Macroeconomic risks are among the most important risks to the incomes of firms and individuals. For financial market participants as well, views on the distribution of possible economic outcomes are critical for asset allocation decisions and risk management. The last 12 months has highlighted the influence of economic data in shaping these views, as investors have struggled to interpret the trajectory of the global economy.
As a result, the main economic data releases can be market-moving events, which may impact several markets simultaneously. While individual data points rarely overturn investors' views on their own, data surprises can mark the beginning of reversals in asset markets.
Goldman Sachs and Deutsche Bank plan to introduce the first derivatives referenced to economic statistics. The first auction will take place on Oct. 1 and there will be a series of options on real economic data releases that will allow investors to directly express their views on the outcome of individual economic releases.
No Longer Academic?
To date, the notion of pure economic derivatives has been largely confined to the halls of academia. Bill Sharpe, Nobel laureate economist at Stanford University, Calif., believes that a developing field of "nuclear financial economics" will allow financial instruments to be broken down into smaller components, thereby creating insights into the pricing and allocation of even the most complex risks.
Robert Shiller, economist at Yale University, has emphasized the need for markets to price and manage these economic risks. In his book, Macro Markets--Creating Institutions for Managing Society's Largest Economic Risks, he envisioned an array of large international risk markets, for claims on national income and components thereof, that would allow individuals to better hedge all manner of risks to their individual living standards.
While the two scholars have no connection to the Goldman Sachs-Deutsche Bank product, economic derivatives could be a significant step toward realizing Sharpe and Shiller's respective risk-isolating and risk-sharing visions.
Non-Farm Payrolls and Beyond
The first auction will be based on the change in September U.S. non-farm payrolls to be released on Oct. 4. A second auction will be held Oct. 3 on the same release. Call and put options, both vanilla and digital, will be available. There will be strike prices reflecting a 2 to 2.5 standard deviation range of potential outcomes for non-farm payrolls. Derivatives will be bought and sold in Dutch auctions prior to the data release, and will settle according to the release.
The plan is to follow this initial auction with auctions on the U.S. retail sales release, the ISM survey and the German IFO index later this year. Initially, Goldman Sachs and Deutsche Bank will hold an auction for each economic statistic several days prior to the release of the number. After the initial auctions, they will begin to hold auctions earlier to provide longer-dated options and build a forward curve for each variable. This will enable market participants to more effectively manage the real ongoing risks associated with the underlying forces that drive the economy and can impact corporate and financial portfolio performance.
Depending on market response, options on industrial production, gross-domestic product growth, inflation, consumer sentiment, retail sales and housing could be next, with a much broader range of U.S. and international statistics to follow.
Going Dutch
The risk-capital requirements of standard market-making for options on economic statistics were prohibitive for dealers until Longitude, a New York technology company, brought Dutch auction technology to the derivatives market. Dutch auction technology increases the efficiency of risk capital enabling liquid markets to develop where there is no underlying instrument. It applies a parimutuel mechanism to optimize pricing and allocation across all of the bids and offers received in the auction. The upshot is optimized overall liquidity for existing supply and demand (see Learning Curve, 11/11).
Initial interest has been very strong, as the Dutch auction process negates some of the issues that typically slow the adoption of new financial products. Normally, clients often stay on the sidelines until they get a sense for fair pricing and liquidity. With economic derivatives, however, option prices are set by the market, based on the relative demand for outcomes among all auction participants. Dutch auction pricing affords all participants the same fair execution price, clients can place limit orders, and it's a transparent two-sided market with real time information for investors.
A Precision Hedging Instrument
For Lower Volatility
A robust market for economic derivatives could have far-reaching implications. For investors who regularly take risk on the basis of views on upcoming data the potential advantages are obvious. They already hedge against adverse data through other financial products that are blunt instruments compared to the precise 100% correlation that economic derivatives provide. Particularly for investors who may have a combination of positions that are at risk from a particular data release, a direct position on the data itself may provide a cheap and efficient way of purchasing protection.
Risk management is generally more effective where risks can be separated as precisely as possible. In order to insure effectively against these kinds of risks, an instrument is needed that provides payoffs closely related to the damaging economic outcome. By developing contracts on consumer sentiment indices, payrolls, housing starts or GDP growth--particularly contracts that stretch a reasonable distance into the future--new opportunities for the allocation of risk may open in ways that allow companies, and through them individuals, to reduce their risk profile or earnings volatility.
If companies can hedge against external economic forces that impact their earnings performance, it stands to reason that their earnings, and their stock price, should be more predictable, allowing more efficient use of their capital, and longer planning horizons.
A Sharper View Of What The Market Expects
The second broader benefit from creating markets in economic statistics is more immediate. In judging macroeconomic risks and in setting investment strategies, it is often useful to have a clear sense of where market expectations stand. Investors constantly look to determine what potential or expected outcomes are priced-in. Given the large amount of information that goes into market prices for most assets, it is often difficult to be precise.
One byproduct of auctions of economic derivatives is a more accurate and detailed view on what the market expects in terms of a particular release. Options orders can be used to back out implied probabilities of particular market outcomes, so that insight is directed not just at what the market thinks the release will be, but into the market's view on the probability for each outcome. This isn't simply a better forecast; it's an expression of risk that parallels a portion of the risk imbedded in other markets that are exposed and respond to the drivers of the economy.
Off To The Races?
Ultimately, there is compelling evidence that market data and insight into risk held by managers leads to more efficient and more stable markets.
The jury is out on these untested instruments. Economic derivatives could simply take race-track mathematics and create the equivalent of off track betting for hedge funds and proprietary traders, or they could reduce market and earnings volatility-- and spawn a Shiller-esque era where Main Street can hedge the price of their home, the probability of losing their job, or the cost of a college education.
This week's Product Focus was written by Oliver Frankel, managing director in economic derivatives, and Jim O'Neill, head of global economic research, at Goldman Sachs in New York.
