Dsquared on Political Event Swaps

Commenter dsquared has made a couple of good points in response

to my post about political

event swaps.

Firstly, the specific example I gave, where ADM tries to hedge the risk of

corn subsidies falling, is not great. Part of the reasons is that there’s a

clear capital-markets correlation, in ADM shares — which means that the hedge

fund taking on the risk would itself hedge that risk by going short ADM. And

it’s not clear that ADM would want to buy an insurance contract from a firm

which was shorting its stock. (On the other hand, companies regularly issue

convertible bonds, which are almost always hedged with a short stock position,

so it’s hardly unthinkable.)

There’s a pat answer to this question, which is "OK, just replace ADM

with Cargill". But it’s a weak answer, because a hedge fund could still

hedge a political event swap with Cargill by going short ADM. In other words,

the trade is not as uncorrelated to the market as all that, and a hedge fund

wanting to take on this kind of risk could conceivably replicate it by selling

out-of-the-money puts on ADM.

On the other hand, there are many more situations where a company might want

to hedge some kind of political event risk which could cost it money without

necessarily having such a clear effect on its share price. Maybe an accountancy

firm or a private-banking operation would want to hedge against the estate tax

being abolished, thereby depriving it of income from tax-planning services.

And indeed, once there was a market in estate-tax-abolition futures or the like,

individuals with large estates could even start to hedge their own future tax

liabilities. And there’s no market proxy for a rich individual’s after-tax inheritance.

Dsquared makes another point: that hedge funds holding these kind of contracts

might become lobbyists, which is "not obviously a sensible thing to do".

To which I say firstly that there are a few hedge funds which already

are lobbyists. And, secondly, that if a real market develops in these things,

then that market’s liquidity might start to replace lobbying expenditures. But

that, admittedly, is a very long way in the future.

This entry was posted in hedge funds, Politics. Bookmark the permalink.