Emerging Derivative Instruments

Abstract

F or nearly 300 years, derivatives trading largely entailed the future delivery of an agricultural commodity. Two early examples of exchange traded derivatives include forward contracting of tulip bulbs on the Royal Exchange in London around 1637 and a standardized rice contract for future delivery that traded on the Yodoya rice market in Osaka, Japan, approximately 13 years later (Chance, 1998). In the United States, the creation of the Chicago Board of Trade in 1848 led to the buying and selling of grain futures, and later in the century, eggs and butter were the underlying assets for contracts on what has now become the Chicago Mercantile Exchange. It was not until the early 1970s that exchanges began trading derivatives on financial assets, specifically foreign currency futures on the International Monetary Market and stock options on the Chicago Board Options Exchange. Within a decade, major exchanges added derivative products on stock indices and interest rate instruments. While new financial derivative products continue to appear, the start of the twenty-first century finds exchanges developing contracts on the two remaining major asset categories, human capital and real estate.1 Consider first the importance of managing the uncertain cash flows derived from human capital. In terms of relative size, annual gross domestic product (GDP) is approximately 10 times larger than corporate earnings. Moreover, Bottazzi, Pesenti, and van Wincoop (1996) find low correlation between returns on financial and human capital, so that existing financial derivatives would provide little in the way of managing risks associated with aggregate income. Citing the necessity for new macroeconomic contracts, Shiller (2003, p. 1) states: “We need to extend the domain of finance beyond that of physical capital to human capital, and to cover the risks that really matter in our lives.” He goes on to argue that the trading of macroeconomic risks would allow individuals to pursue careers of their choice without fear of financial ruin and thus lead to societal gains and increased economic efficiency. In addition to derivatives on income aggregates, markets might trade indexes based on a number of related macroeconomic variables. Examples might include (but are not limited to) contracts on inflation or production. Thus, we wish to consider more generally products on a number of macroeconomic indexes in the