What is an ‘Economic Derivative’
An economic derivative is a relatively new form of derivative contract (the first ones were traded in 2002) that is based on the future value of some national economic indicator, such as non-farm payrolls, the purchasing manager’s index, retail sales levels and the gross domestic product. Most of these economic derivatives are in the form of binary or “digital” options, whereby the only payout options 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 have become attractive for their ability to mitigate some of the market and basis risks found in standard investment vehicles.
Explaining ‘Economic Derivative’
For example, a binary option trading on the GDP would pay its face value if, when the official GDP release is made (the exercise date), the GDP value falls within a specific range (strike range). If the GDP figure is outside of this range, the option expires worthless.
By looking at the implied probabilities of different outcomes, economists and investors can compare economic derivatives to Wall Street estimates and look for discrepancies between the two estimations. As might be expected, the market-driven process seen in derivatives pricing has shown itself to be the more consistently accurate predictor of future indicator release values.
Further Reading
- Constructing a market, performing theory: The historical sociology of a financial derivatives exchange – www.journals.uchicago.edu [PDF]
- Financial bubbles, real estate bubbles, derivative bubbles, and the financial and economic crisis – link.springer.com [PDF]
- Financial derivatives and the theory of money – www.tandfonline.com [PDF]
- The economic effects of financial derivatives on corporate tax avoidance – www.sciencedirect.com [PDF]
- Is economics performative? Option theory and the construction of derivatives markets – www.cambridge.org [PDF]
- Repressed futures: financial derivatives' theological unconscious – www.tandfonline.com [PDF]
- Economic geographies of financialization – www.tandfonline.com [PDF]
- The importance of the financial derivatives markets to economic development in the world's four major economies – www.mdpi.com [PDF]
