On the innovation of forward contracts

Man-Chung Ng, Purdue University

Abstract

Forward markets arise as a response to economic uncertainty. A forward contract is simply a bilateral contract specifying delayed delivery between a purchaser and a seller. The goal of this study is to examine how and why forward contracts are created in terms of the incentives of all the agents in an economy with uncertainty. Essentially, we adopt the model used in Duffie and Jackson (37), which contains a finite number of agents with mean-variance preferences facing random endowments in the future. Our main idea is that forward markets cannot exist unless someone becomes a market maker who provides contracts. Then other agents, namely the traders, in the economy can come to the market maker for forward trading. We prove that under almost all circumstances, every agent has an incentive to become a monopolistic market maker. Provided that all traders are active in trading when they behave optimally, the monopolistic market maker situation always strictly Pareto dominates the no trade situation. Next, we characterize the situation under which no one wants to be a market maker. We then proceed to prove that a monopolistic market maker, knowing the aggregate demand, only has an incentive to provide exactly one contract unless he is given a side payment. Suppose that the monopolistic market maker is able to discriminate among different groups of traders, by providing one contract to all the groups, but at different prices for different groups. Then the problem can be identified as an eigenvalue problem which can be solved systematically when the number of states is finite. We also show that with or without discrimination, a monopolistic market maker cannot gain by providing contracts if and only if for any fixed contract vector designed by him, the optimal way to maximize his utility is to choose a price vector such that the aggregate demand from the traders is zero. Put in another way, no matter what contract vector he designs, the best way for him is to choose a price vector such that he acts as a broker, helping but not participating in actual trading activities.

Degree

Ph.D.

Advisors

Novshek, Purdue University.

Subject Area

Economic theory

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