Innovation in finance – a new derivative

When the term “innovation” is used, most people automatically associate it with new things, specifically new technologies. That innovation = technology formulation is especially true in the current debate on economic competitiveness. However, innovation is a much broader concept. One of the often overlooked areas of innovation is in finance. It is also an area that highlights the complexity of innovation as an outcome by raising the question: “are all innovations good?”
To highlight financial innovation, the Chicago Mercantile Exchange (now simply called the CME) created a Center for Innovation in 2003. One of Center’s programs it the CME Fred Arditti Innovation Award.

The CME Center for Innovation’s signature program is the CME Fred Arditti Innovation Award. The Center annually honors an individual or group of individuals whose innovative ideas, products or services have created significant change to markets, commerce or trade. This award strives to celebrate innovation in action, not only the creative idea, but also the impact that practical application of the idea has made on improving the economic well being of individuals, an industry or a nation.

One of the forthcoming innovations from the CME is described by The Economist“Property derivatives: Homes with hedges”:

In the next few weeks, the CME is likely to open trading in financial futures and options linked to American house prices. Investors who want to hedge the risks of residential property — or merely to speculate on the market’s direction — will be able to bet on a rise or drop in a house-price index, without having to buy or sell bricks and mortar. With interest rates on the rise, prompting worries that the recent housing boom is about to give way to a downturn, the potential appeal of these new hedging products is easy to see.
Punters will be able to bet on price changes in ten cities from Boston to San Diego, as well on a national index that aggregates all ten. The indices will be part of the CME’s Alternative Investment Products group, which fosters derivatives linked to economically important trends and events not directly related to underlying securities or commodities. The group already has products based on the weather and on economic data such as non-farm payrolls.

Now, this immediately brings to mind the negative side of financial innovations: it is just one more tool for speculation. But, while speculation is a part of any financial market, the purpose of these new financial instruments is risk management. As The Economist goes on to explain:

Because the new derivatives will allow bets up to only a year ahead, homeowners will not be able to use them to hedge long-term risks. That limits their usefulness for ordinary folk. For many companies in the property industry, however, they should be helpful. A property developer or contractor, for example, can start a housing project without worrying whether prices will fall sharply by the time it is completed. Monika Piazessi, an economist at the University of Chicago’s Graduate School of Business, says that half the volatility in the price of individual homes is linked to city-wide changes in prices. So the CME’s new city indices could go a long way towards lowering the risks.

As a result:

Financial firms such as mortgage lenders will also no doubt find uses for the new derivatives. And so will investors with a view about America’s residential property market — whether they expect a continued boom, or a bust.

Given that a large percentage of most people’s net wealth is tied up in their homes, it would be a major step forward if these derivatives can smooth out risk of the price volatilities and thereby lessen the underbuild/overbuild cycle. On the other hand, if you believe that derivatives contribute to speculation, then this is a scary step for the housing market. (For more on the derivatives debate – especially Warren Buffet versus Alan Greenspan – see the 2003 story in Forbes. “The Great Derivatives Smackdown”.) (See also Andrew Gyn’s comment in today’s FT – “Finance’s rise threatens economic stability” – subscribtion required).
So, it this a good innovation or a bad innovation? I don’t know, but I am reminded of the old saying from technology assessment: technology is neither good nor bad, nor is it neutral. Maybe we should broaden that phrase to encompass all innovation?

4 thoughts on “Innovation in finance – a new derivative”

  1. Losing US financial comparative advantage

    Brad Setser sees the US losing its financial comparative advantage – RGE – One more sign we live in a new gilded age – Europe is once again the world’s financial center …: In the new Gilded Age, America is…


  2. Losing US financial comparative advantage

    Brad Setser sees the US losing its financial comparative advantage – RGE – One more sign we live in a new gilded age – Europe is once again the world’s financial center …: In the new Gilded Age, America is…


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