Red-Blooded Risk by Aaron Brown

Author:Aaron Brown
Language: eng
Format: epub
Publisher: Wiley
Published: 2011-08-22T16:00:00+00:00

Numeraire

The natural numeraire for a derivatives dealer is not paper money but shares in the clearinghouse. Dealers own stakes in the clearinghouse and are responsible for its debts. Over-the-counter (OTC) derivatives are not traded on public exchanges, and may or may not have clearinghouses. If there is no multidealer clearinghouse, the dealer acts as its own clearinghouse, or else uses another dealer to clear trades.

In principle, you could set up a derivatives exchange and clearinghouse with no reference to paper money at all. As with a paper money issuing bank, you would probably want to contribute some equity capital so people would trust the institution initially, but even that is only a marketing essential, not an economic one. It’s also true that having cash as one of the assets derivatives are written on is handy, because you don’t have contracts for every possible thing someone might want to borrow or lend. But cash is not necessary.

To a derivatives end user, the numeraire is the net product of its economic activity, or the closest approximation that can be made from available contracts. An oil refiner, for example, can use the price of refined products minus the price of crude oil as a numeraire; a shipping company can use the price of commodities at port of consumption minus the price of those same commodities at port of production. This is the key to the economic function of futures markets. When your numeraire is your net economic product, you have no risk. When your numeraire is highly correlated to your net economic product, you have small risk.

With gold and silver money, the profit of a business is the metal received for end products minus the metal paid for inputs. With paper money, it’s more complicated. First, the business can choose from various types of paper money, and can use different types for different transactions. Second, there is an interest rate attached to loans; profit depends on the timing of purchases and sales, not just the net amount. Risky businesses pay higher interest rates than safe ones, so profit is adjusted for risk. Third and most important, the value of paper money changes over time. If a business does badly, but better than the average bank borrower, it can still show a profit. It uses the money it borrows to buy goods at full value for the money, but when it sells its output it may be able to accept money at a discount and use it to repay its loan. If it sells goods for 10 percent less in gold terms than the value of the inputs it bought, but the bank’s money has depreciated 20 percent over the period of production, the company will show a profit. These features—choice of currency, risk-adjusted profits, and relative success criteria—allow for much more nuanced and effective economic signals than a precious metal economy can provide.

Although governments have outlawed competition in money issuance, so there is not as much variety available as there should be, there are still different currencies in different countries.

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