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| Risk & Reward: New Products |
Macro Machinations
John Ferry
08/01/2005
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What blocks an entrepreneur from hedging the risk of a business-imperiling
economic downturn? An investor from hedging the risk of
a return-devouring
spike in inflation? The owner of multiple homes from hedging the risk of a
plunge in real estate prices? Until recently, the answer would be a lack of
adequate tools. The only way to hedge against (or speculate on) movements in
macroeconomic variables such as gross domestic product, inflation or housing
prices was to use instruments designed to hedge exposures to markets—say, bond,
commodity or stock markets—that are buffeted by those larger economic trends.
Unfortunately, markets react in unpredictable ways to macroeconomic events,
making market-based tools a poor fit for those seeking an effective and reliable
hedge for macroeconomic risks.
In the last three years, however, Financial Engineers have devised technologies that allow institutional investors and some
private investors to directly hedge macroeconomic risks such as a dip in GDP or
a spike in inflation. Banks are now working to make these tools more widely
available to private investors.
Economic derivatives
by their nature are short term. They are event
based. A number comes out and the market moves. |
The dream of a world in which every
risk—housing prices, GDP, inflation, even unemployment—can be hedged dates back
to Nobel laureate Kenneth Arrow’s groundbreaking work from the 1950s and has
been a mainstay of Harvard professor and Nobel laureate Robert Merton.
Best-selling author and Yale economist Robert Shiller, of Irrational Exuberance
fame, championed the idea in his 2003 book, The New Financial Order.
The
dream was first made real by Goldman Sachs and Deutsche Bank, which jointly
rolled out a series of options on macroeconomic statistics, which they call
“economic derivatives,” in 2002. These are only traded by institutional
investors, but financial engineers are working to design investments based on
these and other instruments for individuals. Another company, HedgeStreet in San
Mateo, Calif., recently launched a different type of macroeconomic hedging
instrument that private investors are able to trade online. “Flying
Economy"
A Less Dismal Science
The precise match
between the economic derivatives and the risk to be hedged is a major advantage
of these new instruments, their backers explain. “If you are taking a fixed
income position based on where you think the nonfarm payroll [statistic] is
going to come out, then we would suggest that is an inefficient way of taking
that position, because typically you don’t have 100 percent correlation,” notes
Torquil Wheatley, head of economic derivatives at Deutsche Bank in London. “Why
not instead focus on an instrument that gives you direct access to the number?”
Nonfarm payroll figures are a major driver of interest rate behavior, so
traders seeking to hedge, or speculate on, the payroll figures would
traditionally buy or sell interest rate derivatives in strategies that reflected
how they expected the payroll figure to come out and its subsequent effect on
interest rates. Now they can buy derivatives based exactly on what they think
the figure will be.
Deutsche Bank and Goldman Sachs offer economic
derivative options on several macroeconomic figures, including nonfarm payrolls,
Institute for Supply Management manufacturing statistics, retail sales, initial
jobless claims, GDP and the U.S. international trade balance. These instruments
are based on pari-mutuel auction technology, which is similar to the mechanism
that sets the betting odds at horse races. The price of the options (akin to the
odds) is set by the auction participants’ demand, and the “losers” fund the
“winners.” This pari-mutuel system solved the decades-old problem facing those
who wanted to bring Arrow’s dreams to fruition: There were not enough buyers and
sellers to balance the market. “We have around 100 regular participants in the
auctions, ranging from hedge funds, commercial banks, broker-dealers and some
real money managers,” explains Michael Duvally, a spokesman for Goldman Sachs in
New York.
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