- he Bank for International Settlements (BIS) has released this month a report about Economic Derivatives stating that they “offer valuable information on how uncertainty about the economy evolves and affects financial markets”. With the current uncertainty about the future (Global Warming, Terrorism, HIV,..) they look as an attractive tool. But, what are economic derivatives?
- In 1993, Robert Shiller published a book called “MacroMarkets” where he proposed the creation of a new set of financial securities tied to the future path of the macroeconomy. He argued that existing financial markets represent future claims on only a small fraction of future income (mainly equity), and that new Macromarkets would produce a more effective risk allocation, allowing individuals to insure themselves against many macroeconomic risks. The concept can be extended not only to economic magnitudes but to political or environmental concepts such as a US attack on Iran or a bird flu outbreak in Malaysia.
- Not only have these markets the advantage of allowing agents to hedge against different risks, but they also constitute “prediction markets”, i.e. markets where participants trade contracts whose payoffs are tied to a future event, thereby yielding prices that can be interpreted as market aggregated forecasts. For instance, in the Iowa Electronic Market, traders buy and sell contracts that pay $1 if a given candidate wins the election. If a prediction market is efficient, then the prices of these contracts perfectly aggregate dispersed information about the probability of each candidate being elected.
- The main problem associated to the development of these markets is the pricing of the traded derivative instruments as there is no underlying asset or cash-flow. An additional obstacle is the potential lack of liquidity, as it might be difficult to find traders willing to match some specific positions. These problems were solved at the beginning of the decade with the development of Pari-mutuel Digital Call Auctions (PDCA). PDCA are based on pari-mutuel principles invented in late 19th century, which are widely used in many gambling games, such as horse races.1
- In 2002, Goldman Sachs and Deutsche Bank set up the first markets based on PDCA, though they differ from Shiller’s macro-market as they focus on short-term data surprises. These new markets allow investors to purchase options whose payoff depends on growth in non-farm payrolls (NFP), retail sales, unemployment claims or CPI. Auctions were moved to the Chicago Mercantile Exchange in September 2005, where they work as an organised exchange. The markets remain still very small relative to conventional futures and options ones: in 2006, the nominal value of auctions on NFP was less than a 5% of the value-at-risk for the 10-year US Treasury futures of the Chicago Board of Trade.
- As the BIS underlines, the growth potential of these markets might be constrained by their limited attractiveness for hedging against the announcement risk of a portfolio. Nevertheless, the opportunities for financial institutions or governments to develop real “macro-markets” based on PDCA are enormous, not only as potential hedging tools, but also due to the strategic advantage in the decision-making process of possessing a mechanism to aggregate information in a “prediction market”.
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