What is an Economic Derivative?

An economic derivative is an over-the-counter (OTC) contract, where the payout is based on the future value of an economic indicator. It is similar to other derivatives in that it is designed to spread the risk to parties that are willing to take on risks to participate in the rewards. The major distinguishing feature of an economic derivative is that the triggering event is related to an economic indicator.

Key Takeaways

  • An economic derivative is an over-the-counter (OTC) contract, where the payout is based on the future value of an economic indicator.
  • Economic indicators include things like the national unemployment rate, non-farm payrolls (NFP), gross domestic product (GDP) figures, the Institute of Supply Management (ISM) Purchasing Managers Index (PMI), and retail sales figures.
  • Economic derivatives are attractive for their ability to mitigate some of the market and basis risks found in standard investment vehicles.

Understanding Economic Derivatives

Economic derivatives are attractive for their ability to mitigate some of the market and basis risks found in standard investment vehicles. The release of economic indicators has an immediate impact on portfolio values and, even though the timing of these releases is well known, mitigating risks in a portfolio in the short term requires working through the proxies for releases, like bonds or forex.

Potential economic indicators include things like the national unemployment rate, non-farm payrolls (NFP), gross domestic product (GDP) figures, the Institute of Supply Management (ISM) Purchasing Managers Index (PMI), and retail sales figures. Most of these economic derivatives are in the form of binary, or "digital," options, whereby the only payout choices are full payout (in the money) or nothing at all (out of the money). Other types of contracts currently traded include capped vanilla options and forwards.

Economic derivatives provide a direct way to protect a portfolio against the near-term effects of a negative release. Of course, these same features offer a way for traders to speculate on economic data releases even when it won’t impact their portfolios. If a speculator wants to place money on whether a particular indicator is going up or down in the next quarterly releases, he can.

Economic derivatives can be traded on an exchange. The exchange provides the product specifications; for example, the non-farm payrolls economic derivative may be a monthly auction. If a fund manager thinks the NFP numbers will be higher than the consensus estimate, he can purchase a binary option trading on the NFP, which would pay its face value if the NFP value falls within a specific range (strike range). When the official NFP release is made (the exercise date), the digital option pays out if it is in the money or it expires worthless if it is out of the money.

A Brief History of Economic Derivatives

Economic derivatives were first traded in 2002. They were introduced to the market by Deutsche Bank and Goldman Sachs. In 2005, the Chicago Mercantile Exchange (CME) took over the market. In addition to providing hedges and speculation tools to institutional investors, the market for economic derivatives provided economists with a richer and more immediate picture of the consensus figures for the smart money on Wall Street. Unfortunately, the demand for economic derivatives was not as high as anticipated, and the CME shuttered its economic derivatives auctions in 2007. Of course, no financial tool actually dies. Economic derivatives can still be created over-the-counter between willing parties, and it is possible that they could reemerge as more of a force in the right market.