Interesting. I’m sure the extra risk can still be hedged or reduced (as long as each contract has an “anti-contract” that pays out exactly the reverse), but it seems this is not exactly how the market operates in practice.
Think about a farmer who will get a good harvest of the sun shines. So he can sell a contract saying “pay 10,000 if the sun shines this summer”. Someone who buys that contract and want to hedge the risk needs to find someone who wants to sell an anti-contract: “pay 10,000 if it rains”. Maybe there is such a person on the market (mushroom pickers?), in which case the risk can be hedged. Or maybe everyone in the world is actually better off with sunshine (or at least, the total productivity in the economy will be higher), in which case the amount of sunshine is a systematic risk which cannot be hedged.
You’re right—weather (or other time dependent related events) cannot be risk reduced on the moment.
But they can be risk reduced over time, by aggregation. I would be willing to sell ten thousand contracts “pay 1 if it rains this year”, one for each of the next ten thousand years. I would do this if we assume the yearly rains are somewhat independent, and that I have a good estimate of their likelyhood, allowing me to price the events reasonably. This, in practice, is stupid because of the ten thousand year delay. Alternatively, I could sell these contracts in 10 000 different locations on the planet—but they would not longer be even approximately independent.
So there are three limitations to reducing risk through aggregation:
1) Reasonable time scale for aggregation.
2) Establishing a reasonable level of independence in the contracts.
3) Calculating the probabilites correctly.
What most people call “systematic risks”, seem to fail one or more of these three requirements, and so can’t be easily risk reduced through aggregation.
Interesting. I’m sure the extra risk can still be hedged or reduced (as long as each contract has an “anti-contract” that pays out exactly the reverse), but it seems this is not exactly how the market operates in practice.
Think about a farmer who will get a good harvest of the sun shines. So he can sell a contract saying “pay 10,000 if the sun shines this summer”. Someone who buys that contract and want to hedge the risk needs to find someone who wants to sell an anti-contract: “pay 10,000 if it rains”. Maybe there is such a person on the market (mushroom pickers?), in which case the risk can be hedged. Or maybe everyone in the world is actually better off with sunshine (or at least, the total productivity in the economy will be higher), in which case the amount of sunshine is a systematic risk which cannot be hedged.
You’re right—weather (or other time dependent related events) cannot be risk reduced on the moment.
But they can be risk reduced over time, by aggregation. I would be willing to sell ten thousand contracts “pay 1 if it rains this year”, one for each of the next ten thousand years. I would do this if we assume the yearly rains are somewhat independent, and that I have a good estimate of their likelyhood, allowing me to price the events reasonably. This, in practice, is stupid because of the ten thousand year delay. Alternatively, I could sell these contracts in 10 000 different locations on the planet—but they would not longer be even approximately independent.
So there are three limitations to reducing risk through aggregation:
1) Reasonable time scale for aggregation.
2) Establishing a reasonable level of independence in the contracts.
3) Calculating the probabilites correctly.
What most people call “systematic risks”, seem to fail one or more of these three requirements, and so can’t be easily risk reduced through aggregation.