New Derivatives Based On Parimutuel Principles
Deutsche Bank and J.P. Morgan, which are going to start offering derivatives based on economic statistics (DW, 10/29), will employ new technology and intellectual property called Parimutuel Digital Call Auction (PDCA) technology, developed by Longitude, to create the derivatives.
This Learning Curve offers a hypothetical example and perspective on the structure of these new derivatives from Deutsche Bank's point of view.
An Example Of New Derivatives:
Options On German IFO
One of the new products that Deutsche Bank proposes to offer clients will be options on the IFO Business Climate Index for Germany. This activity has the following three key steps.
First, Deutsche Bank determines the underlying risk. Assume that Deutsche Bank offers options on the September IFO released on Friday, Oct 19.
Second, Deutsche Bank determines the strikes for the options that are offered. Since economists forecast September IFO to be between 87 and 90, Deutsche Bank sets the strikes for these options in that range: 87.5, 88, 88.5, 89, and 89.5. Clients can trade digital calls, digital puts, or digital spreads based on these strikes, all with European exercise. European digital options have long been an established part of the landscape for many derivative users, but to recap: a European digital option pays out a fixed amount if the option expires in-the-money and pays out zero if the option expires out-of-the-money.
Third, Deutsche Bank determines the time period for the auction, which is scheduled for a time when client focus on IFO is likely to be particularly high. For the purposes of this example, the auction takes place on Thursday Oct. 18, the day before September IFO is released, from 2 p.m. to 4 p.m. GMT. In the several days leading up to the auction, Deutsche Bank engages in pre-marketing or pre-selling efforts similar to that done in a bond or equity syndicate offering. After this pre-selling effort Deutsche Bank accepts client orders during the auction period.
Who is a typical client and what does a typical order look like for IFO options?
Consider a European fixed income fund manager who is longer-term bearish on the Bund market and thus underweight versus his/her duration benchmark. Say that this fund manager is concerned that a low value of IFO may lead to a Bund market rally and portfolio underperformance versus the benchmark in the short-term. The fund manager may submit an order to buy a put option with a strike of 87.5, with an order amount of EUR5 million. This option order, if filled, generates a payout of EUR5 million for the fund manager, if IFO comes in below 87.5. This client decides that he/she is willing to pay up to 12% of notional a limit price of 0.12 - for this option, or EUR600,000.
How does a client determine what is a sensible limit price for this option?
The client's limit price for this put option depends on the client's estimated probability that IFO will come in below 87.5. To determine this probability, the client might use historical data on IFO or a Bloomberg survey of economists on IFO, as shown below.
In this Bloomberg survey, three of the 22 economists surveyed (14%) predicted IFO below 87.5, hence why a limit price of 0.12 might be chosen.
During the auction period, as client orders are received, the indicative prices for these options will change to reflect demand and supply. These changes, and resulting indicative fills, will be immediately visible to clients via a real-time display grid on the Web. It is important to stress that these bids and offers are only indicative: as mentioned earlier, this is a call auction - no prices and fills will be final until the end of the auction.
At 4 p.m., with all client orders received, the auction is closed or called, and Deutsche Bank provides final prices and fills to its clients using the Longitude system. A filled order results in a standard bilateral contract governed by the terms of the client's existing International Swaps and Derivatives Association master agreement with Deutsche Bank.
For the client order described above, assume that the final equilibrium price for the put struck at 87.5 is 0.10 per euro of notional. The auction is a Dutch auction, which are widely used in the financial markets and specifically in the U.S. Treasury market, so all filled buy orders for puts struck at 87.5 are filled at this final offer price and not at their higher limit prices. Conversely, buy orders with limit prices below the final offer price will not be filled. In this example, the fund manager's order for the 87.5 put is filled for EUR 5 million and the manager pays a total amount of EUR 500,000 for the option.
On Friday morning Oct. 19, September IFO of 85.0 is released. In this case, all holders of call options receive zero, and all clients who purchased put options receive a payout equal to their filled order amount. For instance the fixed income manager in the example above will receive a payout of EUR5 million.
Pricing IFO Options On Parimutuel Principles
In this auction, all client prices and fills are determined by parimutuel principles. The parimutuel system is a price making mechanism that has been widely used in certain wagering markets and provides a number of useful features.
Parimutuel principles determine prices and fills based on the relative prices and the cleared premium of certain "fundamental" options. These fundamental options are also known in the academic finance literature as Arrow-Debreu securities. For the IFO auction, two of the fundamental options are the 87.5 put and the 89.5 call. Parimutuel principles imply that
The other fundamental options in the IFO auction are the digital spreads: the 87.5 to 88 spread, the 88 to 88.5 spread, the 88.5 to 89 spread, and the 89 to 89.5 spread. Prices on the other remaining options are linear combinations of the prices of the fundamental options.
The parimutuel mechanism fundamentally reengineers the order-matching process in such a way that there is no requirement for a direct match of buy orders with sell orders. For instance, in the auction the buy order for a put struck at 87.5 will not be necessarily matched off against a sell order for a put struck at 87.5. Instead, orders from the auction are batched together so as to eliminate the need to search for the specific other side of a transaction. This multidimensional effect benefits clients because they receive better fills than they would receive based on a simple discrete order match. It also provides a highly efficient means for risk transfer at all levels of market liquidity.
The week's Learning Curve was written byTorquil Wheatley, v.p. of derivative products at Deutsche Bank in London.