as ”writing” an option.
  • Put options give the holder the right to sell an underlying asset at a specified price (the strike price). The seller (or writer) of the put option is obligated to buy the stock at the strike price. Put options can be exercised at any time before the option expires. Investors buy puts if they think the share price of the underlying stock will fall, or sell one if they think it will rise. Put buyers – those who hold a “long” – put are either speculative buyers looking for leverage or “insurance” buyers who want to protect their long positions in a stock for the period of time covered by the option. Put sellers hold a “short” expecting the market to move upward (or at least stay stable) A worst-case scenario for a put seller is a downward market turn. The maximum profit is limited to the put premium received and is achieved when the price of the underlyer is at or above the option’s strike price at expiration. The maximum loss is unlimited for an uncovered put writer.

Coupon is the annual interest rate paid on a bond, expressed as percentage of the face value.

Coupon rate or nominal yield = annual payments ÷ face value of the bond

Current yield = annual payments ÷ market value of the bond

The reason for these terms to be briefed here through their definitions from investopedia lies in the fact that these happen to be pillars of synthetic financial instruments, to which we now take a detour.

According to the International Financial Reporting Standards (IFRS), a synthetic instrument is a financial product designed, acquired, and held to emulate the characteristics of another instrument. For example, such is the case of a floating-rate long-term debt combined with an interest rate swap. This involves

  • Receiving floating payments
  • Making fixed payments, thereby synthesizing a fixed-rate long-term debt

Another example of a synthetic is the output of an option strategy followed by dealers who are selling synthetic futures for a commodity that they hold by using a combination of put and call options. By simultaneously buying a put option in a given commodity, say, gold, and selling the corresponding call option, a trader can construct a position analogous to a short sale in the commodity’s futures market.

Because the synthetic short sale seeks to take advantage of price disparities between call and put options, it tends to be more profitable when call premiums are greater than comparable put premiums. For example, the holder of a synthetic short future will profit if gold prices decrease and incur losses if gold prices increase.

By analogy, a long position in a given commodity’s call option combined with a short sale of the same commodity’s futures creates price protection that is similar to that gained through purchasing put options. A synthetic put seeks to capitalize on disparities between call and put premiums.

Basically, synthetic products are covered options and certificates characterized by identical or similar profit and loss structures when compared with traditional financial instruments, such as equities or bonds. Basket certificates in equities are based on a specific number of selected stocks.

A covered option involves the purchase of an underlying asset, such as equity, bond, currency, or other commodity, and the writing of a call option on that same asset. The writer is paid a premium, which limits his or her loss in the event of a fall in the market value of the underlying. However, his or her potential return from any increase in the asset’s market value is conditioned by gains limited by the option’s strike price.

The concept underpinning synthetic covered options is that of duplicating traditional covered options, which can be achieved by both purchase of the underlying asset and writing of the call option. The purchase price of such a product is that of the underlying, less the premium received for the sale of the call option.

Moreover, synthetic covered options do not contain a hedge against losses in market value of the underlying. A hedge might be emulated by writing a call option or by calculating the return from the sale of a call option into the product price. The option premium, however, tends to limit possible losses in the market value of the underlying.

Alternatively, a synthetic financial instrument is done through a certificate that accords a right, based on either a number of underlyings or on having a value derived from several indicators. This presents a sense of diversification over a range of risk factors. The main types are

  • Index certificates
  • Region certificates
  • Basket certificates

By being based on an official index, index certificates reflect a given market’s behavior. Region certificates are derived from a number of indexes or companies from a given region, usually involving developing countries. Basket certificates are derived from a selection of companies active in a certain industry sector.

An investment in index, region, or basket certificates fundamentally involves the same level of potential loss as a direct investment in the corresponding assets themselves. Their relative advantage is diversification within a given specified range; but risk is not eliminated. Moreover, certificates also carry credit risk associated to the issuer.

Also available in the market are compound financial instruments, a frequently encountered form being that of a debt product with an embedded conversion option. An example of a compound financial instrument is a bond that is convertible into ordinary shares of the issuer. As an accounting standard, the IFRS requires the issuer of such a financial instrument to present separately on the balance sheet the

  • Equity component
  • Liability component

On initial recognition, the fair value of the liability component is the present value of the contractually determined stream of future cash flows, discounted at the rate of interest applied at that time by the market to substantially similar cash flows. These should be characterized by practically the same terms, albeit without a conversion option. The fair value of the option comprises its

  • Time value
  • Intrinsic value (if any)

The IFRS requires that on conversion of a convertible instrument at maturity, the reporting company derecognizes the liability component and recognizes it as equity. Embedded derivatives are an interesting issue inasmuch as some contracts that themselves are not financial instruments may have financial instruments embedded in them. This is the case of a contract to purchase a commodity at a fixed price for delivery at a future date.

Contracts of this type have embedded in them a derivative that is indexed to the price of the commodity, which is essentially a derivative feature within a contract that is not a financial derivative. International Accounting Standard 39 (IAS 39) of the IFRS requires that under certain conditions an embedded derivative is separated from its host contract and treated as a derivative instrument. For instance, the IFRS specifies that each of the individual derivative instruments that together constitute a synthetic financial product represents a contractual right or obligation with its own terms and conditions. Under this perspective,

  • Each is exposed to risks that may differ from the risks to which other financial products are exposed.
  • Each may be transferred or settled separately.

Therefore, when one financial product in a synthetic instrument is an asset and another is a liability, these two do not offset each other. Consequently, they should be presented on an entity’s balance sheet on a net basis, unless they meet specific criteria outlined by the aforementioned accounting standards.

Like synthetics, structured financial products are derivatives. Many are custom-designed bonds, some of which (over the years) have presented a number of problems to their buyers and holders. This is particularly true for those investors who are not so versatile in modern complex instruments and their further-out impact.

Typically, instead of receiving a fixed coupon or principal, a person or company holding a structured note will receive an amount adjusted according to a fairly sophisticated formula. Structured instruments lack transparency; the market, however, seems to like them, the proof being that the amount of money invested in structured notes continues to increase. One of many examples of structured products is the principal exchange-rate-linked security (PERLS). These derivative instruments target changes in currency rates. They are disguised to look like bonds, by structuring them as if they were debt instruments, making it feasible for investors who are not permitted to play in currencies to place bets on the direction of exchange rates.

For instance, instead of just repaying principal, a PERLS may multiply such principal by the change in the value of the dollar against the euro; or twice the change in the value of the dollar against the Swiss franc or the British pound. The fact that this repayment is linked to the foreign exchange rate of different currencies sees to it that the investor might be receiving a lot more than an interest rate on the principal alone – but also a lot less, all the way to capital attrition. (Even capital protection notes involve capital attrition since, in certain cases, no interest is paid over their, say, five-year life cycle.)

Structured note trading is a concept that has been subject to several interpretations, depending on the time frame within which the product has been brought to the market. Many traders tend to distinguish between three different generations of structured notes. The elder, or first generation, usually consists of structured instruments based on just one index, including

  • Bull market vehicles, such as inverse floaters and cap floaters
  • Bear market instruments, which are characteristically more leveraged, an example being the superfloaters

Bear market products became popular in 1993 and 1994. A typical superfloater might pay twice the London Interbank Offered Rate (LIBOR) minus 7 percent for two years. At currently prevailing rates, this means that the superfloater has a small coupon at the beginning that improves only if the LIBOR rises. Theoretically, a coupon that is below current market levels until the LIBOR goes higher is much harder to sell than a big coupon that gets bigger every time rates drop. Still, bear plays find customers.

Second-generation structured notes are different types of exotic options; or, more precisely, they are yet more exotic than superfloaters, which are exotic enough in themselves. There exist serious risks embedded in these instruments, as such risks have never been fully appreciated. Second-generation examples are

  • Range notes, with embedded binary or digital options
  • Quanto notes, which allow investors to take a bet on, say, sterling London Interbank Offered Rates, but get paid in dollar.

There are different versions of such instruments, like you-choose range notes for a bear market. Every quarter the investor has to choose the “range,” a job that requires considerable market knowledge and skill. For instance, if the range width is set to 100 basis points, the investor has to determine at the start of the period the high and low limits within that range, which is far from being a straight job.

Surprisingly enough, there are investors who like this because sometimes they are given an option to change their mind; and they also figure their risk period is really only one quarter. In this, they are badly mistaken. In reality even for banks you-choose notes are much more difficult to hedge than regular range notes because, as very few people appreciate, the hedges are both

  • Dynamic
  • Imperfect

There are as well third-generation notes offering investors exposure to commodity or equity prices in a cross-category sense. Such notes usually appeal to a different class than fixed-income investors. For instance, third-generation notes are sometimes purchased by fund managers who are in the fixed-income market but want to diversify their exposure. In spite of the fact that the increasing sophistication and lack of transparency of structured financial instruments sees to it that they are too often misunderstood, and they are highly risky, a horde of equity-linked and commodity-linked notes are being structured and sold to investors. Examples are LIBOR floaters designed so that the coupon is “LIBOR plus”:

The pros say that flexibly structured options can be useful to sophisticated investors seeking to manage particular portfolio and trading risks. However, as a result of exposure being assumed, and also because of the likelihood that there is no secondary market, transactions in flexibly structured options are not suitable for investors who are not

  • In a position to understand the behavior of their intrinsic value
  • Financially able to bear the risks embedded in them when worst comes to worst

It is the price of novelty, customization, and flexibility offered by synthetic and structured financial instruments that can be expressed in one four-letter word: risk. Risk taking is welcome when we know how to manage our exposure, but it can be a disaster when we don’t – hence, the wisdom of learning ahead of investing the challenges posed by derivatives and how to be in charge of risk control.

Deleuzo-Foucauldian Ontological Overview From the Machine to the Archive. Thought of the Day 26.0

In his book on Foucault first published in 1986, Deleuze drew a diagram in the last chapter, Foldings, that depicts in overview the Outside as abstract machine, defined by the line of the outside (1), which separates the unformed interplay of forces and resistance from the strategies and strata that filter the affects of power relations to become “the world of knowledge”.

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The central Fold of subjectification, of ‘Life’ is “hollowed out” and ignored by the forces of the outside as they are realized in the strata fulfilling the obligation of the diagram to “come to fruition in the archive.” This is dual process of integration and differentiation. The residual dust of the affective relations produced by force upon force, integrate into the strata even as they differentiate to forms of realization – visible or articulable. The ‘empty’ fissure/fold attracts and repels these moving curvilinear strategies as they differentiate and ”hop over” it. Ostensibly, the Fold of subjectification effectuates change as both continuously topological, and as discontinuously catastrophic (as in leaping over). So, the process of crystallization from informal to formal paradoxically integrates as it differentiates. Deleuze’s somewhat paradoxical description follows:

The informal relations between forces differentiate from one another by creating heterogeneous curves which pass through the neighborhood of particular features (statements) and that of the scenes which distribute them into figures of light (visibilities). And at the same time the relations between forces became integrated, precisely in the formal relations between the two, from one side to the other of differentiation. This is because the relations between forces ignored the fissure within the strata, which begins only below them. They are apt to hollow out the fissure by being actualized in the strata, but also to hop over it in both senses of the term by becoming differentiated even as they become integrated. Gilles Deleuze, Sean Hand-Foucault

So this “pineal gland” figure of the Fold is the “center of the cyclone”, where life is lived “par excellence” as a “slow Being”.

As clarifying as Deleuze’s diagram is in summarizing the layered dimensionality of the Foucauldian/Deleuzian hybrid, some modifications will be drawn off to alternatively express the realizations of the play of informal forces as this diagram takes on the particular features of a Research Creation praxis. True to the originating wax tablet diagramma, the relations are drawn and redrawn, in recognition, after Bergson’s notion of recognition as the intensive point where memory meets action of the contemporary social field that situates it. The shifts from the 19C to 20C disciplinary diagram of Foucault’s focus modulates with the late 20C society of control diagram formulated by Deleuze. The shorthand for the force field relevant to the research creation diagram of practice-led arts research today is a transdisciplinary diagram, the gamespace of just-in-time capitalism, which necessarily elicits mutations in the Foucault/Deleuze model. Generating the power-resistance relations in this outside qua gamespace are, among others, the revitalized forces of the military-academic-entertainment complex that fuel economic models such as the Creative Industries that pervade the conditions of play in artistic research. McKenzie Wark concludes his book GAMER THEORY, with prescient comments on the black hole quality of a topology of the outside qua contemporary “gamespace” from Deleuze and Guattari (ATP) and Guy Debord. “Only by going further and further into gamespace might one come out the other side of it, to realize a topology beyond the limiting forms of the game. Deleuze and Guattari: “… one can never go far enough in the direction of [topology]: you haven’t seen anything yet — an irreversible process. And when we consider what there is of a profoundly artificial nature […] we cry out, ‘More perversion! More artifice!’ — to a point where the earth becomes so artificial that the movement of [topology] creates of necessity and by itself a new earth.”

Hobbesian Morality and State

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Political Philosophy, as that branch of knowledge which consists of moral philosophy on the one hand and, and politics on the other, was treated systematically and in details by Hobbes in three different pieces of work viz., Elements of Law (1640), in the second and third parts of the Elementa Philosophiae, and in the Leviathan (1651). In all of these three presentations, his political philosophy shows traces of Galilean science and more so of Galileo’s ‘resolutive – compositive’ method. Everyone who has written about Hobbes’ political philosophy has interpreted his treatises as heavily dependent upon natural science, either for his material or method, which he heavily incorporates through out his works. However, the recognition of this fact on closer and meticulous scrutiny proves to be extremely questionable.

The propensity of natural sciences in his political philosophy is questioned, because Hobbes very well knew the fundamental differences between the two disciplines in the contest of material and method. On this awareness lay his basic conviction that political philosophy is essentially independent of natural science. This independence is corroborated because the principles of political philosophy are not borrowed from natural science, and indeed not from any sciences, but borrowed from experience, which one has of him, or to put it more accurately, are discovered by the efforts of self-knowledge and self-examination of everyone. The evidence of political philosophy on the one hand, is much easier to understand: its subjects and its concepts are not so remote from the average man as are the subjects and concepts of Mathematics which form the basis of natural science. On the other hand, ‘the politiques are the harder study of the two’; by reason of their passions, men obscure the, in itself, clear and simple knowledge of the norms which political philosophy builds up. Moreover, man with his passions and his self-seeking is the particular subject of political philosophy, and man opposes by every kind of hypocrisy the self-knowledge on which the proof of these norms rests.

Hobbes considered both political philosophy and the natural sciences as the main components of human knowledge. It can be said that Hobbes’ classification of the sciences is based on a classification of existing things into natural and the artificial. It is not so much the artificially produced things that are basically different from all natural things as the production, the human activity itself, i.e. man as an essentially productive being, especially as the being who by his art produces from his own nature the citizen or the State, who, by working on himself, makes himself into a citizen. In so far as man works on himself, influencing and changing his nature, so that he becomes a citizen, a part of that artificial being called the State, he is not a natural being. ‘Manners of men’ are something different from ‘natural causes’. The basic classification of existing things which in truth underlies Hobbes’ classification of the sciences is classification under nature on the one side, and under man as productive and active being on the other.

The question whether his political philosophy is intended to be naturalistic or anthropological, bears not only on the method, but above all on the matter selected. The significance of the antithesis between naturalistic and anthropological political philosophy for the matter becomes fully apparent if one grasps that this antithesis is only the abstract form of a concrete antithesis in the interpretation of and judgment of human nature which extends throughout the whole of Hobbes’ work. Hobbes summed up his theory of human nature as it underlies his political philosophy in ‘two most certain postulates of human nature’. The first postulate being that of ‘natural appetite’. Eclectic as he was, this postulate takes its roots as rooted in man’s sensuousness, in his animal nature. Like that of all animals, his is constant movement. But, the specific difference between man and other animals is that of reason. Thus man is less at the mercy of momentary sense impressions, he can envisage the future much better than can animals; for this very reason he is not like animals hungry only with the hunger of the moment, but also with future hunger, and thus he is the most predatory, the most cunning, the strongest, and most dangerous animal. This view of human appetite is a specifically Hobbesian view, but then is contradicted in Hobbes’ writings by his repeated and emphatic statement that human appetite is infinite in itself and not as a result of the infinite number of external impressions. Seeing this, one can note that human appetite is essentially distinguished from animal appetite in that the latter is nothing but reaction to external impressions, and, therefore, the animal desires only finite objects as such, while man spontaneously desires infinitely and this corresponds to the intention of Hobbes’ political philosophy. The two conceptions viz., mechanistic and vitalistic conceptions differ not only in substance, but also in method. The mechanistic conception is based on the mechanistic explanation of perception and on the general theory of motion; on the other hand, the apparently vitalistic conception is based not on any general scientific theory, but on insight into human nature, deepened and substantiated by self-knowledge and self-examination. In spite of these differences, the two conceptions below the surface have something in common, which allows us to characterize them both  as naturalistic. 

The naturalistic conception of human appetite is clearly expressed in the proposition that man desires power and ever greater power, spontaneously and continuously, in one jet of appetite, and not by reason of a summation of innumerable isolated desires caused by innumerable isolated perceptions

‘…in the first place, I put for a generall inclination of all mankind, a perpetuall and restless desire of power after power, that ceaseth only in Death’. And the cause of this, is not alwayes that a man hopes for a more intensive delight, than he has already attained to; or that he cannot be content with a moderate power: but because he cannot assure the power and the means to live well, which he hath present, without the acquisition of more’.

According to him, only the irrational striving after power, which is found more frequently than the rational striving, is to be taken as the natural human appetite. The only natural striving after power, and thus man’s natural appetite, is described by Hobbes as follows: ‘men from their birth, and naturally, scramble for everything they covet, and would have all the world, if they could, to fear and obey them’.1 In the case of man, animal desire is taken up and transformed by a spontaneous infinite and absolute desire which arises out of the depths of the man himself.

We find a more detailed definition of the irrational striving after power:

‘because there be some, that taking pleasure in contemplating their own power in the acts of conquest, which they pursue farther than their security requires; if others, that otherwise would be glad to be at ease within modest bounds, should  not by invasion increase their power, they would not be able, long time, by standing only on their defence, to subsist. And by consequence, such augmentation of dominion over men, being necessary to a man’s conservation, it ought to be allowed him’.

It is clearly seen here that rational permissible striving after power is in itself finite. The man guided by it would remain ‘within modest bounds’, would ‘be content with a moderate power’. Only the impermissible, irrational, lustful striving after power is infinite.

In four different arguments, Hobbes designated the characteristics in the difference between man and animal as the striving after honour and positions of honour, after precedence over others and recognition of this precedence by others, ambition, pride, and the passion for fame. Since man’s natural appetite is a striving after precedence over others and recognition of this precedence by others, the particularities of natural appetite, the passions, are nothing other than particular ways of striving after precedence and recognition. Speaking about the cause of madness, Hobbes says: “The Passion, whose violence, or continuance maketh Madnesse, is either great vaine-glory; which is commonly called Pride, and selfe-conceipt; or great Dejection of mind”. All passions and all forms of madness are modifications of conceit or of a sense of inferiority, or in principle, of the striving after precedence and recognition of that precedence.

The same conclusion is reached if one compares the arguments by which Hobbes in the three presentations of his political philosophy proves his assertion that the war of everyone against everyone arises of necessity from man’s very nature. Every man for that reason is the enemy of every other man, because each desires to surpass every other and therefore offends every other. The discrepancies between the three presentations shows that Hobbes himself never completed the proofs of his fundamental assertion, and, as is seen on closer inspection, did not complete them simply because he could not make up his mind explicitly to take as his point of departure the reduction of man’s natural appetite to vanity. At the end of the most important part of his work, “Leviathan”, Hobbes says:

‘Hitherto I have set forth the nature of Man, (whose Pride and other passions have compelled him to submit himselfe to Government;) together with the great power of the Governour, whom I compared to Leviathan, taking that comparison out of the last two verses of the one and fortieth of Job; where God having set forth the great power of Leviathan, called him the King of the Proud’.

The state is compared to Leviathan, because it and it especially is the ‘King of all the children of pride’. Only the State is capable of keeping pride down in the long run, indeed it has no other raison d’etre except that man’s natural appetite is pride, ambition, and vanity. 

Why could not Hobbes take man’s natural appetite, which is vanity as the basis of his political philosophy?  If this conception of natural appetite is right, if man by nature finds his pleasure in triumphing over all others, then man is by nature evil. But he did not dare to hold this consequence of his theory. For this very reason, in the Leviathan, he puts vanity in the end. Because man is by nature animal, he is not by nature evil, therefore he is as innocent as the animals; thus vanity cannot characterize his natural appetite. Hobbes in defence against the reproach that according to his theory man is by nature evil does not mention vanity at all. In laying the foundations of his political philosophy, Hobbes puts vanity more and more into the background in favour of innocent competition, innocent striving after power, innocent animal appetite, because the definition of man’s natural appetite in terms of vanity is intended as a moral judgment. He is finally obliged to attribute to the judges the wickedness which he disallows in the case of the guilty, the criminals; he betrays particularly in his description of the striving after power itself, that the innocence, neutrality, and moral indifference of that striving is only apparent. The apparent moral indifference arises simply and solely through abstraction of the necessary moral difference. Hobbes’ political philosophy rests not on the illusion of an amoral morality, but on a new morality, or, so to speak according to Hobbes’ intention, on a new grounding of the one eternal morality.

The second of the ‘two most certain postulates of human nature’ is ‘the postulate of human reason’. In accordance with the naturalistic reasoning this postulate is reduced to the principle of self-preservation: since the preservation of life is the condition sine qua non for the satisfaction of any appetite, it is the ‘primary good’. As a logical conclusion of this thought, Hobbes attempts to deduce natural right, natural law, and all the virtues from the principle of self-preservation. It is noteworthy that Hobbes prefers the negative expression ‘avoiding death’ to the positive expression ‘preserving life’. That preservation of life is the primary good is affirmed by reason alone. On the other hand, that death is the primary evil is affirmed by passion, the passion of fear of death. And as reason itself is powerless, man would not mind to think of the preservation of life as the primary and the most urgent good, if the passion of fear of death did not compel him to do so. According to Hobbes, the preservation of life is the primary good, an unhindered progress to ever further goals, a ‘continuall prospering’, in a word, happiness is the greatest good, but there is no supreme good in the enjoyment of which the spirit might find repose. On the other hand, death is the primary as well as the greatest and the supreme evil. For death is not only the negation of the supreme good; but at the same time, it is the negation of all the goods. Only through death has man an aim, the aim that is forced upon him by the sight of death, the aim of avoiding death. For this reason, Hobbes uses the negative expression ‘avoiding death’ to the positive expression ‘preserving life’. This is also because we fear death infinitely more than we desire life. 

But Hobbes also does not adhere to the theory of death as the supreme evil, since for him the tortured life is a greater evil as compared to death. So for him, an agonizing death is much more evil than death. But in contradiction, if Hobbes had considered agonizing death as the supremest evil, he would have attributed an ever-greater importance on medicine, which he tends to forget. When he says of an agonizing death that it is the greatest evil, he thinks exclusively of violent death at the hands of other men. This fear of getting killed at the hands of other men, is a mutual fear, i.e. it is a fear each man has of every other man as his potential murderer. This fear of a violent death, pre-rational in its origin, but rational in its effect, and not the rational principle of self-preservation, is, according to Hobbes, the root of all right and of all morality. He finally denied the moral values of all virtues which do not contribute to the making of the State, to consolidating peace, to protecting man against the danger of violent death, or, more exactly expressed, of all virtues which do not proceed from the fear of violent death.

Since, Hobbes reduces man’s natural appetite to vanity, he cannot but recognize the fear of a violent death, not the fear of a painful death, and certainly not the principle of the preservation of life as the principle of morality. The ever-greater triumph over others, and not the ever-increasing, but rationally increasing, power is the aim and happiness of natural man. ‘Continually to out-go the next before is felicity’. Man’s life may be compared to a race: ‘but this race we must suppose to have no other goal, nor other garland, but being foremost’. Absorbed in the race after the happiness of triumph, man cannot be aware of his dependence on the insignificant primary good, the preservation of life and limb; failing to recognize his bodily needs, man experiences only joys and sorrows of the mind, i.e. imaginary joys and sorrows. Living in the world of his imagination, he need do nothing, in order to convince himself of his superiority to others, but simply think out his deeds for himself; in this world, in which indeed ‘the whole world obeys him’, everything is accomplished according to his wishes. He can awaken himself from this dream world only when he feels in his own person, by bodily hurt, the resistance of the real world. ‘Men have no other means to acknowledge their own Darknesse, but onely by reasoning from the unforeseen mischances, that befall them in their ways’. Because man by nature lives in the dream of the happiness and triumph, of a glittering, imposing, apparent good, he requires a no less imposing power to awaken him from his dream: this imposing power is the imperious majesty of death.

The ideal condition for self-knowledge is, therefore, unforeseen mortal danger. The vain man, who, in his imagination, believes himself superior to others, cannot convince himself of the rightness of his estimate of himself; he requires the recognition of hiss superiority by others. He therefore steps outside his imagination. Now, either the others take his claim seriously and feel themselves slighted, or they do not take his claim seriously and he feels himself slighted. In either case the making of the claims leads to contempt. The one slighted longs for revenge. In order to avenge him he attacks the other, indifferent whether he loses his life in so doing. Unconcerned as to the preservation of his own life, he desires, however, above all that the other should remain alive; for ‘revenge aimeth not at the death, but at the captivity and subjection of an enemy…revenge aimeth at triumph, which over the dead is not’. The struggle which thus breaks out, in which, according to the opinion of both opponents, the object is not the killing, but the subjection of the other, of necessity becomes serious, because it is a struggle between bodies, a real struggle. From the beginning of the conflict, the two opponents have, without realizing and foreseeing it, completely left the imaginary world. At some point in the conflict, actual injury, or, more accurately, physical pain, arouses a fear for life. Fear moderates anger, puts the sense of being slighted into the background, and transforms the desire for revenge into hatred. The aim of the hater is no longer triumph over the enemy, but his death. The struggle for pre-eminence, about ‘trifles’, has become a life and death struggle. In this way natural man happens unforeseen upon the danger of death; in this way he comes to know this primary and greatest and supreme evil for the first time, to recognize death as the greatest and supreme evil in the moment of being irresistibly driven to fall back before death in order to struggle for his life. Only for a moment can he free himself from the danger of death by killing his enemy, for since every man is his enemy, after killing of the first enemy he is ‘again in the like danger of another’, indeed of all others. The killing of the enemy is thus the least far-sighted consequence of the withdrawal from death. In order to safeguard his life, not only for the moment, but also in the long run, man needs companions, with whose help he can successfully defend his life against the others. Companions can be gained in two ways, by force or by agreement. The former appears as if it stands in the midway between the killing of the enemy and agreement with him; so it is natural enough for him to try out the latter. Since fear can hardly be made manifest, but by some action dishonourable, that betrayeth the conscience of one’s own weakness; all men in whom the passion of courage or magnanimity have been predominated, have abstained from cruelty…In one word, therefore, the only law of actions in war is honour. Thus arises the relationship of master and servant. The victor who has safeguarded his honour becomes the master. The vanquished, who ‘submitteth…for fear of death’, who admits his weakness and with that has forfeited his honour, becomes the servant. The dominion of the master over the servant, despotic rule, is one form of the natural State, and as the other part of the natural State, patriarchy, is construed by Hobbes entirely according to the pattern of despotic rule, we may even say: despotic rule is the natural State. The artificial State, which is as such more perfect, arises when the two opponents are both seized with fear for their lives, overcome their vanity and shame of confessing their fear, and recognize as their real enemy not the rival, but ‘that terrible enemy of nature, death’, who, as their common enemy, forces them to mutual understanding, trust, and union, and thus procures them the possibility of completing the founding of the State for the purpose of providing safeguards for the longest possible term, against the common enemy. And while in the unforeseen life-and-death struggle, in which vanity comes to grief, the futility of vanity is shown, it is revealed in the concord of living, and of living in common, to which their pre-rational fear of death leads them, that the fear of death is appropriate to human conditions, and that it is ‘rational’. It is even ostensibly shown that it is only on the basis of fear of death that life comes to concord and that the fear of death is the only ‘postulate of natural reason’.

Hobbes distinguishes no precisely than any other moralist between legality and morality. Not the legality of the action, but the morality of the purpose, makes the just man. That man is just who fulfils the law because it is law and not for fear of punishment or for the sake of reputation. Although Hobbes states that those are ‘too severe, both to themselves, and others, that maintain, that the First motions of the mind, be Sinnes’, he yet ‘confesses’ that ‘it is safer to erre on that hand, than on the other’. In believing that the moral attitude, conscience, intention, is of more importance than the action, Hobbes is at one with the Christian tradition. He differs from this tradition at first sight only by his denial of the possibility that just and unjust actions depend wholly on the judgment of the individual conscience. In the state of nature every action is in principle permitted which the conscience of the individual recognizes as necessary for self-preservation, and every action is in principle forbidden which according to the judgment of the individual conscience does not serve the purpose of self-preservation. If, then, in the state of nature, any and every action is permitted, even in the state of nature not every intention is permitted, but only the intention of self-preservation. Thus the unequivocal distinction between just and unjust intentions holds even for the state of nature and is, therefore, absolute.

Hobbes expressly denies the existence of a law, as if it were a natural law, which obliged man unconditionally, and therefore obliged him even in the state of nature. He says: ‘These dictates of Reason, men use to call by the names of Lawes; but improperly: for they are but Conclusions, or Theoremes concerning what conduceth to the conservation and defence of themselves; whereas Law, properly is the word of him, that by right hath command over others’. Law as an obligation is the basis of a covenant between formerly free and unbound men. Thus ‘where no Covenant hath preceded, there hath no Right been transferred, and every man has right to everything…But when a Covenant is made, then to break it unjust: And the definition of injustice, is no other than the not Performance of Covenant’. The just attitude cannot be anything but earnest striving to keep one’s given word; and is therefore far from being obedience that it is, on the contrary, nothing else but proud self-reliance. From the Leviathan, it is clearly noticeable that opinion, far from being the origin of just attitude, is rather the only origin of the unjust attitude. Not pride, and still less obedience, but fear of violent death, is according to him the origin of the just intention. It makes possible the distinction between the attitude of an unjust man who obeys the laws of the State for fear of punishment, and the attitude of the just man, who for fear of death, and therefore from inner conviction, as it were once more accomplishing in himself the founding of the State, obeys the laws of the State. 

Since man is by nature fast in his imaginary world, it is only by unforeseen mischance that he can attain to knowledge of his own darkness and at the same time a modest and circumspect knowledge of the real world. That is to say: the world is originally revealed to man not by detachedly and spontaneously seeing its form, but by involuntary experience of its resistance. The least discriminating and the detached sense is the sense of touch. This explains the place of honour which is tacitly granted to the sense of touch in Hobbes’ physiology and psychology of perception; all sense-perception, particularly that of the most discriminating and detached sense, the sense of sight, is interpreted by experience of the sense of touch.

Thus it can be seen, that the moral and humanist antithesis of fundamentally unjust vanity and fundamentally just fear of violent death is the basis Hobbes’ political philosophy. As an objection, it can be called to effect that this antithesis is to be found in Hobbes’ political philosophy only because Hobbes had not yet completely freed himself from the influence of the Christian Biblical tradition. This antithesis is the ‘secularized’ form of the traditional antithesis between spiritual pride and fear of God, a secularized form which results from the Almighty God having been replaced by the over-mighty State, ‘the Mortall God’. Is this affiliation to the antithesis in Hobbes’ moral work right by itself?

On the contrary, this antithesis is an essential indispensable element, or, more accurately, the essential basis of, Hobbes’ political philosophy. Political philosophy deprived of its moral foundations is, indeed, Spinoza’s political philosophy, but not Hobbes’. Spinoza made might equivalent to right. Thanks to the moral basis of his political philosophy, Hobbes kept the possibility of acknowledging justice as such and distinguishing between right and might. Hobbes’ political philosophy is really based on knowledge of men, which is deepened and corroborated, by the self-knowledge and self-examination of the individual, and not on a general scientific and metaphysical theory. And because it is based on experience of human life, it can never, in spite of all the temptations of natural science, fall completely into the danger of abstraction from moral life and neglect of moral difference.

The contention is that Hobbes’ humanist moral motivation of his political philosophy is more original than the naturalistic motivation. The important points of his moral motivation were firmly established well before he turned his attention to natural science and especially to Euclid’s Elements. This discovery of Euclid was an epoch in his life; everything he thought and wrote after that is modified by this happening. His discovery lent maturity to his later works and whether this is the case, can be decided only after the sparse remnants of his youthful philosophy is meticulously studied.