Risk Markets And Politics

Friday, June 30, 2006

Retail hedging?

Hedgestreet is taking a lot of heat lately from bloggers who focus on prediction markets. Steve Roman has labeled their official strategy of catering to retail hedgers an "imaginary niche". If this is the case, why? Consider that both John Delaney of Intrade and Robert Dubil, Hedgestreet's Chief Economist, have recently stated that many traders prefer binary markets because of their greater volatility. One would expect retail hedging of things like home and gasoline prices to occur in long-dated index contracts, not short-dated options. Hedgestreet offers both capped futures and options, and experiences better volume on the options side. The futures side seems to be dwindling, and almost has a vestigial feel to it.

Even the CME doesn't offer housing futures more than one year out although the contracts were originally touted for their hedging utility. The low overhead of running an electronic market combined with the aggregate wealth of potential retail hedgers seems outweighed by the danger of liquidity cannibalization. In other words, it's not worth introducing long-dated contracts that would cater to retail hedgers because these might dilute the liquidity of existing short-dated markets. How much of the lack of retail hedging is reducible to attitudes towards risk versus education and ease-of-use? Or is the public smart to not hedge certain risks?

It could be that the general population is not risk-averse with respect to some prices, or that many do not even perceive their risks. For instance, on the latter count, Robert Shiller and others combat the notion that housing prices drift permanently upwards. Even if risk appetites and perceptions are partly responsible for the lack of retail hedging, this may not be the most cogent answer to the question. After all, the person who is likely to sign-up and trade in an online market is typically a speculator (and possibly a "sensation-seeker"), so basing this conclusion on the dearth of retail hedging in that particular environment could be misleading. Maybe it's just that electronic auctions are not the right means for retail hedging?

At the beginning of the month, General Motors and Ford introduced sales promotions that amount to gasoline hedges. GM's "Fuel Price Protection" program provides new car buyers with pre-paid gas cards that cover the cost of any gas above $1.99 per gallon. What if such cards were offered at gas stations and sold at a premium to current fuel prices? Or cards that entitled their holder to X gallons of gas, a la the USPO's plans for the "forever" stamp? What if similar features were offered as credit card promotions or as capabilities embedded in private banking websites? The idea would be to push hedging instruments at the general public "on the ground" so to speak, in environments where their utility will be especially tangible, and in which their usage will be straightforward, or at least much more straightforward than setting up an account on an online exchange and explicitly trading options.

The pricing of these new "user-friendly" options would of course be somewhat less clear to consumers, which is why someone might want to sell them, and this brings us to the last possibility: that the public is largely wise to not want to enter hedging markets. To what extent would hedging be taking a guaranteed loss? Are premiums and transaction costs fair? Now, you could say "Wait a minute - many insurance premiums aren't 'fair' and that's a huge business." Yes, but there is a practical difference between hedging against a massive and irreversible loss and hedging against an incremental, reversible one. A crash in the housing market could qualify as the former for some, but in those cases the education and ease-of-use perspective would seem to be more apt.

Maybe housing and even gasoline prices just aren't volatile enough to spur retail hedging, and the public won't reach for the morphine drip until it experiences more pain.

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