Economic Derivatives and the Art and Science of Investment
In its new “Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity,” the Bank for International Settlements (BIS) presents figures on the typical daily trading in April 2004, based on data from 52 central banks and monetary authorities. The BIS estimates that global derivatives and foreign exchange turnover reached $2 quadrillion a year. Average daily turnover on traditional foreign exchange markets increased by 57 per cent compared to three years ago, reaching $1.88 trillion. By far the leading country in foreign exchange transactions is Britain ($753bn), followed by the US ($461bn), Japan ($199bn), Singapore ($125bn), Germany ($118bn), and Hong Kong ($102bn). These country figures include some double counting and therefore add up to more than the $1.88 trillion.
OTC derivatives turnover has increased 112 per cent in three years and reached $1.22 trillion a day in April 2004. Again, Britain is by far the biggest market for such transactions ($643bn), followed by the US ($355bn) and France ($154bn). The BIS emphasizes the ever more prominent role of hedge funds in the OTC derivatives business. In 43 per cent of the OTC transactions, one of the two counterparties is a non-bank (in most cases a hedge fund or an insurance firm). For a full year, these April figures lead to an annual turnover of roughly $500 trillion in traditional foreign exchange transactions and $300 trillion in OTC derivatives. The annual turnover in exchange-traded derivatives, according to the latest BIS Quarterly Report, currently amounts to $1.2 quadrillion. This all adds up to an annual foreign exchange and derivatives turnover of about $2 quadrillion.
These figures are indicative of the presence of derivatives in even the most ordinary financial transaction. But, they provide little hint to whether the growth of derivatives is leading to a reduction of, or at least, a wider coverage of known types of risks. From a firm’s perspective, unsystematic risks (i.e. risks that are intrinsic to the firm) can be easily hedged away even without a financial derivative instrument; for example through diversification. But systematic risks (i.e. risks attributable to the market or the economy) tend to remain even after extensive diversification. Economy-wide risks stem from breakdowns in fundamental economic equilibrium. These breakdowns translate into fluctuating employment rates, changing retail sales and industrial production. They may also take the form of frequent swings in inflation and consumer sentiment, and eventually unpredictable economic growth. Conventional financial instruments have been of little help even though research indicates that effective hedging would reduce the earnings volatility of many firms. 1 Consequently, economic policy makers have often tried to control the negative effects of economic events with various tools using a “top-down” approach. Central banks use interest rates. National governments use taxes, controls and even laws. Multilateral organizations such as the World Bank and the IMF use economic reform programmes, while the European Union adopted a collective measure in the form of a “Growth and Stability Pack”. This pack sought to maintain the yearly budget deficit of member-states under 3 per cent. However, many large economies (e.g. Germany, France, and Italy) struggled for years and failed to comply, eventually leading to the collapse of the pack in 2004.
All that may soon be a thing of the past with the arrival of economic derivatives jointly developed by Goldman Sachs and Deutsche Bank two years ago. Derivatives and particularly futures and options on economic events are not new. Back in the 1980s when financial engineers began to experiment the idea of better economic risk management instruments, financial institutions were not receptive to the idea of making markets for options on economic statistics. The first reason was that the cash value of the underlying economic variables was thought to be generally discontinuous because they were released at discrete intervals and also often subject to revisions at a later date. 2 Economic data was therefore seen as non-tradable underlying assets. Second, it was difficult to find discrete order matches and consequently, there was no way to build volume and liquidity. Third, the mindsets of economists and financial engineers seemed irreconcilable as the latter often thought that the basis for calculation of macroeconomic data was arbitrary and inconsistent. 3 An attempt by the Coffee, Sugar and Cocoa Exchange to establish a futures market in the consumer-price index in order to provide insurance against inflation failed in the early 1980s due to lack of interest. A similar experiment by the London Futures and Options Exchange with betting on real-estate prices collapsed in the early 1990s after revelations that false trades had inflated trading volume. The US government scored a relatively higher success with inflation insurance sold in the form of treasury bonds that pay more if inflation rises. A modest success has been recorded with the sale of homeowners’ policies that automatically increase coverage with rising construction costs. Finally, many insurance companies have developed various types of bonds linked to an index or to economic events. Economic derivatives however, are market-based tools for the effective management of the uncertainties associated with economic events. They may be used in combination with or even replace existing instruments or policy tools. They are therefore flexible and more adaptable to the changing needs of small firms, conglomerates and nations.
The materialization of economic derivatives today is not the outcome of teamwork. Academia did the vital groundwork, financial engineers put the ideas into commercial use and technology provided access for all. Bill Sharpe 4, a pioneer of nuclear financial economics believed, that segmenting financial instruments into smaller components, provided an efficient way of understanding and minimizing the risks in pricing and asset allocation. Robert Shiller 5 suggested a wider application of this sort of surgical risk management techniques, where even individuals could hedge claims and income. In developing the new products, Deutsche Bank and Goldman Sachs built on the work of Sharpe, Schiller and many other researchers and conceived the infrastructure for the distribution of the new instruments. This required defining the role of intermediaries, mapping out the flow of transactions and also providing interfaces for pricing and communication between market participants. The new instruments are traded through a Universal Dutch Auction format. This automated parimutuel technique has been improved to serve as a risk exchange framework by Longitude (a New York/New Jersey based technology firm). With simultaneous large orders, it maximizes liquidity when compared to traditional order-matching practices. The auction format nonetheless uses standard trading conventions, whereby participants may buy and sell options by submitting limit order bids and offers. ICAP, the international broker, offers the brokerage and distribution platform.
More research is required to study the impact of economic derivatives on investment strategies. Focusing on inflation as an example, three simplified scenarios suggest that they may influence areas such as accounting, performance, tax and hedging decisions. If the risks of inflation can be fully hedged away, then there should be no economic reason to provide special treatment (e.g. restatement of accounts) for the effect of inflation 6 and other major economic events. For the same reasons, firms may no longer be able to ascribe poor performance to bad luck (i.e. bad turnout of economic events). Conversely, if the tax regime provides advantages on the basis of inflation adjustments, some people may hesitate between the advantages of inflation taxation and the benefits of risk reduction. This may happen when firms see no strategic reason to hedge (even when all the best instruments are available) because the tax advantages outweigh the losses incurred by the risk exposure.
However, the intuition behind economic derivatives is unique. First, users can directly relate the benefits of these instruments to their businesses. Second, in situations where the user has a direct exposure or position on the economic data, there is a 100 per cent correlation, which enables an accurate and perhaps cheaper alternative hedging approach, and more importantly, a simultaneous management of basis risk. Third, the auction system should enable a transparent pricing from the sell- and buy-sides and allows participants to be involved and get a real chance to understand the mechanics of pricing.
The growth of some of the most exciting new financial instruments has often been nipped in the bud by developments elsewhere; for example in accounting standards, tax and regulations. But, the current context is rather favorable to economic derivatives. Tax regimes are improving. Accounting standards such as SFAS 133 in the US and IAS 39 for international accounting standards provide a framework for reporting and disclosure. The Sarbanes-Oxley Act in the US and the Basel II Capital Adequacy framework gives financial and non-financial institutions working guidelines on derivatives. The US Securities and Exchange Commission (SEC) is preparing a framework for the registration of hedge funds.
The first auction took place in October 2002 since then there have been 151 Economic Derivative Auctions, 62 Prepay Auctions and 27 Commodity Derivative Auctions. These auctions covered four data releases: ISM Manufacturing, Change in Non-Farm Payrolls, Initial Jobless Claims and Multiple eurozone harmonized index of consumer prices (ex tobacco). More auctions are planned on other data sets. So, if you thought everyday economic statistics are boring, then think again.
The scope of application of economic derivatives seems endless. Governments may be able to hedge fluctuations in tax revenues, corporations their earnings, hedge funds will trade and provide liquidity. However, t he obstacle to the growth of this new market may come from the very initial underlying that generates them in the first place: the economy. Some of the reasons are obvious and some are not. For example, is it more efficient to isolate and hedge the risks of long-term persistent unemployment (such as that experienced by France and Germany since 1990) or a chronic deflation, which has been rampant in Japan for more than a decade? Should the continued overheating (since 1990) of the real estate and property markets in the United Kingdom or the long-term decline of the steel sector in the US be hedged or tackled by policy makers? Presumably more long-term contracts will address some of these questions. But how can a firm be protected when a fundamental disruption is simmering under the surface of the economy especially in the context of globalization, where changes in economic data in one country or region may have their roots in another.
In the past, new financial products tended to be oversold leading to high expectations, abuse, fraud and crime by some market participants. This time, things could turn out differently and if the new instruments can also help to effectively manage long-term macroeconomic risks, then this could be the dawn of a significant innovation in the art and science of investment.
1 Bansal, Vipul J. Marshall, John F. and Yuyuenyongwatana, Robert P. (1994): “Hedging Business Cycle Risk with Macro Economic Swaps: Some preliminary Evidence”, Journal of Derivatives, pp 50-58.
Bansal, Vipul J. Marshall, John F. and Yuyuenyongwatana, Robert P. (1995): “Macoeconomic Derivatives More Viable Than First Thought” , Global Finance Journal, pp 101-110.
2 Das, Satyajit (2004): Swaps/Financial Derivatives: Products, Pricing Application and Risk Management, Third Edition, Wiley, page 4366
3 Das, Satyajit (2004): Swaps/Financial Derivatives: Products, Pricing Application and Risk Management, Third Edition, Wiley, page 4366
4 Sharpe, William (1995): “Nuclear Financial Economics,” Risk Management: Problems & Solutions, (William H. Beaver and, George Parker, editors), McGraw-Hill, 1995, pp. 17-35.
5Shiller, Robert (1993) Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks, Oxford University Press.
6See for example the US Statement of Financial Accounting Concepts 5 (SFACs 5): Application of accounting recognition and measurement when for example inflation increases to the point where it may distort financial statements. See also IAS 29: Financial Reporting in Hyperinflationary Economies.