Modeling derivative instruments to hedge macro economic shocks

Abstract

In this paper we studied the various economic indicators which signal the inflection points in the economic cycle. Most of these indicators signal investor's prediction about the future of the economy. We also looked at three of the macro shocks like Foreign Exchange shock, unemployment risk, and Inflation risk. We observed strong correlations of these macro variables with financial market indicators and formed indices wherever possible for these shocks. For instance, the index of lead indicators which is used for inflation is a seven series dynamic indicator whose composition changes as per the state of the economy. Even while the market significance of these Lead Economic Indicator, Composite Lead Indicator appear just as moderate, the importance of these in predicting the recessionary economic cycles has been significant i.e., The daily or periodic relevance of these indicators in hedging against seasonal oil shocks may not very significant but the aggregate index is useful in signaling the phase of business cycle, viz., whether the economy is in expansionary phase or is in a recessionary phase. An early recognition of economic recession is necessary for introducing countercyclical stabilization policies. We devised hedging strategies to express bullish, bearish and range bound sentiments based on the indices developed for the underlying. For instance, we suggested both inexpensive strategies for investors in developing economies like long collar as well as more effective exotic strategies like kick-in kick-out options for bulk exporters in order to give complete price protection.