Risk Markets And Politics

Wednesday, December 13, 2006

Economic Derivatives Auction trader motivations

The National Association for Business Economics' experimental auction data for the October payrolls release seems to be unavailable, but let's compare their forecasts to CME's economic derivatives auction for the September release.



The CME numbers had more variance and fatter tails. Specifically:

NABE: Less than 5% in the less-than-0k and greater-than-250k tails.
CME: 10.1% in the less-than-0k and greater-than-250k tails.

NABE: Approximately 75% between 75k and 175k
CME: 47.7% between 75k and 175k

One possible interpretation is that the tails of the CME auction are overbought (by hedgers?). I have not seen the CME data recently, but from what I hear it does not actually show a longshot bias over time. This suggests that the tails were underbought in the NABE auction. We don't have enough NABE data to analyze, but since their participants were fully-funded we might expect them to herd around the consensus number. Justin Wolfers has also suggested that what we see in the NABE auction is overconfidence, which would dissipate in an auction with larger stakes.

In any case, hedging against the payroll release has recently been an absurd exercise. The number reported for September was 51k, but this was later revised to 148k. This revision was reported on the day of the October payrolls release, along with a second revision to the August number, which now stands at 230k. That is, the numbers on which the CME auctions for August and September were settled were low by a total of approximately 200k. Revised numbers were a well-known inevitability to the market's designers and traders, but this had to be exasperating for anyone actually hedging a fixed income position with the October release auction. If this theoretical person had been long fixed-income, he probably would have hedged by buying the upper tail of the payroll outcome: a result likely to embolden the fed and send bonds lower. The October number actually came in on the low side, and our theoretical trader would have happily accepted his hedging loss, but wait a minute... the numbers for the earlier two months were simultaneously revised much higher, causing the largest one-day sell-off in bonds in months.

This begs the question of whether our theoretical hedger exists. A recent article by Howard Simons at TheStreet.Com echoes the earlier opinions of JC Kommer and myself that the economic derivatives markets mainly represent a new avenue of speculation (which is perfectly admirable). Using the risk-based definition of gambling (which I am not endorsing), Simons writes, "The risk, however, is attached to particular markets, not to the number. [...] But in the absence of a tradable instrument created for the sole purpose of assuming that risk -- our definition of gambling above -- the number carried no actual risk itself."

The massive effects of revisions only reinforce the argument against the existence of substantial hedging in economic derivative auctions, but even without hedging utility the auctions still fulfill an information discovery function.

[Cross-posted from Midas Oracle]


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