Notable References/Sources: Credit/Economic Derivatives

Here are two very interesting references on the specific financial instruments of (credit) derivatives. Both of the sources are taken from the BIS.

First off we have a recent speech by deputy governor of Sveriges Riksbank Lars M. Nyberg on the 'risks and opportunities of credit derivatives'. Here is an excerpt from the intro ...

A credit derivative is a financial contract between two parties. It insures the buyer of the contract against the credit suffering a credit event during a predetermined period. The credit event quite simply defines what the insurance covers, in roughly the same way as the conditions in a normal home insurance. I shall return to this shortly.

Take, for instance, a company like TeliaSonera. Then imagine a bank that has loaned money to this company. This may involve a lot of money as TeliaSonera is a large company. Although Telia’s ability to pay is good when the loan is taken, the bank is exposed to the risk that it may deteriorate in the long term. If the bank considers the credit risk to be too high, it may choose to "sell" part of it to another investor. Then the bank can use the credit derivatives market.

For the bank, which in this case is the seller of credit risk, the credit derivative functions roughly like a normal insurance. The buyer of the credit risk (the insurance provider) commits itself to compensating the bank if TeliaSonera does not fulfil its obligations in some way during the contract period. The bank pays a regular premium for this, which is determined when the contract is signed. The definition of failing to fulfil its obligations is made clear in the contract between the bank and the investor. This is what is known in the jargon as a credit event. It could mean, for instance, that TeliaSonera doesn’t pay the interest as agreed, that it defaults on payment of the outstanding debt or that it goes bankrupt. The premium the bank has to pay to the investor reflects the market’s assessment of the risk that such an event will occur. The greater the probability, the higher the premium.

Second off we have a note by Blaise Gadanecz, Richhild Moessner, and Christian Upper on economic derivatives and here is the abstract as well as a an excerpt from the conclusion. Note the difference between credit derivatives described by Lars above which hedges against credit risk and economic derivatives which are the subject of this paper.

Economic derivatives allow traders to take direct positions on the outcomes of macroeconomic data releases. In contrast to survey-based measures, the prices of economic derivatives provide information on the entire probability distribution underlying these expectations, not just point estimates. Measures for uncertainty derived from such distributions offer valuable information on how uncertainty about the economy evolves and affects financial markets.

(...)

Economic derivatives allow market participants to trade directly on macroeconomic data releases and unbundle the news component of announcements from the basis risk contained in financial assets traditionally
used as proxies.

Policymakers can use the prices of economic derivatives to obtain information on the perceptions of market participants about the state of the economy. In contrast to survey-based measures, they are true density forecasts, covering the whole distribution of the “market’s view”, not just point estimates. This information could be used to track the uncertainty of market participants about the state of the macroeconomy and to monitor the probabilities they attach to tail events. However, so far this has mainly been possible for US data releases only, with euro area HICP being the exception.
When interpreting the information contained in the prices of economic derivatives, one has to bear in mind that it refers to market participants’ perceptions of the current economic situation and not to their expectations of outcomes further ahead. While this may be a limitation when analysing issues

such as the transmission mechanism of monetary policy, it may not matter in other settings. For example, the impact of central bank communications might depend on the views of market participants about the current state of the economy, not just on their expectations for the future. That said, it would be useful to have more forward-looking indicators, eg on inflation and growth in the short and medium term, which could complement the information contained in longer-term instruments such as inflation-linked securities. The potential size of the market for economic derivatives might be limited.
In particular, it is not clear whether the market is able to attract a substantial amount of hedging demand, which could serve as a counterweight to highly sophisticated informed traders. In the absence of hedging activity, it is possible
that liquidity may dry up in times of limited disagreement between a relatively small number of informed participants.

Update on Monday, July 2, 2007 at 08:03AM by CV

Will these things ever pick up?

(from the the WSJ economics blog) 

Another attempt to spread risk around has bit the dust. The Chicago Mercantile Exchange and the International Securities Exchange have decided to discontinue economic derivatives auctions.

The market was created in 2002 as a way for institutional traders to hedge risk or profit from economic data. Auctions were conducted prior to the release of nonfarm payrolls, the consumer price index, retail sales, and weekly initial jobless claims reports.

The shuttering follows other such ventures into the sunset. The Coffee, Sugar and Cocoa Exchange’s attempt to establish a futures market in the consumer-price index, died in the early 1980s as a result of lack of interest. The London Futures and Options Exchange’s experiment with betting on real-estate prices collapsed in the early 1990s amid reports that false trades had inflated trading volume.

A lack of interest was apparently behind the closure. The ISE declined to release volume figures for the market and a spokeswoman said there was a “client base.” However, a spokeswoman from the CME said, “combined with low market participation, [ISE’s] decision to discontinue the products was not a surprise.” –Phil Izzo