U.S. patent application number 11/893017 was filed with the patent office on 2008-02-14 for methods and apparatus for formulation, initial public or private offering, and secondary market trading of risk management contracts.
Invention is credited to John Nafeh, Kenton K. Yee.
Application Number | 20080040257 11/893017 |
Document ID | / |
Family ID | 27399415 |
Filed Date | 2008-02-14 |
United States Patent
Application |
20080040257 |
Kind Code |
A1 |
Nafeh; John ; et
al. |
February 14, 2008 |
Methods and apparatus for formulation, initial public or private
offering, and secondary market trading of risk management
contracts
Abstract
Key features of these methods, apparatus, and designs include
(but are not limited to) innovations and implementations of futures
securities; the notion of Type I, Type II, and Type III futures
contracts custom tailored to specific clienteles; the notion of
tickets and coupons as tradable futures contracts; the notion of
bifurcation; the notion of redeemable bundles; and notion of
realization of the futures market on the Internet; the apparatus of
an Internet-based trading interface and engine; the notion of
cookie-cutter futures electronic Internet-based futures markets for
each security; the feature of maximal reliance on the Internet; and
the business concept of "profitability without the need for high
trading volume."
Inventors: |
Nafeh; John; (Portola
Valley, CA) ; Yee; Kenton K.; (Stanford, CA) |
Correspondence
Address: |
CARR & FERRELL LLP
2200 GENG ROAD
PALO ALTO
CA
94303
US
|
Family ID: |
27399415 |
Appl. No.: |
11/893017 |
Filed: |
August 13, 2007 |
Related U.S. Patent Documents
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Application
Number |
Filing Date |
Patent Number |
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09923035 |
Aug 6, 2001 |
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11893017 |
Aug 13, 2007 |
|
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60240903 |
Oct 17, 2000 |
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60284051 |
Apr 16, 2001 |
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Current U.S.
Class: |
705/37 |
Current CPC
Class: |
G06Q 40/04 20130101 |
Class at
Publication: |
705/037 |
International
Class: |
G06Q 40/00 20060101
G06Q040/00 |
Claims
1. A method of conducting business comprising the steps of:
establishing a computer-network based coupons trading system
electronically accessible by traders; selling, over said trading
system, coupons, each coupon for a prespecified item of value;
accepting for reselling, over said trading system, at least one of
said coupons; settling the at least one of said coupons; and
assessing, a transaction fee for at least one of said steps of
selling, accepting for reselling, or settling of said coupons.
2. The method of claim 1, wherein the computer-network based
coupons trading system is electronically accessible by the traders
via at least the Internet.
3. The method of claim 2, wherein said coupons trading system
includes a user interface that allows the traders to access said
coupons trading system.
4. The method of claim 3, wherein the user interface is a
world-wide-web user interface.
5. The method of claim 3, wherein said user interface allows any of
the traders to access said coupons trading system in order to view
information about coupons selling on said coupons trading
system.
6. The method of claim 3, wherein said user interface allows any
network users to access and view said coupons trading system.
7. The method of claim 1, wherein the step of settling the at least
one of said coupons is at an expiration thereof.
8. The method of claim 7, wherein the step of settling is through a
web-based electronic interface.
9. The method of claim 1, wherein the step of settling the at least
one of said coupons is prior to an expiration thereof.
10. The method of claim 9, wherein the step of settling is through
a web-based electronic interface.
11. The method of claim 1, wherein the step of settling the at
least one of said coupons is on demand in a predesignated maturity
period.
12. The method of claim 11, wherein the step of settling is through
a web-based electronic interface.
13. The method of claim 1, further comprising the step of:
determining, prior to the step of selling, whether a prespecified
item of value for which a coupon is desired is suitable for
issuance of coupons thereon.
14. The method of claim 1, wherein said prespecified item of value
is provided as a regular recurring occurrence and wherein said
method further comprises the step of: selling over said coupons
trading system, a coupon having a time period from a sale thereof
to an expiration thereof, which partially overlaps a time period
from a sale of another coupon until the expiration of said another
coupon.
15. The method of claim 14, wherein for each coupon sold, a
corresponding expiration thereof corresponds to a timing of a
specific periodic provision of the prespecified item of value
associated therewith.
16. The method of claim 15, further comprising the step of:
selling, over said coupons trading system, coupons associated with
the specific periodic provision of the prespecified item of value
at substantially the same time as an expiration of coupons
associated with another periodic provision of the prespecified item
of value.
17. The method of claim 1, wherein the step of selling coupons and
the step of settling said coupons are accomplished in a credit-risk
free manner.
18. The method of claim 1, wherein: the step of selling coupons
comprises selling coupons on margin; and the step of selling
coupons and the step of settling said coupons are accomplished in a
credit-risk manner.
19. The method of claim 1, further comprising the step of accepting
an indicia of an identity of at least one of the traders.
20. The method of claim 19, wherein the step of selling, accepting
for reselling, settling or assessing, over said coupons trading
system is only with respect to the at least one of the traders.
21. The method of claim 1, wherein only a predetermined group of
traders may access the coupons trading system.
22. The method of claim 21, wherein said predetermined group is
selected from a group consisting of predefined and prequalified
traders.
23. The method of claim 1, further comprising the step of providing
a promoter for mediating any dispute related to said coupons
trading system.
24. The method of claim 1, further comprising the step of:
interfacing with a point of sale terminal configured to receive an
indicator of an identity of at least one of the traders and to
receive a coupon associated with said at least one of the traders
to be settled.
25. A computer-network based coupons trading system, comprising:
computer means; means for selling, over said trading system,
coupons, each coupon for a prespecified item of value; means for
reselling, over said trading system, at least one of said coupons;
means for settling the at least one of said coupons; and means for
assessing a transaction fee, for said selling by said means for
selling, said reselling by said means for reselling, or said
settling by said means for settling, for any of said coupons.
26. The computer-network based coupons trading system of claim 25,
wherein said means for settling includes a means for interfacing
with a point of sale terminal, the point of sale terminal adapted
to receive an indicator of trader identity and to receive the at
least one of said coupons associated with the trader identity; and
wherein said means for settling the at least one of said coupons is
responsive to a communication from the point of sale terminal
received via said means for interfacing.
27. The computer-network based coupon trading system of claim 25,
further comprising: a point of sale terminal communicatingly
connected to said means for settling.
28. The computer-based coupons trading system of claim 25, further
comprising: means for allowing a computer-network user to view said
coupons trading system.
29. The computer-based coupons trading system of claim 28, wherein
the computer-network user is a member of a predetermined group of
computer-network users.
30. The method of claim 1, wherein said step of selling is
performed by a market authority and further comprising the step of
accepting said coupons for settlement upon demand of the market
authority prior to a predesignated maturity period thereof.
31. The method of claim 1, further comprising the step of accepting
an indicia of an identity of a counterparty.
32. A computer-based coupons trading system for the formation,
sale, resale and settlement, of coupons, the system comprising: a
communications interface for communicating data; a processor system
for executing processing modules; a first processing module for
receiving data to define at least one coupon desired for a
prespecified item of value; a second processing module, responsive
to said first processing module, for defining said at least one
coupon based on said received data; a third processing module for
selling said at least one coupon to a trader; a fourth processing
module for reselling said at least one coupon; a fifth processing
module for settling said at least one coupon; and a sixth
processing module for assessing a transaction fee, for said selling
by said third processing module, for said reselling by said fourth
processing module, or said settling by said fifth processing
module.
33. The computer-based coupons trading system of claim 32, further
comprising: a seventh processing module for maintaining account
information.
34. The computer-based coupons trading system of claim 33, wherein
said seventh processing module is adapted to access said account
information.
35. The method of claim 1, wherein the computer-network based
coupons trading system is electronically accessible by non-trading
observers.
36. The method of claim 1, wherein said step of selling is
performed by a promoter.
37. The method of claim 1, further comprising assessing a
transaction fee for a reselling of said coupons.
Description
CROSS-REFERENCE TO RELATED APPLICATIONS
[0001] This application is a divisional and claims the priority
benefit of U.S. patent application Ser. No. 09/923,035, entitled
"Methods and Apparatus for Formulation, Initial Public or Private
Offering, and Secondary Market Trading of Risk Management
Contracts" and filed Aug. 6, 2001, which claims the priority
benefit of U.S. Provisional Patent Application Ser. No. 60/240,903
filed Oct. 17, 2000, and U.S. Provisional Patent Application Ser.
No. 60/284,051 filed Apr. 16, 2001, the entire contents of each of
which are hereby incorporated by reference.
FIELD OF THE INVENTION
[0002] The present invention relates to a method and apparatus for
risk management and to a method and apparatus for establishing and
maintaining a market for initial and secondary trading in risk
management instruments.
BACKGROUND OF THE INVENTION
[0003] General George Patton is reputed to have once said, "Take
calculated risks. That is quite different from being rash." General
Patton's attitudes about risk had far-reaching implications indeed,
in that the decisions he made and the risks he took sometimes cost
the lives of men in battle. But the notion of calculated risk goes
well beyond warfare; it is a process that we all engage in as we
make the daily decisions that define our lives. And the fact
remains that most of the risks--economic and otherwise--that
individuals face in their lives are not shared by society. As
inefficient and insecure as it may seem, "we allow our standards of
living to be determined substantially by a game of chance."
[0004] Over the years a number of instruments have emerged that
enable people to "hedge their bets" in the face of risk. Insurance,
in its many forms, is the classic example of a hedge instrument. So
too, is the futures market for hedging the price of commodities. In
fact, a futures market can exist for anything, functioning as a
market where bets can be placed on the course of the price or index
that defines that market. Hedging in any market--whether it be
commodities, real estate, or anything with any kind of economic
consequences--is essentially the same as buying insurance against
price changes.
[0005] A number of financial management systems have been proposed
in the past. Exemplary systems include U.S. Pat. Nos. 4,232,367,
4,633,397, 4,742,457, 4,752,877, 4,766,539, 4,839,804, 4,876,648,
5,083,270, 5,101,353, 5,136,501 and 5,206,803. Broadly speaking,
the prior art has proposed several methods to transfer the types of
risks, which are common to many people. These include banks,
insurers, equities and commodities exchanges, the bond and swap
markets, and mutual funds, each of which developed from a
recognition that numerous parties with similar risk exposures
needed effective methods of transfer and a means of determining the
value of risk transfer at any given time.
[0006] These structures operate on the basis of transferring risk
to an entity which utilizes one of two primary forms of capital
structure: a capital leveraging system (banks and insurance
companies) or a capital matching system (the exchanges and
markets).
[0007] Under the capital leveraging system, an insurer may accept
any type or amount of risk, subject to internal underwriting
guidelines and regulatory restrictions. This format provides a
significant degree of flexibility in the pricing, terms, and limits
of risks accepted. These insurers operate on the premise that
premiums cover claims. Their capital is available to pay claims if
losses exceed premiums and investment income. The aggregate of
policy liabilities though, is generally much larger than their
combined premium and capital. So, like a bank, which could not pay
if all depositors asked for their money, insurance companies are
not generally designed to pay if all policies claimed their
limits.
[0008] Leveraging capital, i.e., a small amount of capital compared
to the risk exposures assumed, translates a small underwriting
profit on premium into a substantial return on capital. Conversely,
a relatively small loss over premium results in a significant loss
to capital. This system does not absolutely assure an insurer's
ability to pay in that an insurer's policy limits are generally
much larger than its assets. Hence, an insurer must only accept
risks common to many people, limiting its exposure to each single
risk to a small percentage of its capital, and relying on
geographic and risk type diversification, as well as reinsurance,
to protect its shareholder's capital. This works well when losses
are predictable. It is when insurers accept unique or
difficult-to-place risks that premium as well as capital may not be
sufficient to cover claims. Even Lloyd's of London (which operates
in a manner similar to a collection of small insurance companies
with the exception that should losses exceed available funds, its
underwriting members, similar to shareholders, can be forced, in
theory, to pay up to the limit of their assets) has experienced
such difficulties.
[0009] Under the prior art, insurance policies have provided
security to insureds based on and no greater than the general
claims paying ability rating (the ability to pay claims) of an
insurer to perform its obligations. Although reinsurance has
sometimes been available, reinsurance policies likewise protect the
insurer only to the extent of the reinsurance company's capacity to
pay loss claims as they accrue.
[0010] In contrast, a capital matching system such as an exchange,
accepts risk by matching buyers and sellers, i.e., parties transfer
risk to those accepting it, in effect matching risk to capital.
Under this system parties transfer or accept risks which are easily
quantified in comparatively small units, such as through futures
and options contracts. It limits the types and conditions under
which parties may transfer to specifically defined contractual
units, priced by the marketplace, being a price agreed between
those parties wishing to transfer risk and those willing to accept
it.
[0011] These narrowly defined contracts offer little flexibility in
the risk being accepted. Although each investor can select the type
and amount of risk accepted, parties transferring risks are not
concerned with the performance of a specific party having accepted
a corresponding amount of risk. The exchange stands as the
intermediary between all parties, perfectly matched, with its only
exposure being the credit performance of any one participant. Like
Lloyd's, these parties' assets can be attached to secure their
performance.
[0012] Each system operates on the basis of accepting risks which
are common to large numbers of people. As financial transactions
and our world in general grow more complex, certain types of risk
exposures have become increasingly difficult to transfer in today's
markets. In the insurance markets, catastrophic events and judicial
reinterpretation have caused a contraction in some types of
insurance capacity. It appears that today's insurance markets are
frequently unable or unwilling to facilitate the transfer of unique
risks such as those with a high possibility of loss, where the loss
could come earlier rather than later or with more severity than
projected. The exchanges have taken some steps toward addressing
unique risks, such as catastrophe futures contracts, but again the
terms are restrictive and do not easily integrate with the
flexibility of a reinsurance contract. In essence, neither the
exchanges nor mutual funds can accept a single unique risk.
[0013] In spite of insurance companies and exchanges, the fact
remains that there are no existing instruments that people can use
to hedge most of the common, everyday risks they face. For example,
workers have no direct way to hedge against the pain of prolonged
work stoppage. Retailers have no way to hedge against macroeconomic
surprises in the global economy which could impact the availability
of inventory items. And individuals have no way to hedge against
government decisions--such as war, economic embargoes, legislation
and a myriad of other possibilities--that could substantially
impact their livelihoods.
[0014] One limited attempt to address the above shortcomings has
been presented by the Iowa Electronic Markets (IEM), which are
operated by faculty at the University of Iowa Tippie College of
Business as part of a research and teaching mission. The IEM are
real-money futures markets in which contract payoffs depend on
economic and political events such as elections. More specifically,
the IEM is a real-money, small-scale futures exchange in which the
ultimate values of the contracts traded are determined by political
events, financial events and economic indicators or other
real-world events such as companies' earnings per share (EPS) or
stock price returns. Participants in these markets invest their own
funds, buy and sell listed contracts, and bear the risk of losing
money as well as earning profits.
[0015] The exclusive purposes of the IEM are teaching and research.
Through the IEM as a teaching device, participants learn first-hand
about the operation of a financial market. Because they have an
added incentive to do so, they often become better informed about
events determining the ultimate value of the contract being
traded--be that a political race, the earnings per share of a
company, the stock return of a company, or the exchange rate
between a foreign currency and the dollar. Through the IEM as a
research venture, the markets provide insights into market and
trader behavior. Participation in the IEM is open to students,
faculty, and staff at colleges and universities worldwide; IEM
political markets are also open to non-academic participants.
[0016] The IEM is operated as a not-for-profit venture. No
commissions or transactions fees are charged, and the method of
issuing contracts and making final payoffs on these contracts
ensures that the IEM does not realize financial profits or suffer
losses from market transactions. Although the IEM is under the
regulatory purview of the Commodity Futures Trading Commission
(CFTC), it is not regulated by, nor are its operator registered
with, the CFTC or any other regulatory authority.
[0017] As noted above, the market operates on computer systems at
the Henry B. Tippie College of Business of the University of Iowa;
traders gain access through the World Wide Web. At the time of this
writing, the home page for the IEM is
http://www.biz.uiowa.edu/iem/index.html.
[0018] While the IEM goes somewhat beyond traditional commodity
futures in the types of contracts which are offered, much of the
system is modeled on conventional futures trading principles.
Accordingly, IEM, like other traditional risk hedging methods such
as insurance, offers a limited variety of contracts and provides
incomplete markets and thus restricts opportunities for risk
management.
[0019] Thus, presently available risk hedging methods, including
IEM, fail to address potential needs of parties including such
problem as: [0020] Inadequate contract diversity to address the
vast range of uncertainties for which risk hedging is potentially
advantageous; [0021] Excessive transaction costs rendering small
markets of limited traders impractical; [0022] Liquidity
restrictions to trading viability in brick and mortar futures
markets; [0023] Inadequate real time communications capabilities
necessary for market trading when traders are geographically
dispersed; [0024] Problems due to the absence of liquid secondary
markets in tickets, coupons, hotel and airline reservations, and
advance purchase orders; and [0025] Problems in inventory
management
[0026] Thus, there continues to be a long felt need for a system
and a platform which brings buyers and sellers together, and thus
engenders a viable and populated market across which a nearly
unlimited variety of hedge instruments can be created and executed.
But, because of a variety of heretofore insurmountable barriers, no
such platform has yet emerged in the world.
SUMMARY OF THE INVENTION
[0027] In spite of existing brick and mortar futures markets, there
exists a continuing need for additional futures markets to
facilitate the vast variety of risk management needs. As described
in the Prior Art section, liquidity is the lifeblood of existing
futures markets. Traditional futures markets such as the CME
require a minimum trading volume before they are able to sanction
and administer the trading of a security. Without a rather high
minimum trading volume, the market cannot break even.
[0028] Accordingly, in view of the shortcomings of prior art, it is
an object of the present invention to provide a risk hedging,
contract trading system whereby prospective traders can transact
with each other with low transaction overhead, in real-time, near
instantaneous speed, twenty-four hours-per-day, 7 days-per-week,
and without any intermediary or broker.
[0029] It is also an object of the present invention to enable and
provide markets, for trading to any interested parties, risk
hedging contracts pertaining to a virtually unlimited range of
possible events.
[0030] It is also an object of the present invention to enable and
provide a system for creating and managing markets for risk hedging
contracts having de minimus transaction costs so that a minimum
market size or trading volume is not necessary for efficiency,
practicality or viability.
[0031] It is a further object of the present invention to act as an
umbrella aggregator, facilitator, administrator and electronic
platform for supporting a nearly unlimited number of simultaneous
trading markets in hedge instruments, and to act as a disseminator
of information pertaining to the activities on these markets.
[0032] It is still a further object of the present invention to
enable and provide a trading platform that is equally and nearly
instantaneously accessible to traders who may be located anywhere
in the world.
[0033] It is still a further object of the present invention to
aggregate in one electronic platform support for simultaneous, but
separate, trading of publicly-traded hedging instruments and
trading of restricted hedging instruments, the trading of which is
restricted to a group of specially authorized traders.
[0034] It is a still further object of the present invention to
provide a trading platform together with all necessary support and
brokerage services, including user-friendly Web interface,
newswire, settlement, clearance, money transfer, and accounting
management features.
[0035] It is a still further object of the present invention to act
as a government sanctioned institution to interact with government
regulatory agencies so that all activities within the platform
comply with government regulations and principles of fairness,
integrity, and public transparency.
[0036] It is a still further object of the present invention to be
easily expandable and adaptive to incorporate the trading of new
hedging instruments and, also, interact with new telecommunications
media.
[0037] These and other objectives and advantages of the present
invention are provided by a computer-network based futures trading
system, or platform, which is electronically accessible by
prospective traders, for enabling transactions related to futures
contracts and futures contract bundles.
[0038] The computer-network based platform is preferably
implemented as an internet-accessible web site, having an
interactive interface and being configured to enable anyone who
accesses the platform to apply for a new account and to view data
and news related to activity within markets within the platform.
The interface is configured to enable registered users to log in,
place trades, and perform related maintenance activities related to
their account.
[0039] The computer-network based system enables transactions
relating to bundles of futures contracts, where each bundle
includes at least two futures contracts, each of which corresponds
to one of at least two future possible outcomes of a phenomenon at
a time of maturity of the contracts. The futures contract bundles
are defined to pay an aggregate fixed sum at maturity and each of
constituent futures contracts pay the fixed sum at maturity upon
the happening of the future possible outcome of the phenomenon
associated with that particular risk management contract.
Conversely, each of the risk management contracts pay a zero sum at
maturity upon the non-happening of the future possible outcome of
the phenomenon associated with that specific risk management
contract.
[0040] Transactions on contract bundles include purchase and sale
of complete bundles from the market authority, which always stands
ready to sell or purchase bundles at a fixed, prestated price.
[0041] The computer-network based system also enables transactions
relating to individual futures contracts, each of which are traded
in an individual market. Owners of contracts may place limit orders
to sell one or more contracts. Likewise, potential buyers of
contract(s) may place limit orders offering to purchase one or more
contracts at a certain price.
[0042] The computer-network based system also enables transactions
relating to sets of individual futures contracts which do not form
a complete bundle. In particular, at any given time the market
authority has discretion either to split one contract into several
separately traded contracts, or to recombine several contracts into
one contract. The computer-network based system will facilitate
splitting and recombination in an efficient way that is
substantially automated and that does not reduce the event-based
liquidation value of any contract owner.
[0043] The computer-network based system also has a means for
soliciting, evaluating, and optionally implementing ideas for
innovative new contracts and contract bundles the trading of which
enables hedging in new dimensions.
[0044] The computer-network based system also acts an umbrella
aggregator, facilitator, and administrator of potentially thousands
or millions of small, simultaneous markets, each of which may have
virtually zero trading volume individually. This is possible
because the platform profits from aggregate activity integrated
over all of the small individual markets. Thus, the platform is
able to (i) effectively "complete" the securities market for risk
management; (ii) act as an umbrella portal where hedgers can go to
access millions of futures markets in one place; and (iii) provide
a direct channel to the hedging and speculating clientele for
advertisers and others.
[0045] One aspect of the present invention is that, because of new
software and database technologies and the instantaneous
multimedia, multi-user telecommunications capability offered by the
World Wide Web, it is now profitable to facilitate and administer
the trading of futures contracts with very low or even negligible
trading volume. This is because given "template" software and Web
interfaces for futures markets, it is virtually costless to
electronically reproduce this template again and again to
facilitate the trading of highly specialized hedging
instruments--even instruments with extremely low popularity and
trading interest. If at least two counterparties (one buyer and one
seller) are interested in trading a futures contract, everyone is
better off if a market is created to enable the two parties to
establish their positions: the two counterparties benefit from
establishing their positions, and any third party speculators and
spectators benefit from either participating or just passively
observing the transaction price. (I.e., the transaction price
reveals information about the traders' expectations.)
BRIEF DESCRIPTION OF THE DRAWINGS
[0046] A more complete understanding of the present invention and
its advantages will be readily apparent from the following Detailed
Description taken in conjunction with the accompanying drawings.
Throughout the accompanying drawings, like parts are designated by
like reference numbers.
[0047] FIG. 1 illustrates a preferred embodiment of the present
invention implemented as a general internet-based webserver.
[0048] FIG. 2 shows an expanded view of the Market Authority
500.
[0049] FIG. 3 shows an expanded view of the Clearance and
Settlement 690 function.
[0050] FIG. 4 shows a general top level web-site design in
accordance with a preferred embodiment of the present
invention.
[0051] FIG. 5 shows an expanded view of the pages which are located
below the New User Registration Page 450.
[0052] FIG. 6 shows an expanded view of some of the pages which
belong to the Public Pages 470.
[0053] FIG. 7 shows a flow chart of a member interacting with the
Trade Engine 300 function of FIG. 1.
DETAILED DESCRIPTION OF THE INVENTION
I. Description of the Types of Contracts and how Use of these
Contracts Enables Hedging
[0054] As noted in the summary of the invention, an objective of
the present invention is to enable and provide a new form of risk
hedging. While the present invention is directed to a novel method
and apparatus for risk hedging, proper understanding of the
invention first requires an understanding of various hedging
contracts or instruments, the sale and transactions in which are a
necessary adjunct to the inventive process and apparatus.
Accordingly, next will be discussed three types of contracts or
hedging instruments which can be used in the inventive system. For
convenience, these three types of contracts are referred to herein
as Type I contracts, Type II contracts and Type III contracts.
Based on the present disclosure, however, one of ordinary skill in
the art will appreciate that the present invention is not limited
to these types of contracts and many other types of contracts could
be employed to hedge risk without departing from the spirit of the
present invention.
[0055] A. Type I ("Event") Contracts
[0056] As the name suggests, event contracts pay out based on the
realized outcome of contingent events. By way of example and not by
way of limitation, an event contract may pay off either $10 or $0
depending on the outcome of a specified event. If a particular
criteria is met (i.e. a particular outcome occurs), then the claim
pays off $10. Otherwise, the contract pays off $0. Event contracts
are cash settled. Event contracts can be designed around almost any
risky event in the world. For instance, events may be a state's
gubernatorial election; firm's quarterly earnings announcement; or
Federal Reserve Open Market Committee (FOMC) meeting announcements.
Examples of outcomes corresponding to these events might be,
respectively, whether the incumbent governor wins re-election;
whether the firm meets or beats analysts' expectations; or whether
the Fed hikes interest rates. There are an unlimited number of
possible events which can be commodified with event contracts and
therefore render, for the very first time, their associated risks
hedgeable.
[0057] Type I contracts will be designed specifically to hedge
economic risks contingent on future events. Contracts are designed
in such a way that they can be used, with reasonable
predictability, by participants in the contract market to
neutralize, or at least reduce, the risk of an adverse outcome with
respect to the underlying event. Like futures contracts traded in
existing contract markets, they are intended as risk-shifting
vehicles.
[0058] A full understanding of the types of contracts and the
present invention requires an appreciation of the following
terminology which is used throughout this application:
[0059] The "market authority" is the official agent charged with
the absolute authority and ability--subject to legal
limitations--to issue, expire, terminate, buy, sell, or otherwise
alter the nature of the instruments trading in the market, and to
alter the nature of the market itself.
[0060] A state of nature "s" is a possible final outcome realized
at a prespecified date T. States of nature, s and s', are mutually
exclusive if they cannot occur together. A set of states, S={s1,
s2, . . . , sN} is complete if: (i) the members of S are all
mutually exclusive, and (ii) every possible final outcome is a
member of S. The number, N, of states of S can be, in principle,
any number greater than or equal to 2.
[0061] A contract is a tradable instrument that pays off a nonzero
value in one state of nature, s, and $0 in all other states of
nature at date T. In the following examples and throughout this
specification, for simplicity, the nonzero payoff value of the
tradeable instrument in the one state of nature will be $10,
however, one of ordinary skill in the relevant art will appreciate
that any value can be used.
[0062] In the following examples, date T will sometimes be referred
to as the "expiry" date.
[0063] A "contract bundle" is a collection of contracts whose
aggregate payoff at date T in any state of nature is $10. For
instance, suppose S={s1, s2, s3, s4, s5} is a complete set of
possible states for a given event. Then a bundle might consist of
the set {A, B, C, D, E} of 5 contracts. In this example: [0064] At
time T, contract #1 (A) pays off $10 if state s1 occurs, and $0
otherwise. [0065] At time T, contract #2 (B) pays off $10 if state
s2 occurs, and $0 otherwise. [0066] At time T, contract #3 (C) pays
off $10 if state s3 occurs, and $0 otherwise. [0067] At time T,
contract #4 (D) pays off $10 if state s4 occurs, and $0 otherwise.
[0068] At time T, contract #5 (E) pays off $10 if state s5 occurs,
and $0 otherwise.
[0069] Because the possible states for a given event {s1, s2, s3,
s4, s5} are mutually exclusive, and because the set S includes all
possible outcomes, one (but only one) of the states will be
achieved at time T. Thus, regardless of which one of the states is
achieved at time T, the aggregate value of the contract bundle will
always be $10.
[0070] According to the present invention, there can be otherwise
identical contracts and/or contract bundles whose only difference
is the expiration date T. For example, quarterly earnings
announcements occur four times a year. Thus, at any one time, there
can be a first set of contracts which pay off depending on the
outcome of Company A's first quarter announcement; a second set of
contracts whose payoff depends on Company A's second quarter
results; and a third and fourth set which pay off depending on
Company A's third and fourth quarter results, respectively. The
collection of all these contracts would be referred to as the
"earnings announcement class for Company A." All contracts in this
class with the same expiration date would be referred to as the
date T contract series of that class. For instance, "the second
quarter series contract of Company A" refers to the contracts whose
payoff is determined by the outcome of Company A's earnings
announcement in the second quarter. Note that Company A's earnings
announcement class could consist of more or less than four contract
series depending on how many expiration dates the market authority
sanctions contracts for.
TYPE I CONTRACT EXAMPLES
Example 1
Gubernatorial Election
[0071] State A holds a gubernatorial election on November, 20xx. In
February of the same year, the market authority could issue bundles
of contracts which pay off depending on the outcomes of the
election, as certified by the State's Secretary of State.
[0072] For the gubernatorial race, the set S={incumbent wins,
otherwise} constitute a complete set of states at T of the results
of the gubernatorial race. Accordingly, the bundle would consist of
the set {A, B} of N=2 contracts. The bundle would sell for $10
where: [0073] Contract A pays off $10 if, and only if, the
incumbent governor wins reelection. [0074] Contract B pays off $10
if, and only if, anybody else is certified as the winner of the
gubernatorial race, for any reason.
[0075] The expiry date T is the day Secretary of State (or the
appropriate election authority) certifies the winner of the
gubernatorial race in that state. If the ultimate realization of
this date is in controversy, the decision of the market authority
is final.
Example 2
AOL Earnings Announcements
[0076] The "big board" NASDAQ and NYSE traded companies announce
quarterly earnings 4 times per year on a regular (usually
pre-announced) schedule. An earnings announcement does not become
official until the company files its Form 10-K with the SEC. For
contract purposes, one can define the event in this situation as
the announcement of the "official" earnings number as "earnings
before special items" listed in the document (Form 10-K) officially
filed with the Securities and Exchange Commission.
[0077] The states which define the possible outcomes in this
situation pertain to whether AOL "beats," "meets," or "misses" a
benchmark (or "expected") earnings number. Thus, based on the
above, the set S={beats, meets, misses} constitute the complete set
of possible states at T for AOL Earnings. Accordingly, the bundle
would consist of the set {A, B, C} of N=3 contracts. The bundle
would sell for $10, where: [0078] Contract A pays off $10 if and
only if AOL's 1st Qtr earnings (before special items) exceeds $0.41
(rounded to the nearest penny) per share. [0079] Contract B pays
off $10 if and only if AOL's 1st Qtr earnings (before special
items) falls within the range $0.39-$0.41 (rounded to the nearest
penny) per share. [0080] Contract C pays off $10 if and only if
AOL's 1st Qtr earnings (before special items) falls below $0.39
(rounded to the nearest penny) per share.
[0081] For example, the expiry date T is the day after Form 10-K is
first available on FreeEdgar.com. This date is not specified as a
calendar date--it depends on when AOL officially files with the
SEC. Sometimes a company may pre-announce earnings. Regardless, T
is based on the official SEC 10-K filing, not the pre-announcement
or any version of company press release. Moreover, if a company
after the initial SEC filing goes back to amend and re-compute
earnings, the payoff does NOT hinge on the re-computed number. The
payoff is based on the original SEC filing.
[0082] In the above, contract B's payoff range of "$0.39-$0.41"
reflects an estimate of AOL "meeting" earnings expectations. The
market authority determines/chooses this numerical range based on
its own private judgement.
[0083] The AOL Earnings Class: At any given time, 4 different
earnings contract series for AOL can be trading. The 4 series
correspond to the 4 upcoming quarterly earnings announcements.
After one series expires, the year-ahead one for the same quarter
is introduced to start trading. For instance, typically AOL would
file its 4th quarter 1999 earnings with the SEC near the end of
January, 2000. Immediately afterwards, on Jan. 31, 2000--as
indicated in the Table below--the market authority would issue a
series based on 4th quarter, 2000 earnings for trading.
TABLE-US-00001 Earnings Series Trading Start Expiry 4.sup.th Qtr.
2000 Jan. 31, 2000 at SEC filing 1.sup.st Qtr. 2000 Mar. 31, 2000
at SEC filing 2.sup.nd Qtr. 2000 Jun. 30, 2000 at SEC filing
3.sup.rd Qtr. 2000 Sep. 30, 2000 at SEC filing
Example 3
FOMC Interest Rate Changes
[0084] For a contract bundle, or contract bundle series directed to
the Federal interest rates (Fed Interest Rates), a bundle can
consist of the set {A,B,C,D,E} of 5 contracts. For example the
bundle would sell for $10 (plus any transactions fee), as follows:
[0085] Contract A pays off $10 if and only if the interest rate is
lowered by more than 25 basis points between midnight EDT June 29,
and midnight EDT Aug. 23, 2000. [0086] Contract B pays off $10 if
and only if the interest rate is lowered by exactly 25 basis points
between June 29 and August 23. [0087] Contract C pays off $10 if
and only if the interest rate is unchanged between June 29 and
August 23. [0088] Contract D pays off $10 if and only if the
interest rate is raised by exactly 25 basis points between June 29
and August 23. [0089] Contract E pays off $10 if and only if the
interest rate is raised by more than 25 basis points between June
29 and August 23.
[0090] Based on this example, at any given time, eight Fed Interest
Rate series might be trading. These eight series correspond roughly
to the eight scheduled FOMC meeting per year. After one series
expires, the corresponding year-ahead one is introduced to start
trading. For instance, as indicated in the schedule below, on Feb.
16, 2000 the series based on how much the Fed changes interest
rates between Jan. 1, 2001 and Feb. 15, 2001 starts trading. This
series trades continuously for one year until Feb. 15, 2001, the
expiry date. Note that while the "rate accrual period" intends to
roughly approximate the period between 2 FOMC meetings, the outcome
is not based on whether the FOMC meets on those dates or not. The
outcome is based on the accumulated net amount the Fed changes
interests rates during the period between midnight EDT Jan. 1, 2001
and midnight EDT Feb. 16, 2001. TABLE-US-00002 Rate Accrual Period
Trading Start Expiry Jan. 1, 2001-Feb. 15, 2001 Feb. 16, 2000 Feb.
15, 2001 Feb. 16, 2001-Mar. 31, 2001 Apr. 1, 2001 Mar. 31, 2001
Apr. 1, 2001-May 22, 2001 May 23, 2001 May 22, 2001 May 23,
2001-Jun. 28, 2001 Jun. 29, 2001 Jun. 28, 2001 Jun. 29, 2001-Aug.
22, 2001 Aug. 23, 2001 Aug. 22, 2001 Aug. 23, 2001-Oct. 15, 2001
Oct. 16, 2001 Oct. 15, 2001 Oct. 16, 2001-Nov. 22, 2001 Nov. 22,
2001 Nov. 22, 2001 Nov. 22, 2001 v Dec. 31, 2001 Jan. 01, 2002 Dec.
31, 2001
[0091] Transactions of Type I Contracts
[0092] A full understanding of the types of transactions in the
various contracts in the present invention requires an appreciation
of the following terminology and concepts pertaining to market
transactions involving contracts:
[0093] A "trader" is any person authorized to buy or sell, or to
make offers to buy or sell, contracts or contract bundles in the
market.
[0094] "Sale Of A Bundle By The Market Authority"--When the market
authority authorizes a new series of contracts for trading, it
stands ready to sell to traders, at any time, contract bundles
pertaining to that series of contracts for a fixed price. Ignoring
transactions fees, this fixed price is typically equal to the
aggregate payoff of a complete bundle of contracts at expiry. By
way of example, in the following discussions the fixed price is
$10, however, any other value can also be used.
[0095] "Passive Redemption Of Bundles By The Market Authority"--The
market authority stands ready to redeem for $10 any complete bundle
of contracts offered for sale to it by any traders.
[0096] "Active Redemption Of Bundles By The Market Authority"--The
market authority may, at its discretion, actively monitor the order
queues and purchase every complete bundle that it can construct and
buy for under $10 (e.g. for $9.75). In making such purchases, the
Market Authority respects the priority of other traders' orders in
the queue, and it never unfairly jumps ahead of other legitimate
higher priority orders queued by traders.
[0097] "Splitting of a Contract"--The market authority may at any
time elect to split any contract into two or more contracts. When a
contract, for instance contract A, is designated for splitting into
M contracts, say A.1-A.M, the following occurs: [0098] (i) The
market authority announces the split and defines the payoffs of the
M contracts subject to the following conditions: [0099] If at date
T, original contract A pays off $10 in state s, and $0 otherwise,
then the aggregate payoff of contracts A.1-A.M at date T must also
pay off $10 in state s and $0 otherwise. In this sense, owning
contract A is equivalent to owning: the set of M contracts A.1-A.M.
[0100] Each of the individual M contracts must pay off either $10
or $0 at date T. These conditions are fulfilled if the market
authority partitions the state s into M mutually exclusive states
{s1, . . . , sM} such that the union of s1, s2, . . . & sM
equals state s; and, then, the market authority defines contract
A.j as paying off $10 if, and only if, state sj occurs, and $0
otherwise. [0101] (ii) The market authority replaces every contract
A held in each trader's account with contracts A.1-A.M. [0102]
(iii) All contract bundles sold in the future by the market
authority contains the new contracts A.1-A.M in place of contract
A.
[0103] "Merger of Contracts" The market authority may at any time
elect to merge two or more contracts into a single contract. When M
contracts, A.1-A.M, are designated for merger into one contract, A,
the following occurs: [0104] (i) The market authority announces the
merger, and defines the new contract A as follows. Suppose at date
T the individual contracts Aj pay off $10 in state sj and zero
otherwise. Define the aggregate state s as the union of states {s1,
. . . , sM} (for j=1 to M). Then contract A pays off $10 if, and
only if, at date T state s is realized; otherwise A pays $0. In
this sense, owning contract A is equivalent to owning the M
contract, A.1-A.M. [0105] (ii) The market authority replaces every
set of contracts A.1-A.M held in every trader's account with
contract A. Note that if a trader holds some, but not all, of the M
contracts, then his contracts will not be merged and will not be
replaced by contract A. Only complete sets of A.1-A.M will be
replaced by A. [0106] (iii) All contract bundles sold in the future
by the market authority will contain contract A in place of
contracts A.1-A.M. [0107] (iv) The markets for the individual
contracts Aj will continue trading until every contract Aj has been
redeemed by the market authority. In the meantime, contract bundles
containing original contract A will still be redeemable for
$10.
[0108] "Limit Order For Purchase Of A Contract"--The only orders
traders may place to buy or sell individual contracts are limit
orders. A limit order to purchase a contract A is an outstanding
offer to buy at a certain price for a certain period of time. The
offer must specify: [0109] numbers of A contracts desired, [0110]
maximum price per A contract the aspiring buyer is offering, and
[0111] an expiration date after which the offer terminates.
[0112] Acceptance of an outstanding limit order is binding on the
offeror. The order is automatically withdrawn at 12.01 A.M. on the
expiration date. However, traders may cancel their limit order at
any time prior to their stated expiration date by placing a
cancellation order.
[0113] "Limit Order For Sale Of A Contract"--A limit order to sell
a contract is an outstanding order specifying: [0114] a quantity of
contracts offered for sale, [0115] a minimum price per contract
demanded, and [0116] an expiration date after which the offer
terminates.
[0117] Acceptance of an outstanding limit order is binding on the
offeror. However, traders may cancel their limit order at any time
prior to their stated expiration date by placing a cancellation
order.
[0118] Description of Type I Contract Markets
[0119] Consider a given series of contracts. Suppose this series of
contracts consists of bundles of N contracts each. Then at any
given time, there will be N distinct parallel markets--one market
for each of the N contracts.
[0120] At any given instant before expiry, any one of these N
markets will consist of the following: [0121] a market authority
who stands ready to sell and redeem a bundle of N contracts for a
predetermined price, for example $10 per bundle, [0122] a
collection of traders' accounts qualified to transact in this
market; that is, a collection of accounts qualified to place limit
and buy orders on this contract, [0123] a queue of limit orders to
buy contracts. The queue can be arranged in priority according to
any one of (or more than one) the following criteria in order of
importance: [0124] (i) price per contract (highest order first)
[0125] (ii) number of contracts offered (greatest quantity first)
[0126] (iii) time order was entered (earliest order first) [0127] a
queue of limit orders to sell contracts. The queue can be arranged
in priority according to any one of (or more than one of) the
following criteria in order of importance: [0128] (iv) price per
contract (lowest price first) [0129] (v) number of contracts
offered (greatest quantity first) [0130] (vi) time order was
entered (earliest order first), and [0131] a mechanism for
communicating to all traders' accounts timely information about the
status of the market, including the price and volume information of
recent trades, and the best limit prices and quantities in the
limit buy and sell queues.
[0132] Description of the Setting in which Contract Trading Might
Be Desirable
[0133] Suppose there are N states of nature {s1, s2, . . . , sN}
which comprise a complete set of possible outcomes of an event.
This means the ultimate outcome of the event must be either s1, s2,
. . . , or sN. Consider a potential hedger--who can be anyone from
a large corporation to a private individual--who finds herself in a
risky position that pays off Q(sn) dollars in state sn. Q(sn) may
be negative or positive. Without loss of generality, suppose these
payoffs are arranged in order of size so that Q(s1)>Q(sn) for
all n>1.
[0134] Without hedging, this potential hedger cannot guarantee
herself of a certain outcome, and she would be at the mercy of
whatever outcome sn and payoff Q(sn) that befalls her.
[0135] But suppose there is a bundle of futures contracts #1, #2, .
. . , #N which are available. These contracts respectively pay $10
if and only if state s1, s2, . . . , sN occurs.
[0136] Hedging Method Using Type I Contracts
[0137] In the above example, to completely hedge her position and
guarantee herself a riskless position, this hedger should buy:
[0138] (a) {Q(s1)-Q(s2)}/10 shares of contract #2.
[0139] (b) {Q(s1)-Q(s3)}/10 shares of contract #3
[0140] *
[0141] *
[0142] (z) {Q(s1)-Q(sN)}/10 shares of contract #N.
[0143] This position assures the hedger a completely riskless net
profit (after paying for the contracts) of:
p=p(s1)Q(s1)+p(s2)Q(s2)+ . . . +p(sN)Q(sN)
Hedging Method Example 1
Earnings Announcements
[0144] An earnings announcement contract pays off based on whether
a company's quarterly announcement "beats," "meets," or "misses" a
benchmark (or "expected") earnings number.
[0145] Consider, for instance, AOL. Suppose the consensus analysts'
estimate is for AOL to earn $0.40 per share in the upcoming
quarter.
[0146] For this earnings announcement, the Market Authority would
offer a bundle consisting of the following set {A,B,C} of 3
contracts, which would sell for $10: [0147] Contract A pays off $10
if and only if AOL's 1st Qtr earnings (before special items)
exceeds $0.41 (rounded to the nearest penny) per share. [0148]
Contract B pays off $10 if and only if AOL's 1st Qtr earnings
(before special items) falls within the range $0.39-$0.41 (rounded
to the nearest penny) per share. [0149] Contract C pays off $10 if
and only if AOL's 1st Qtr earnings (before special items) falls
below $0.39 (rounded to the nearest penny) per share.
[0150] For contract purposes, the Market Authority, acting in
accordance with the present invention, can define the "official"
earnings number as "earnings before special items" listed in the
document (Form 10-K) officially filed with the Securities and
Exchange Commission. This document is publicly available for
download on FreeEdgar.com ostensibly within 24 hours of filing.
Therefore, the settlement date is on the day after Form 10-K is
first available on FreeEdgar.com. This date is not specified as a
calendar date because it depends on when AOL officially files with
the SEC.
[0151] Sometimes a company may pre-announce earnings. However, the
settlement date in the present example is based on the official SEC
10-K filing, not the pre-announcement or any version of company
press release. Moreover, if a company after the initial SEC filing
goes back to amend and re-compute earnings, the preferred
embodiment of the present invention does not use the re-computed
number. Thus, the payoff is preferably based on the original SEC
filing.
[0152] Contract B's payoff range "$0.39-$0.41" intends to proxy for
a best estimate of AOL "meeting" earnings expectations. The Market
Authority acting in accordance with the present invention
determines/chooses this numerical range based on its own private
judgement. To pick these payoff criteria, the Market Authority can
consult First Call or other financial analyst forecast databases
(including "whisper number" databases). No matter, the Market
Authority preferably reserves the right to pick this number
internally any way it chooses. Even more preferably, the Market
Authority does not publicly commit to any predetermined formula for
choosing the payoff criteria; it may not even disclose how it
chooses them.
[0153] Likewise, contracts A and C pay off $10 if AOL,
respectively, "beats" and "fails to meet" earnings
expectations.
[0154] The AOL Earnings Class: At any given time, 4 different
earnings series for AOL would be trading. The 4 series correspond
to the 4 upcoming quarterly earnings announcements. After one
series expires, the one year-ahead for the same quarter is
preferably introduced to start trading. For instance, typically AOL
would file its 4th quarter 1999 earnings with the SEC near the end
of January, 2000. Immediately afterwards, on Jan. 31, 2000--as
indicated in the Table below--the Market Authority would introduce
the series based on 4th quarter, 2000 earnings for trading.
TABLE-US-00003 Earnings Trading Start Expiry 4th qtr, 2000 Jan. 31,
2000 at SEC filing 1st qtr, 2001 Mar. 31, 2000 at SEC filing 2nd
qtr, 2001 Jun. 30, 2000 at SEC filing 3rd qtr, 2001 Sep. 30, 2000
at SEC filing
[0155] Hedging With Earnings Announcement Contracts
[0156] Suppose an investor, Pete, holds a $100,000 long position in
AOL stock. While Pete is optimistic about AOL long term, Pete is
concerned about short term volatility in the AOL stock price.
(Perhaps Pete manages a hedge fund, and short term volatility would
scare away his clients; or perhaps Pete is highly margined, and
price volatility might make Pete liable to a margin call.) In any
case, AOL is due for an earnings announcement, and Pete is worried
that if AOL does not beat expectations, AOL stock will fall. In
particular, Pete believes his unhedged AOL portfolio would be worth
one of the following:
[0157] (a) $125,000 if 1st Qtr earnings exceeds $0.41 cents;
[0158] (b) $95,000 if 1st Qtr earnings falls within $0.39-$0.41
range;
[0159] (c) $85,000 if 1st Qtr earnings misses the $0.39
expectations threshold.
[0160] Thus, to fully hedge his position, Pete would buy the
following contracts:
[0161] (i) 3000 type B contracts=(125,000-95,000)/10; and
[0162] (ii) 4000 type C contracts=(125,000-85,000)/10.
[0163] Then no matter if AOL beats, meets, or fails to meet
earnings expectations, the value of Pete's hedged portfolio is
locked in at $100,000 after the earnings announcement.
[0164] To put some numbers on the consequences of Pete's hedging
position, suppose, for instance, the market believes AOL has a 25%
chance of beating expectations, a 50% chance of meeting
expectations, and a 25% chance of falling short of expectations.
Then Pete would pay $15,000 (=3000.times.$10.times.0.50) for 3000
type B contracts, and $10,000 (=4000.times.$10.times.0.25) for 4000
type C contracts--for a total upfront payment of $25,000.
[0165] While the expected value of the Pete's portfolio is
$100,000, without hedging the realized value after the earnings
announcement could be anywhere from a high of $125,000 to a low of
$85,000. So Pete's unhedged portfolio is potentially volatile.
[0166] However, with hedging, after the earnings announcement,
Pete's portfolio net the $25,000 upfront payment would be:
TABLE-US-00004 Upfront Change Payoff Of Net Final Value Initial
Value Of Payment For B In Contract Of Pete's Pete's Portfolio &
C Contracts Value Portfolio Portfolio 100,000 -25,000 +25,000 0
100,000 100,000 -25,000 -5,000 +30,000 100,000 100,000 -25,000
-15,000 +40,000 100,000
[0167] The first row of numbers show Pete's situation if AOL beats
earnings. In this event, Pete's B & C contracts are worthless,
but Pete recovers his original $25,000 investment for the B & C
contracts because the value of his AOL stock increases by $25,000.
The second and third rows of numbers show Pete's outcome if AOL
does not beat expectations. If AOL meets or fails to meet earnings
expectations, Pete recovers his initial investment in the contracts
plus the drop in value of his portfolio, because the B & C
contracts pay off in the exact compensating amounts.
[0168] Therefore, once hedged, Pete is guaranteed a riskless
outcome of $100,000 after netting out the original upfront
investment.
[0169] What happens if the Market Authority made a mistake and
issued contracts based on wrong earnings expectations?
[0170] Suppose the market expects, as in the preceding setting, AOL
to report earnings in the $0.39-$0.41 range. However, the Market
Authority over-estimates market expectations for AOL's earnings,
and issues for $10 the following bundle {D,E,F} of 3 contracts
instead of {A,B,C}: [0171] Contract D pays off $10 if and only if
AOL's 1st Qtr earnings (before special items) exceeds $0.61
(rounded to the nearest penny) per share. [0172] Contract E pays
off $10 if and only if AOL's 1st Qtr earnings (before special
items) falls within the range $0.59-$0.61 (rounded to the nearest
penny) per share. [0173] Contract F pays off $10 if and only if
AOL's 1st Qtr earnings (before special items) falls below $0.59
(rounded to the nearest penny) per share.
[0174] First, the market would pay virtually nothing for contracts
D and E, and almost $10 for contract F.
[0175] Can Pete still hedge his portfolio with {D,E,F}?
Unfortunately, not. Contracts D and E are useless to Pete, because
all the volatility in Pete's portfolio occurs in the earnings range
of $0.39-$0.41. Contracts {D,E,F} cannot distinguish between
whether AOL meets $0.39-$0.41 or not. So these contracts do not
enable Pete to hedge his risk.
[0176] However, the existence of contracts {D,E,F} do not make Pete
worse off. After all, Pete can always choose not to participate.
There is no reason for Pete to buy {D,E,F} so Pete would probably
just not take positions on these contracts. Pete is not made worse
off by the mere existence of these contracts, since he can always
ignore them.
[0177] Another Application of the AOL Earnings Contracts
[0178] In the previous example the hedger, Pete, was an AOL
investor. We do not want to leave the impression that only
financial market investors could use AOL earnings to hedge risks.
Indeed, anybody with AOL-related business risk, including AOL's
creditors, employees, suppliers, customers and even competitors,
will find AOL earnings contracts useful for hedging.
[0179] Consider a small company, Sysco. Suppose Sysco is a supplier
of operating hardware to AOL's network headquarters in Virginia. In
fact, AOL is Sysco's single largest customer. When AOL's business
booms, AOL will order more hardware from Sysco. In slower times,
AOL will reduce its orders. In either case, Sysco believes AOL's
quarterly earnings announcements reflect how well AOL is doing and,
accordingly, how much AOL will expand or reduce needs for Sysco's
products. In particular, Sysco believes the net present value (NPV)
of its AOL business, if unhedged, would change by:
[0180] (a) $1,250,000 if 1st Qtr earnings exceeds $0.41 cents;
[0181] (b) $950,000 if 1st Qtr earnings falls within $0.39-$0.41
range;
[0182] (c) $850,000 if 1st Qtr earnings misses the $0.39
expectations threshold.
[0183] To fully hedge its business risk, Sysco would buy from the
Market Authority:
[0184] (i) 30,000 type B contracts=(1250K-950K)/10; and
[0185] (ii) 40,000 type C contracts=(1250K-850K)/10.
[0186] To put some numbers on the consequences of Sysco's hedging
position, suppose, for instance, the market believes AOL has a 25%
chance of beating expectations, a 50% chance of meeting
expectations, and a 25% chance of falling short of expectations.
Then Sysco would pay $150,000 (=30000.times.$10.times.0.50) for
30000 type B contracts, and $100,000 (=40000.times.$10.times.0.25)
for 40000 type C contracts--for a total upfront payment of
$250,000.
[0187] The expected value of the Sysco's AOL business is
$1,000,000. But after the earnings announcement the realized value
could be anywhere from a high of $1,250,000 to a low of $850,000.
So Sysco's unhedged business risk is potentially volatile.
[0188] With hedging, after the earnings announcement, Sysco's
portfolio net the $250,000 upfront payment would be: TABLE-US-00005
Initial Value Of Upfront Payoff Of Net Final Value Sysco's Payment
For B Change In Contract Of Sysco's Portfolio & C Contracts
Value Portfolio Portfolio 1,000,000 -250,000 +250,000 0 1,000,000
1,000,000 -250,000 -50,000 +300,000 1,000,000 1,000,000 -250,000
-150,000 +400,000 1,000,000
[0189] Hence, no matter if AOL beats, meets, or fails to meet
earnings expectations, the value of Sysco's hedged portfolio is
locked in at $1,000,000 after the earnings announcement. As Sysco,
all of AOL's individual suppliers, programmers, employees, and
third-party contracts may use AOL earnings announcements to hedge
their AOL-related business risk.
Hedging Method Example 2
FOMC Interest Rate Changes
[0190] At any given time, eight Fed Interest Rate series will be
trading. These eight series correspond roughly to the eight
scheduled FOMC meeting per year. After one series expires, the
corresponding year-ahead series is introduced to start trading. For
instance, as indicated in the hypothetical schedule below, on Feb.
16, 2000 the series based on how much the Fed changes interest
rates between Jan. 1, 2001 and Feb. 15, 2001 starts trading. This
series trades continuously for one year until Feb. 15, 2001, the
expiry date. Note that while the "rate accrual period" intends to
roughly approximate the period between 2 FOMC meetings, we do not
legally base the outcome on whether the FOMC meets on those dates
or not. The outcome is based on the accumulated net amount the Fed
changes interests rates during the period between midnight EDT Jan.
1, 2001 and midnight EDT Feb. 16, 2001. TABLE-US-00006 Rate Accrual
Period Trading Start Expiry Jan. 1, 2001-Feb. 15, 2001 Feb. 16,
2000 Feb. 15, 2001 Feb. 16, 2001-Mar. 31, 2001 Apr. 1, 2001 Mar.
31, 2001 Apr. 1, 2001-May 22, 2001 May 23, 2001 May 22, 2001 May
23, 2001-Jun. 28, 2001 Jun. 29, 2001 Jun. 28, 2001 Jun. 29,
2001-Aug. 22, 2001 Aug. 23, 2001 Aug. 22, 2001 Aug. 23, 2001-Oct.
15, 2001 Oct. 16, 2001 Oct. 15, 2001 Oct. 16, 2001-Nov. 22, 2001
Nov. 22, 2001 Nov. 22, 2001 Nov. 22, 2001-Dec. 31, 2001 Jan. 01,
2002 Dec. 31, 2001
[0191] An FOMC contract bundle is a collection of contracts whose
total payoff is $10. For Fed Interest Rates, the bundle would
consist of the following set {A,B,C,D,E} of 5 contracts, which
would sell for $10 (plus any transactions fee): [0192] Contract A
pays off $10 if and only if the interest rate is lowered by more
than 25 basis points between midnight EDT June 29 and midnight EDT
Aug. 23, 2000. [0193] Contract B pays off $10 if and only if the
interest rate is lowered by exactly 25 basis points between June 29
and August 23. [0194] Contract C pays off $10 if and only if the
interest rate is unchanged between June 29 and August 23. [0195]
Contract D pays off $10 if and only if the interest rates is raised
by exactly 25 basis points between June 29 and August 23. [0196]
Contract E pays off $10 if and only if the interest rate is raised
by more than 25 basis points between June 29 and August 23.
[0197] Application to Hedging
[0198] Suppose a retailer, Widco, sells things on credit and
typically carries $1,000,000 worth of receivables on its books.
Since Widco does not ask for any interest payments on those
receivables, they are essentially a continuously stream of
interest-free loans to Widco's customers. Whenever interest rates
move up, Widco is incurring additional loss of interest payments on
these interest-free loans. (In other words, whenever interest rates
go up Widco faces a higher cost of doing business while its credit
customers do not pay any extra interest for their credit line.)
Widco would prefer to lock in a constant interest rate so that its
profits are more predictable. In particular, Widco believes its
unhedged change in earnings between August 24-October 15 would
be:
[0199] (a) $50,000 under a 50 basis point rate decrease;
[0200] (b) $25,000 under a 25 basis point rate decrease;
[0201] (c) $0 if the rate does not change;
[0202] (d) -$25,000 under a 25 basis point rate increase;
[0203] (e) -$50,000 under a 50 basis point rate increase.
[0204] To approximately hedge its interest rate risk exposure,
following the Hedging Recipe given above, Widco would buy from the
Market Authority:
[0205] (i) 2500 type B contracts=(50,000-25,000)/10;
[0206] (ii) 5000 type C contracts=(50,000-0)/10;
[0207] (iii) 7500 type D contracts=(50,000+25,000)/10; and
[0208] (iv) 10,000 type E contracts=(50,000+50,000)/10.
[0209] To put some numbers on the consequences of Widco's hedging
position, suppose, for instance, the market believes there is a 35%
chance of a 50 basis point decrease, 40% chance of a 25 basis point
decrease, and a 19% chance of no change, a 5% chance of a 25 basis
point increase, and a 1% chance of a 50 basis point increase. Then
Widco would pay $10,000 (=2500.times.$10.times.0.40) for 2500 type
B contracts; $9500 (=5000.times.$10.times.0.19) for 5000 type C
contracts; $3750 (=7500.times.$10.times.0.05) for 7500 type D
contracts; and $1000 (=10,000.times.$10.times.0.01) for 10000 type
E contracts--for a total upfront payment of $24,250.
[0210] The expected value of Widco's contracts is $1,025,750; but
the realized value could be anywhere from a high of $1,050,000 to a
low of $950,000. So Widco's unhedged business risk is potentially
volatile.
[0211] With hedging, after the earnings announcement, Widco's
portfolio net the $24,250 upfront payment would be: TABLE-US-00007
Initial Upfront Change In Payoff Of Net Value Of Payment Value Of
Contracts Final Value Widco's For B- Widco's In Hedge Of Widco's
Receivable E Contracts Receivable Portfolio Portfolio 1,000,000
-24,250 50,000 0 1,025,750 1,000,000 -24,250 25,000 25,000
1,025,750 1,000,000 -24,250 0 50,000 1,025,750 1,000,000 -24,250
-25,000 75,000 1,025,750 1,000,000 -24,250 -50,000 100,000
1,025,750
[0212] The first row of numbers show Widco's situation if the
interest rate falls by 50 basis points. In this event, Widco's
futures contracts are worthless, but Widco recovers its original
$24,250 hedging cost because the value of its receivables increases
by $50,000. Likewise, the other rows show Widco's outcome if the
interest rate decreases by 25 basis points or less, remains the
same, or increases. In these cases, Widco's receivables is changes
in value, but the value of the Widco's hedge portfolio of contracts
exactly compensates for Widco's initial investment of $24,250 plus
the change in value of the receivables.
[0213] In summary, no matter if the Fed raises or lowers interest
rates, the value of Widco's hedged receivables portfolio is locked
in at $1,025,750--the ex ante expected value of its receivables
portfolio.
[0214] Comments about Use of Hedging Recipe:
[0215] Even without hedging, given the implied probabilities, the
ex ante expected value of the hedger's position is also p. Hedging
does not improve or--absent transactions cost--lower the expected
value of a hedger's position.
[0216] What hedging does is change the hedger's actual or realized
outcome--which could have varied between Q(s1) down to Q(sN)--to a
guarantee, riskless outcome of p dollars. In other words, hedging
changes the hedger's position from a risky one to a riskless
one.
[0217] This hedging method is not negatively affected by the
possibility of splitting and merger since splitting and merger does
not affect a hedger's position as long as the hedger does not sell
any of the post-split contracts.
[0218] Description of Hedging Procedure
[0219] How to Use Contract Splitting
[0220] Suppose contract bundles comprised of four contracts each
are issued pertaining to the earnings announcement of Company A in
the year-ahead quarter where:
[0221] Contract A: payoff $10 if earnings exceeds $0.30
[0222] Contract B: payoff $10 if earnings fall within
($0.05,$0.30)
[0223] Contract C: payoff $10 if earnings fall within
($0.00,$0.05)
[0224] Contract D: payoff $10 if earnings are negative.
[0225] The payoff ranges very coarse here because it is hard to
predict with any precision earnings 1 year ahead.
[0226] However, nine months later, there will be much more
information about A's earnings. Accordingly, the market will be in
a position to differentiate between contracts based on a finer
payoff structure. Suppose at that time that analysts' consensus
expects that earnings will be $0.25. Then splitting contract B into
five contracts gives the market a way to bet on a finer payoff
structure, as follows:
[0227] (i) Continue trading contracts A, C, D (they will have very
little value).
[0228] (ii) Split contract B into 5 contracts where: [0229] B1:
pays off $10 if earnings fall between ($0.05,$0.10) [0230] B2: pays
off $10 if earnings fall between ($0.10,$0.15) [0231] B3: pays off
$10 if earnings fall between ($0.15,$0.20) [0232] B4: pays off $10
if earnings fall between ($0.20,$0.25) [0233] B5: pays off $10 if
earnings fall between ($0.25,$0.30)
[0234] In the above approach, following the split, contract B no
longer exists. Instead, everyone who owned contract B now owns five
contracts, B1-B5 and can sell off, piecewise, any subset of B1-B5
they do not want.
[0235] Thus, after the splitting process, there are eight contracts
trading: A, C, D and B1-B5; these eight contracts form a
bundle.
[0236] At the discretion of the market authority, splitting can
occur at any time depending on the development of events. The
number of new contracts created by a split is again at the
discretion of the market authority. No existing contract owners are
hurt by splitting since if they keep all the new contracts after
the split, their post-split position is exactly the same as their
original one. Indeed, owners benefit by a split since they have the
option to sell away the post-split contracts they don't want and,
by doing so, refine their position(s).
[0237] How to Use Contract Merger
[0238] Suppose contract bundles comprised of four contracts each
are issued pertaining to the earnings announcement of Company A in
the year-ahead quarter where:
[0239] Contract A: payoff $10 if earnings exceeds $0.30
[0240] Contract B: payoff $10 if earnings fall within
($0.05,$0.30)
[0241] Contract C: payoff $10 if earnings fall within
($0.00,$0.05)
[0242] Contract D: payoff $10 if earnings are negative.
[0243] As in the previous example, nine months later, there will be
much more information about A's earnings. Accordingly, the market
will have different expectations based on the new information.
Suppose at that that time analysts' consensus expects that earnings
will be $0.35. Then contracts B, C, and D will be nearly worthless
as the odds of them paying off $10 is slim. Suppose B, C, and D at
that time, respectively, trade for $0.10, $0.05, and $0.01.
Moreover, in view of the high likelihood of them paying off $0 at
expiry, owning them is highly speculative and, accordingly, they
will not be very liquid.
[0244] To ameliorate this situation, the market authority can do
the following: [0245] (i) Split Contract A into five contracts
where: [0246] A1: pays off $10 if earnings falls between
($0.30,$0.32) [0247] A2: pays off $10 if earnings falls between
($0.32,$0.34) [0248] A3: pays off $10 if earnings falls between
($0.34,$0.36) [0249] A4: pays off $10 if earnings falls between
($0.36,$0.38) [0250] A5: pays off $10 if earnings exceeds $0.38.
[0251] (ii) Merge contracts B, C, D to form one contract, E. Upon
merger, contract E will be worth $0.16, the sum of the values of
contracts B, C and D. Contracts B, C, and D continue trading since
traders who own only one or two of these three contracts, but not
all three, cannot trade their contracts in for an E contract. (If
they want to trade for an E, they must first purchase in the open
market contracts to form a complete set of three contracts.)
[0252] Thus, immediately after the split and merger procedures,
there are nine contracts actively trading: A1-A5, B, C, D and E;
however, new bundles are comprised of the six contracts A1-A5, and
E. Thus a trader can redeem $10 for either a bundle comprised of
A1-A5 and E; or a bundle comprised of A1-A5 and B, C, and D.
[0253] At the discretion of the market authority, merger can occur
at any time depending on the development of real events. The number
of contracts merged into a single contract is again at the
discretion of the market authority. No existing contract owners are
hurt by merger since if they keep all the new contracts after the
merger, their post-merger position is exactly the same as their
original one. Indeed, owners benefit by a merger since merger
converts illiquid "penny" contracts into a bigger, usually more
liquid contract.
[0254] B. Type II ("Coupon") Contracts
[0255] As the name suggests, coupons contracts (or simply
"coupons") are future contracts which may be redeemed for a
service, product, or ticket (or some combination thereof, which may
itself be a choice of the redeemer). As specified on a
contract-by-contract basis, the redemption date or period may be
set or vary depending on the choice of the coupon holder. Unlike
Type I "event" contracts, the payoff of coupon contracts may be
fixed, or they may be chosen by the coupon holder from a set of
pre-specified possibilities. Moreover, the settlement date for a
coupon contract may be at the coupon holder's choice. For instance,
a coupon for a restaurant meal, by design, may be redeemable
anytime in February for any meal on the restaurant's menu. A simple
scenario follows to illustrate the value of such coupon
contracts.
[0256] In January 2001, a user purchased nonrefundable San
Francisco Symphony tickets for a Stravinsky concert to be held on
Feb. 22, 2001. Unfortunately, the user later needed to be out of
town that day. While the San Francisco Symphony does permit ticket
exchanges (for a $10 fee), as it turns out, all of the San
Francisco Symphony concerts of interest to the user for the
remainder of the season were sold out. Hence, the user did not
exchange the tickets, and took a 100% loss on the original amount
paid. This unfortunate episode will make the user hesitant to buy
advance tickets in the future.
[0257] Coupons settle with the physical delivery of the underlying
good or service. They are essentially continuously tradable claim
checks, or continuously tradeable newspaper coupons--if newspaper
coupons were tradeable (which they are currently not). Coupons may
be American or European in style. For instance, a car wash coupon,
if American, would be redeemable (at the holder's option) for a car
wash at any time. Alternatively, the holder may choose to hold the
coupon exclusively for trading purposes.
[0258] It should be emphasized that what distinguishes these
coupons from traditional newspaper clip out coupons is that every
coupon will be continuously traded in a pre-defined market. In this
respect, coupons are more like futures contracts than illiquid
newspaper clip out coupons or even their electronic new age
cousins. As a result, the value of a coupon is not strictly tied to
liquidation--some coupon holders, either hedgers or speculators,
may be holding coupons purely for resale into the market. This
illustrates how coupons commodify risks in new dimensions.
[0259] Part of the preferred embodiment of the present invention
includes creating markets for the promotion, sales, distribution,
and exchange (trading) of coupons. Coupons can be claims on any
product or service. Preferably, coupons are claims on any product
or service with an established brand, because the brand reassures
coupon buyers of quality and fair play by the producer. Potential
products include new books, wine, electronic goods, office
supplies, and homes in new housing developments. Coupons can also
be created for any other standard event, including four star
restaurant meals, hotel rooms, time share vacations, airline
tickets, theatre and SuperBowl tickets, any sports event ticket,
cruise and vacation tickets, and even Time Square hotel rooms on
New Year's Day.
[0260] Terminology
[0261] While the characteristics and use of Type II (Coupon)
contracts will be discussed further, a full understanding of the
types of contracts and the present invention requires an
appreciation of the following terminology which is used throughout
this application:
[0262] The "Promoter," similar to the "Market Authority" is the
official agent charged with the absolute authority and
ability--subject to legal limitations--to issue, expire, terminate,
buy, sell, or otherwise alter the nature of the instruments trading
in the market, and the market itself.
[0263] A "coupon" is a tradable instrument which pays off, at
expiry, a prespecified item of value, which can be anything
including goods or services. For example, the payoff may be a
ticket, an option to buy a ticket at a predetermined price, a night
in a hotel, an option to buy one ticket, and option to buy a ticket
to one of two concerts.
[0264] "Expiry" refers to the period or time when the coupon may be
redeemed for the payoff object.
[0265] Frequently, one may have otherwise identical coupons whose
only difference is their expiry. For example, Hotel Chain A may
sell "one night stay" hotel room coupons, some which are redeemable
only in January, some only in February, some only in March, and so
forth. In order to guarantee that its rooms are not oversubscribed
in January, the hotel would not allow redemption of the March
coupons in January or vice versa. The collection of all these
coupons would be the "one night stay class for Hotel Chain A." All
coupons in this class with the same expiry period would be referred
to as the "Month T coupon series" of that class. For instance, "the
July series coupon of Hotel Chain A" refers to the coupons
redeemable for a one night stay in Hotel Chain A.
[0266] In the following, several examples of Type I (Coupon)
contracts are described and the manner in which each allows risk to
be hedged explained.
Example 1
Coupon for a Concert Ticket
[0267] The Grasshoppers plan to tour the U.S. in September. In
every city, the promoters face demand risks. How many nights can
San Francisco support? Is a 30,000 seat stadium big enough, or is
there enough demand to justify a 55,000 seat stadium? A related
risk is price risk; what is the most that fans are willing to pay?
Can promoters clear a bigger net profit by doubling ticket prices?
How can promoters foil scalpers?
[0268] Potential ticket buyers also face risks. If a customer buys
a ticket in January, what if he has an unexpected plans change and
cannot go? It is too much trouble (if not illegal) to try to scalp
the ticket. On the other hand, if the customer waits until August
to buy a ticket, all the good seats will be gone. At that time,
scalpers will be charging a premium for the few remaining
seats.
[0269] The apparatus and method according to the present invention
provides a solution which is to sell tradable coupons. Tradable
coupons eliminate the liquidity risks faced by early ticket buyers.
Buyers who can't go can easily resell their coupons into the market
at the fair, competitive market price. Simultaneously, tradable
coupons reduce risks faced by promoters by: [0270] Allowing
promoters to pre-sell tickets earlier since buyers with no
liquidity risk will be more willing to buy earlier and pay more;
[0271] Allowing promoters to monitor the trading prices of their
tickets, and hence obtain information about market demand and
pricing, which they can use to set future prices and marketing
strategies; and [0272] Eliminating scalpers and other
inefficiencies in the ticket supply chain.
[0273] If the Grasshoppers are holding a series of concerts around
the country, then they would issue a new class of coupons, one for
each city. If they hold more than one concert in a given city, then
they will then issue a series of coupons for that city, one for
each concert. For example, to see the Grasshopper's second concert
in San Francisco, one would buy the "Grasshopper-San Francisco
class coupon, series #2" coupon.
Example 2
Coupon for a McDonald's.RTM. Meal
[0274] As part of its marketing strategy, McDonalds.RTM. Restaurant
issues a series of coupons which are redeemable for a "Complete
Meal" consisting of a Quarter Pounder.RTM., a Super Size.RTM. fry,
an apple pie, and a large soft drink. The series of coupons are
monthly, and are issued 3 months ahead of their expiration month.
This means that on March 1st, the March, April, and May coupons
have been issued, and are trading. The March coupon may be redeemed
at any participating McDonalds in March. Likewise, the April and
May coupons may be redeemed, respectively, at any participating
McDonald's during April and May. (Note: McDonald's.RTM. and Quarter
Pounder.RTM., are registered trademarks and Super Size.RTM. is a
registered service mark of McDonald's Corporation.)
[0275] McDonald's benefits from using these coupons in at least
three ways: [0276] (i) Since it gets cash up front when the coupons
are originally sold, the coupons give McDonald's more control of
its cash flow. [0277] (ii) The trading activity and prices on the
coupons help McDonald's to gauge the demand curve for its meals
three months in advance. This insight into future demand assists
McDonald's in managing its inventory and marketing strategy. [0278]
(iii) Coupon trading and redeeming coupons stimulates interest in
eating at McDonald's.
[0279] Once a coupon is sold, McDonald's realizes the profit even
if the coupon later expires unredeemed.
[0280] Consumers benefit from trading coupons because the consumer
is able to lock in meal prices at an earlier date. Tradable coupons
are also good gifts, since the receiver may easily sell them in the
market if she doesn't wish to eat at McDonald's.
Example 3
Coupon for a Pre-Paid Holiday Inn.RTM. Hotel Room
[0281] Hotels have trouble because their customers don't like them
to re-adjust their prices and charge a premium during seasonal peak
periods. For instance, the price for a Holiday Inn.RTM. hotel room
does not fluctuate much during the year, although demand for rooms
fluctuates a lot. Clearly, hotels would benefit if they could sell
their rooms at a fair market value that floats with demand. (Note:
Holiday Inn.RTM. is a registered service mark of Holiday Inns,
Inc.)
[0282] Customers do not like to put down money for "guaranteed"
rooms ahead of time because they might have unforeseen plan changes
and not be able to use the room. So customers would benefit by an
option to easily resell an unneeded reservation.
[0283] Each Holiday Inn hotel would sell its own series of coupons.
Each coupon would entitle the holder to a one-night stay in that
Holiday Inn on a specific date. If Holiday Inn wants to allow
year-ahead reservations, then it would have a series of 365
coupons, one coupon for each day of the year. Every day, one of the
coupons in the series would expire, and the hotel would issue a new
coupon for the same day, one year ahead. Note that the hotel does
not need to offer every available coupon for a date for sale all at
once; it could sell a fraction of the coupons, get a feel for what
prices the market is willing to pay, and then sell more at the new
market price.
Example 4
Advance Purchase Order for a Christmas Toy
[0284] Producers and developers of new cars, Broadway plays, and
condominiums must risk incurring huge up front costs without
knowing the ultimate demand for their product. The apparatus and
method of the present invention can create markets for the
promotion, sales, distribution, and trading of claim checks on
advance sales items. Such prepaid claim checks will be referred to
hereinafter as Advance Sales Coupons (ASCs). It should be noted
that these markets can either be within a web portal operated by a
hedging service, or be part of the producer's own web site, in
which case the hedging service will be acting as a co-brander and
consultant.
[0285] ASCs can be designed for any product. Preferably ASCs are
designed for a product with an established brand. The brand
reassures ASC buyers of quality and fair play by the producer. Such
products include groceries, new books, wine, electronic goods,
shoes, office supplies, designer dresses, and homes in new housing
developments.
[0286] In one aspect of the present invention, a hedging service,
which may operate a computer network system for selling and
exchanging hedge instruments, would charge manufacturers and
producers an up-front sales and distribution fee for providing a
distribution channel for their ASCs. Optionally, the hedging
service can levy a per-trade transactions fee on ASC buyers and
traders.
[0287] Selling tradable ASCs enables these producers to spread
their demand risk with their potential customers. Also, the market
demand for their ASCs provides probably the best information to the
producers about actual market demand for their product. In return
for being willing to assume some of the producer's risk when a
customer buys an ASC, customers get a slightly lower price for that
new car, movie ticket, or condo than they would otherwise get by
waiting.
[0288] Selling tradable ASCs is also a way for producers to finance
the production of their product. ASC financing may be superior to
debt or equity financing, especially if the amount of funds needed
is small-too small to justify going through traditional banking
paperwork.
[0289] Historically, customers assume two kinds of risk if they
make an advance purchase order: (i) liquidity risk: risk that their
situation may change, and they do not have the time, money, or
inclination to use the book, movie, or condo when it is ready for
consumption two years later; (ii) information asymmetry risk: risk
that they are being duped by the promoter into committing to buy a
flop.
[0290] By making ASCs tradable, the system and method of the
present invention reduces or eliminates liquidity risk faced by
consumers. If an ASC holder's situation changes, she can liquidate
her ASC for a fair price. Because of their liquidity, consumers are
empowered to buy more ASCs for books, movies, and condos they might
want to buy two years down the road.
[0291] The system and method of the present invention also reduces
information asymmetry risk by establishing a market price for the
ASCs. Customers who feel they are naive about the potential quality
of a new product will be reassured by an established market price
for the ASCs. This is because, by market efficiency, market prices
reflect the consensus expectation for the product based on the best
publicly available information. Note that producers can also use
information in the market price of the ASC to determine if they
need to improve the quality of their final product (e.g. hire a
better leading lady for their movie).
[0292] As a result, producers and consumers both benefit from
ASCs.
[0293] For example, retailers like Amazon or Walmart face much
uncertainty when planning their inventory orders several months
ahead for the Christmas Shopping season. What will be the "blowout"
toy next Christmas? If it becomes very popular, will my toy maker
be able to make them fast enough on short notice? Will the
manufacturer raise wholesale prices at the last minute? How much of
this toy should they buy for inventory? Also, Amazon would like to
generate more cash flow in the off-season to run operations and pay
salaries.
[0294] Given this situation, Amazon would greatly benefit if it
could effectively spread the Christmas shopping season over the
whole year. (Spreading shopping interest throughout the year
potentially also increases aggregate shopping interest and hence
sales--it has spillover revenue-enhancement benefits.) However,
shoppers face risks if they buy their Christmas gifts too early. If
one buys a Barbie doll in March, how do they know their daughter
will still want it in December? Maybe she will develop an interest
in piano, in which case the better gift would be some music
books.
[0295] By establishing a market in Christmas gift ASCs (a distinct
ASC series for each toy or toy category), the system and method of
the present invention addresses both Amazon's and shoppers
concerns. Amazon can generate cash flow throughout the year by
selling new ASCs into the market. The ASCs' trading prices tells
Amazon the market's anticipated demand for various toys during
Christmas. Customers will be willing to buy ASCs for specific toys
in February since they can also resell them back if change their
mind about a toy.
[0296] ASCs can be created for any product or bundle of products.
For instance, Amazon might sell a booklet of ASCs (one ASC for a
Barbie, another ASC for a book, another for a radio, etc.). Amazon
could sell the whole booklet at a package discount steep enough to
attract buyers. Buyers can then keep the ASCs they want, and
re-sell the other ASCs in the thus created market. Booklets are a
good way for Amazon to stimulate sales volume.
Example 5
Advance Sales Coupon for New Car
[0297] In the Amazon example above, the coupon was for redemption
of a product already in existence. ASCs can also be sold for
yet-unproduced items, such as new books, new movies, new wines, or
new cars.
[0298] For example, suppose Ford is introducing a new luxury line
of Sky Spirit. Ford's risk is that market demand is volatile, but
Ford cannot quickly respond to unexpected changes in demand since
it takes 5 months to aggregate raw materials and manufacture each
car from scratch. In the past, Ford has produced too many cars,
which then must be sold at a discount. Other times, Ford has
produced too few cars, and lost the opportunity to sell more cars
and at higher profit margins.
[0299] On the other side of the transaction, customers do not like
to commit to buying a car many months before delivery because of
fashion and liquidity risk--not to mention natural procrastination.
If it is a brand new line, the line may turn out to be a lemon.
Tradable Sky Spirit ASCs help solve both Ford and the customers'
concerns.
[0300] Economic Benefits of Tradable Coupons
[0301] Selling tradable coupons enables producers or goods and
services to share the risk of future low demand for their goods or
services with their customers. Also, the market price for their
coupons provides probably the best information to the producers
about actual market demand for their product. In return for
willingness to assume some of the producer's risk when a customer
buys a coupon, customers would get a better market price on the
coupon than they would if they wait to buy the good or service at
the last minute.
[0302] Selling tradable coupons is also a way for producers to
finance the production of their product. Coupon financing may be
superior to debt or equity financing, especially if the amount of
funds needed is small--too small to justify going through
traditional banking paperwork.
[0303] For instance, producers and developers of music events,
Christmas gifts and new cars risk incurring huge up front costs
without knowing the ultimate demand for their product. Absent
tradable coupons, customers would assume two kinds of risk if they
file a traditional advance purchase order: [0304] liquidity risk:
risk that their situation may change, and they do not have the
time, money, or inclination to use the book, movie, or condo when
it is ready for consumption later; [0305] information asymmetry
risk: risk that they are being misled by the promoter into
committing to buy a flop.
[0306] By making coupons tradable, the system and method of the
present invention eliminates liquidity risk faced by consumers. If
the situation of a coupon holder changes, she can liquidate her
coupon in the thus formed market for a fair price. Because of the
liquidity of the coupons, consumers are empowered to buy more
coupons for books, movies, condos, and other goods and services
they might want to buy down the road.
[0307] The system and method of the present invention also reduces
information asymmetry risk by establishing a market price for the
coupons. Customers who feel they are unsure about the potential
quality of a new product will be reassured by an established market
price for the coupons. This is because, by market efficiency,
market prices reflect the consensus expectation for the product
based on the best publicly available information. Note that
producers can also use information in the market price of the
coupon to determine if they need to improve the quality of their
final product (e.g., hire a better leading lady for their movie).
As a result, producers and consumers both benefit from coupons.
[0308] For instance, in regard to the example above for sales of
Grasshopper concert tickets, Promoters would benefit from a system
in accordance with the apparatus and methods of the present
invention in the following way. The Promoter can "test" the market
by putting up, say, 5000 futures coupons for sale in January for
"IPO" price of $25. Suppose the original IPO batch trades at a
market price of $38 in February. Then the promoter can slowly offer
additional coupons for sale at the new market price ($38). At the
same time, the promoter can also adjust his retail advertising
campaign to try and improve the market price. The promoter might
choose to ultimately sell all or just a fraction of the seats via
our futures market. (Of course, the promoter will have trouble
selling tickets for higher than the price buyers can get from the
futures market.)
[0309] The promoter benefits since the continuous market action
informs the promoter about the demand for his product, and thus how
much consumers are willing to pay. Consumers, in turn, are more
willing to buy futures in January since they can easily resell
(perhaps even at a higher price) if they change their mind about
attending. If sales go well (or not), the promoter might even be
able to move the concert to a bigger or smaller stadium. Finally,
the market puts third party scalpers out of business.
[0310] Similarly, consumers benefit in the above-described
situation. Consumers will be eager to buy their seats in January at
the lower IPO price, since they can always resell later if they
cannot attend the concert. Latecomers also benefit from the market
price, since they can always buy from the market by meeting the
latest ask price. Effectively, the concert is never sold out since
one can always buy a ticket by meeting the then-prevailing market
ask price.
[0311] Description of Type II Contract Markets
[0312] The following terminology and concepts pertain to market
transactions involving Type II contracts. It will be appreciated
that there is some overlap to the terminology and concepts
pertaining to market transactions involving Type I contracts.
[0313] A "trader" is any person authorized to buy or sell, or to
make offers to buy or sell, coupons in the market.
[0314] A "Promoter" is a special trader who has the power to issue
its own coupons for sale. Like any other trader, promoters may also
trade coupon in the market by meeting bid/ask prices in the
market.
[0315] "Sale of a coupon by the Promoter"--When the promoter
authorizes a new series of coupons for trading, it initializes the
market by offering to sell to traders, at a stated offering price,
coupons of that series. The promoter is not obligated to sell all
its coupons at once, or to offer them for the same price. For
instance, the promoter may sell the first 500 coupons at one price;
wait a few days; offer to sell an additional 1000 coupons at a
different price (which may reflect demand for the first 500
coupons); wait a week; offer to sell additional coupons, etc.
Promoters may also offer to buy back coupons at stated prices from
the market. Of course, market participants are not required to
accept the promoter's offer.
[0316] "Active redemption of coupons by the promoter"--In certain
cases, promoters may design the coupon so that it always has a
right, but not an obligation, to buy back all coupons at a
pre-stated price. Promoters may do this, for instance, if it
anticipates a possibility that it may want to cancel an event.
Then, to cancel the event, the promoters would simply buy back all
the coupons, which relieves them of the obligation to settle the
coupons at expiry.
[0317] "Limit order for purchase of a coupon"--The only orders
traders may place to buy or sell individual coupons are limit
orders. A limit order to purchase a contract A is an outstanding
offer to buy at a certain price for a certain period of time. The
offer must specify: [0318] numbers of A coupons desired [0319]
maximum price per A coupon the aspiring buyer is offering [0320] an
expiration date after which the offer terminates.
[0321] Acceptance of an outstanding limit order is binding on the
offeror. The order is automatically withdrawn at 12.01 a.m. of the
expiration date. However, traders may cancel their limit order at
any time prior to their stated expiration date by placing a
cancellation order.
[0322] "Limit order for sale of a coupon"--A limit order to sell a
coupon is an outstanding order specifying: [0323] quantity of
coupons offered for sale [0324] minimum price per coupon demanded
[0325] an expiration date after which the offer terminates.
[0326] Acceptance of an outstanding limit order is binding on the
offeror. However, traders may cancel their limit order at any time
prior to their stated expiration date by placing a cancellation
order.
[0327] Components of Coupon Markets
[0328] At any given instant before expiry, any coupon market will
preferably consist of the following: [0329] a promoter who may (at
its own discretion) sell additional coupons to or buy back coupons
from the market [0330] a collection of traders' accounts qualified
to transact in this market; that is, a collection of accounts
qualified to place limit and buy orders on this coupon [0331] a
queue of limit orders to buy coupons, preferably arranged in
priority according to the following criteria in order of
importance: [0332] price per coupon (highest order first) [0333]
number of coupons offered (greatest quantity first) [0334] time
order was entered (earliest order first) [0335] a queue of limit
orders to sell coupons, preferably arranged in priority according
to the following criteria in order of importance: [0336] price per
coupon (lowest price first) [0337] number of coupons offered
(greatest quantity first) [0338] time order was entered (earliest
order first), and [0339] a mechanism for communicating to all
traders' accounts timely information about the status of the
market, including the price and volume information of recent
trades, and the best limit prices and quantities in the limit buy
and sell queues
[0340] C. Type III ("Firm-Issue" and "Intra-Industry")
Contracts
[0341] Firm-Issue and Intra-Industry Contracts are custom-tailored
contracts designed in consultation with industry and firm partners.
They are designed to enable one or more firms within one or more
specific industries to manage and/or share risks. For instance, a
manufacturer may manage its inventory risks by issuing tradable
coupons to its distributors as a means of pre-selling wholesale
inventory to its retail distributors. Similarly, a loose
confederation of firms may use intra-industry contracts to
diversity their receivables portfolios, and reduce the seasonality
of their cash flows. Firm-issue and Intra-industry contracts may be
written on events or prices of noncommodity or inventory
manufactured items. Tailored to the needs of the firms, they may be
American or European, settle on cash, goods, or services
and--depending on specific needs--may have exotic path-dependent
payoff rules.
[0342] Since the clientele for firm-issue and intra-industry
contracts is restricted and sophisticated, embodiments of the
invention will usually include working with clients to specifically
tailor and design contracts that meet individual needs. Firm-Issue
and Intra-Industry contracts may also be referred to hereinafter as
"restricted clientele" contracts.
[0343] Companies carry many risks such as those inherent in
receivables, cash flow, supply chain and inventory management. A
Market Authority acting in accordance with the present invention
can help firms hedge these risks by designing firm-specific hedging
contracts for these firms.
[0344] Relative to Type III contracts, a Market Authority would act
as a firm's investment banker, and help the firm design, market,
and sell (IPO) its hedging instruments into the thus created market
or set up an internal firm-Specific or intra-industry futures
markets for (1) supply chain management or (2) risk-sharing
management. A business acting in accordance with the present
invention could charge firms an up-front consulting fee and set up
for these services, plus an on-going "market management" fee. The
market-management fee could be per-transaction or a flat fee.
[0345] Supply Chain Management
[0346] To determine how much to manufacture or buy for inventory,
manufacturers and retailers like to solicit "advance purchase
orders." These prepaid contracts are redeemed for delivery of a
product or service at a later date. However, such contracts are
unattractive to customers since they force early customers to
forecast future needs and assume the risk associated with early
precommitment. But without precommitment from its customers,
manufacturers and retailers face costly returns of unsold
inventory.
[0347] One form of Firm-Specific and Intra-Industry Contracts are
advance purchase orders on any product, cash amount, or service
with an established quality that are tradable between a
pre-qualified group of traders. The ability to trade them
dramatically enhances the value of advance purchase orders to both
the issuers and customers. The underlying products may include raw
materials, intermediate goods, as well as wholesale consumer items.
Wholesale consumer items may include new books, wine, electronic
goods, office supplies, as well as semi-commodity items
semiconductor chips, copper wire, photocopy paper, solar energy,
and cable TV time. Firm-specific and Intra-Industry Contracts
settle with the physical delivery of the underlying goods or
services.
[0348] The thing that distinguishes Firm-Specific and
Intra-Industry Contracts from Type II coupons is that the trading
and holding of Firm-Specific and Intra-Industry Contracts are
restricted to a pre-qualified set of traders.
[0349] Components of Firm-Specific and Intra-Industry Contract
markets
[0350] A Firm-Specific and Intra-Industry Contract is a tradable
instrument that pays off at expiry a prespecified inventory item.
The inventory item may be a commodity, a semi-commodity, or a
specific product of manufacture. For example, the payoff may be a
batch of 500 semiconductor chips, a ton of a given grade of high
grade aluminum, a gallon of a specific grade of gasoline, a dozen
Nike shoes of a given size and design, one dozen copies of the next
year's Microsoft Windows operating system, or 100,000 banner ad
displays on Yahoo!
[0351] "Expiry" refers to the period or time when the Firm-Specific
and Intra-Industry Contracts may be redeemed for the payoff object.
As specified on a contract-by-contract basis, the redemption date
or period may be set or vary depending on the choice of the
contract holder. Unlike Type I "event" contracts, the payoff of
Firm-Specific and Intra-Industry Contracts may be fixed, or they
may be chosen by the holder from a menu of possibilities
pre-specified by the issuer. Moreover, the settlement date for a
Firm-Specific and Intra-Industry Contracts contract may be at the
contract holder's choice.
[0352] A "qualified trader" is any person authorized to buy or
sell, or to make offers to buy or sell for a specific Firm-Specific
and Intra-Industry Contract. A trader must specifically and
separately qualify to trade in each Firm-Specific and
Intra-Industry Contract. The qualifications for trading in a
particular contract is determined by the Market Authority.
[0353] A "promoter" is a specially qualified trader who has the
power to issue its own Firm-Specific and Intra-Industry Contracts
for sale. Like any other qualified trader, promoters may also trade
Firm-Specific and Intra-Industry Contracts in the market by meeting
bid/ask prices in the market.
[0354] Sale of a Firm-Specific and Intra-Industry Contracts by the
Promoter
[0355] When the promoter authorizes a new series of Firm-Specific
and Intra-Industry Contracts for trading, it initializes the market
by offering to sell to qualified traders, at a stated offering
price, Firm-Specific and Intra-Industry Contracts of that series.
The promoter is not obligated to sell all its Firm-Specific and
Intra-Industry Contracts at once, or to offer them for the same
price. For instance, the promoter may sell the first 500
Firm-Specific and Intra-Industry Contracts at one price; wait a few
days; offer to sell an additional 1000 Firm-Specific and
Intra-Industry Contracts at a different price (which may reflect
demand for the first 500 Firm-Specific and Intra-Industry
Contracts); wait a week; offer to sell additional Firm-Specific and
Intra-Industry Contracts, etc. Promoters may also offer to buy back
Firm-Specific and Intra-Industry Contracts at stated prices from
the market. Of course, market participants are not required to
accept the promoter's offer.
[0356] Active Redemption of Firm-Specific and Intra-Industry
Contracts by the Promoter
[0357] In certain cases, a promoter may design the Firm-Specific
and Intra-Industry Contracts so that it always has a right--but not
an obligation--to buy back all Firm-Specific and Intra-Industry
Contracts at a pre-stated price. A promoter may do this, for
instance, if it anticipates a possibility that it may want to
cancel a product. Then, to cancel the product, the promoters would
simply buy back all the Firm-Specific and Intra-Industry Contracts,
which relieves them of the obligation to settle the Firm-Specific
and Intra-Industry Contracts at expiry.
[0358] Limit orders for Type III contracts work just like limit
orders for Types I and II, which have been described above.
[0359] At any given time before expiry, any Firm-Specific and
Intra-Industry Contracts market will consist of the following:
[0360] a promoter who may (at its own discretion) sell additional
Firm-Specific and Intra-Industry Contracts to or buy back
Firm-Specific and Intra-Industry Contracts from the market [0361] a
collection of qualified traders' accounts qualified to transact in
this market; that is, a collection of accounts qualified to place
limit and buy orders on this Firm-Specific and Intra-Industry
Contracts [0362] a queue of limit orders to buy Firm-Specific and
Intra-Industry Contracts, arranged in priority according to the
following criteria in order of importance: [0363] price per
Firm-Specific and Intra-Industry Contracts (highest order first)
[0364] number of Firm-Specific and Intra-Industry Contracts offer
(greatest quantity first) [0365] time order was entered (earliest
order first) [0366] a queue of limit orders to sell Firm-Specific
and Intra-Industry Contracts, arranged in priority according to the
following criteria in order of importance: [0367] price per
Firm-Specific and Intra-Industry Contracts (lowest price first)
[0368] number of Firm-Specific and Intra-Industry Contracts offer
(greatest quantity first) [0369] time order was entered (earliest
order first) [0370] a mechanism for communicating to all qualified
traders' accounts timely information about the status of the
market, including the price and volume information of recent
trades, and the best limit prices and quantities in the limit buy
and sell queues.
Example 1
Inventory Futures for Supply Chain Management
[0371] Nike faces a persistent "supply chain" problem for its
designer shoes. If a shoe store in Germany orders 1000 pairs of a
particular design, it takes Nike several months to buy the raw
materials, manufacture that lot (usually in an Asian factory), and
transport it cost effectively (usually by cargo ship) to Germany.
The problem is compounded because (i)
[0372] Nike has outlets all over the world; (ii) the popularity of
different designs vary greatly around the world; (iii) fads change
in geographically-idiosyncratic ways in different geographical
markets. For instance, a German store might believe in March that
red Michael Jordan designs will become popular next Christmas and
order 1000 pairs. However, in September it turns out that white
shoes are the rage in Germany, and the German store can no longer
sell the red shoes. However, suppose a red shoe fad takes hold in
Brazil, and a Canadian outlet is willing to cancel its order of 500
pairs of white shoes--for the right price.
[0373] What is the most efficient way to reorganize this
contractual arrangement so that the German outlet gets the white
shoes, the Brazilian outlet the red shoes, and the Canadian outlet
the right size?
[0374] Like other businesses, Nike has tried to solve its supply
chain problem using Electronic Data Interchange (EDI). EDI is a
form of business-to-business (B2B) intranet. However, EDI cannot
efficiently solve the German-Brazilian-Canadian problem above.
While the EDI model enables outlet stores to shorten the waiting
time between their orders and receiving their goods, the wait time
is still over one month. This is why there are frequent shortages
of popular shoe brands, and overstocking of other brands. For the
rush Christmas season, Macy's needs to place orders in September or
October. And once orders are locked in, Macy's cannot cancel or
change its order without costing somebody to suffer transactions
costs. Even worse, Macy's looses customers, reputation, and profits
whenever it cannot supply the hottest designs in a timely
manner.
[0375] A Market Authority acting in accordance with the present
invention can enable Nike to solve its supply chain management
problem by setting up an internal futures market where Nike's
wholesale customers (the individual stores of Macy's, Walmart,
LLBean, Sears, etc.) can trade advance Firm-Specific and
Intra-Industry Contracts between themselves. Instead of arranging
individual supply contracts with Nike, every outlet goes to the
futures market and buys the contracts it anticipates it needs. The
outlets which are willing to pay the most for a particular design
will buy it in the market (that is, the German outlet will offer
higher prices for the white shoes contracts because of local
demand, and when the price is high enough, the Canadian outlet will
sell them--even if there is a moderate amount of local Canadian
demand). At the same time, the German firm can sell its red shoes
contracts to the Brazilian firm at the market price. The futures
prices are determined by market forces and are fully liquid.
[0376] Moreover, prices of the various contracts inform Nike of
market conditions in real time. So, if Nike sees that the price of
a particular contract is increasing, it learns there is unmet
demand for that type of shoes. Based on this real-time information,
Nike can choose to increase supply and issue more contracts--but
only if it is feasible and profitable for it to do so taking into
account the market price and its cost of production.
[0377] Note: Nike gets paid for the shoes immediately upon sales of
its futures contract into the market, and the contracts are only
redeemable for shoes, not cash.
Example 2
Mutual Fund Cash Flow Management
[0378] Open end mutual funds have problems with cash flow. In such
funds, investors have the right to buy or redeem more shares at
will. Therefore, depending on market sentiment, these funds face
either mass redemptions (and thus a cash shortage) or mass
purchases (and thus cash surpluses due to excess inflows of
investor cash). These wide swings in cash force mutual funds to
alter their investment behavior. When they have a cash shortage,
they are forced to sell shares. When there is a cash surplus, funds
are pressured to making additional investments. However, these
forced sales and purchases may be suboptimal. For instance, when
the market crashes, investors tend to redeem their shares, which
forces mutual funds with long positions to sell equity at lower
prices that they otherwise would want to.
[0379] There are widely publicized indices which measure net cash
inflow (NCI) or redemptions each month. Based on these indices, A
Market Authority acting in accordance with the present invention
could create bundles of contracts like the following: [0380] A
contract A which pays $10 if NCI is positive and $0 otherwise;
[0381] A contract B which pays $10 if NCI remains steady and $0
otherwise; [0382] A contract C which pays $10 if NCI becomes
negative and $0 otherwise.
[0383] Note that while the structure of this particular contract is
like the Type I contracts, and A, B, and C together form a riskless
bundle, not all Firm-Specific and Intra-Industry Contracts will be
of this form. Thus, mutual funds that go long can smooth their NCI
by buying contract C and Mutual funds that go short can smooth
their NCI by buying A.
[0384] Banks, which are required by law (FDIC) to maintain a
certain level of liquid cash on hand to enable depositors to
withdraw their money, can use analogous contracts to insure a
steady cash flow.
Example 3
Risk-Sharing Management
[0385] Firms A, B, and C are insurance companies that are liable
for $1.0 billion of housing reconstruction in event of an
earthquake in Los Angeles and firms X, Y, and Z are housing
construction companies in Los Angeles.
[0386] Firms A, B, and C are risk complements to X, Y, and Z in the
following sense. While an earthquake is financially devastating for
A, B, and C, they create windfall profits for X, Y, and Z. A, B,
and C and X, Y, and Z could reduce their financial volatility by
pooling their risks so that, regardless of whether an earthquake
occurs or not, each are guaranteed of a medium outcome.
[0387] These six firms can hedge each other's risk by forming a
private market to trade the following two contracts: [0388]
Contract I which pays $10 if there is a 7.0 or greater earthquake
in Los Angeles during year 2002, and $0 otherwise. [0389] Contract
II which pays $10 if there is not a 7.0 or greater earthquake in
Los Angeles during year 2002, and $0 otherwise.
[0390] While these six firms may use a generic (publicly traded)
earthquake contract to hedge, there are many reasons why A, B, C
and X, Y, Z may prefer to trade between themselves in a private,
industry-limited market. For instance, because the sums of payoff
money involved are very large ($1.0 Billion), they may not want to
use the pay-up-front bundles model. Instead, they may want to
contract just between themselves, without prepayment, in which case
credit risk and the identity of the qualified traders is important.
Also, for competitive reasons, they may not want the price of the
contracts to be publicly disclosed. So a Market Authority acting in
accordance with the present invention can help them to create
custom-tailored "club-only" futures markets for their own industry
consortium.
[0391] Other examples of risk-complement industries include: [0392]
public transportation verses auto manufacturers [0393] airlines and
oil companies [0394] telephone modem manufacturers, DSL providers,
and cable modem service providers [0395] ice cream manufacturers
and hot chocolate manufacturers [0396] network computer
manufacturers and traditional computer manufacturers [0397] genetic
therapy firms and traditional drug manufacturers [0398] brick and
mortar retailers verse Internet retailers [0399] banks and
brokerage houses [0400] alternative energy suppliers verses
traditional utilities.
Example 4
Egghead-Onsale Cash Flow Futures
[0401] Egghead-Onsale is worried that if things do not go well in
the next quarter, it may have cash flow liquidity problems. It is
too late to be doing a new SPO (in any case, management would
prefer not to dilute the shares), and the interest rate that banks
are demanding for debt is unattractive.
[0402] If there is no hedging and things go well (50% chance),
Egghead-Onsale will have $11 million dollars of cash at the end of
the quarter. If things do not go well (50% chance), Egghead-Onsale
will be $1 million dollars in the red.
[0403] Egghead-Onsale would prefer to lock-in a riskless cash
balance of $5 million. To do this, a Market Authority acting in
accordance with the present invention can help Egghead-Onsale by
constructing the following contracts: [0404] Contract I which pays
$10 if Egghead-Onsale has more than $10 million dollars cash as
reported on its audited financial statements for year-end 2002, and
$0 otherwise. [0405] Contract II which pays $10 if Egghead-Onsale
has between $0 and $10 million dollars cash as reported on its
audited financial statements for year-end 2002, and $10 otherwise.
[0406] Contract III which pays $10 if Egghead-Onsale has less than
$0 cash as reported on its audited financial statements for
year-end 2002, and $0 otherwise.
[0407] In the simplest design, a Market Authority acting in
accordance with the present invention will issue these contracts
into the market. Egghead-Onsale will establish long positions on
both Contracts II and III according to the "hedging recipe" given
above for Type I contracts.
[0408] Other examples include rent payment futures for office
complexes and futures on property resale prices.
Example 5
Receivables Futures Example
[0409] Suppose that Sun Microsystems ("Sun") sells hardware to
Internet startups on a long term credit basis. It now has $1.0
billion of receivables on its books. Sun expects that about 10-20%
of those receivables will not be collectible since some of its
customers will declare bankruptcy. Sun would be willing to sell its
$1 billion of risky receivables for $850 million cash. By designing
and trading futures contracts that pay off depending on how much of
the $1.0 billion is collected, a Market Authority acting in
accordance with the present invention can help Sun sell its
portfolio for $850 million cash.
[0410] Economic Benefits of Tradable Firm-Specific and
Intra-Industry Contracts
[0411] Using the example above of Nike shoes, Nike benefits from
numerous ways from the futures markets: [0412] Nike can "test" the
popularity of each shoe design by first putting up, for instance,
5000 futures contracts for sale in January for "IPO" price of $25.
Suppose the original IPO batch trades at a market price of $38 in
February. Then Nike can gradually offer additional contracts for
sale at the new market price ($38). [0413] At the same time, Nike
can monitor which geographic location is buying which type of
contract and, therefore, gain insight into the fads for that year
and use this information to focus its advertising campaign and
production schedule. [0414] Nike has the discretion ultimately to
sell all or just a fraction of each shoe via the futures market.
[0415] At its discretion, Nike has an American option to repurchase
its own contracts from the futures market if it decides delivery of
the shoes is not in its own best interest. [0416] This
"self-organizing" market mechanism reduces Nike's sales staff and
administrative overhead.
[0417] The retail outlets also benefit. Outlets, in turn, are more
willing to buy Christmas futures early in the year since they can
always resell if that particular design is not popular in their
region.
[0418] Also, if a fad breaks out in Brazil for red Nike shoes, the
Brazilian outlet will be willing to pay more for the red shoes
futures; as a result, both the German seller and the Brazilian
buyer benefits. In other words, the outlets share in the more
efficient allocation of the shoes through trading the futures.
[0419] One of ordinary skill in the relevant art will appreciate
that analogous contracts can be created for any other inventory
semi-commodity product in any industry.
[0420] While several types of contracts have been described, and
examples of each given, the present invention is not limited to
methods and apparatus for trading only these types of instruments.
Instead, the present invention is directed to a method and
apparatus that can create a risk hedging marketplace and is not
limited by the types of risk instruments which can be traded
there.
II. Description of the Contract Trading System and the Pieces of
the System
[0421] As noted in the summary of the invention, an objective of
the present invention is to enable and provide a new form of risk
hedging. The first section of this specification addressed the
various hedging contracts or instruments, the sale and transactions
which are a necessary adjunct to the inventive process and
apparatus. Having defined and described some of the types of risk
hedging instruments which can be sold and traded to hedge risk, the
discussion will now address preferred embodiments of the method and
apparatus according to the present invention.
[0422] A preferred embodiment of the present invention will be
described next in reference to the various figures. A preferred
embodiment of the present invention is configured as an
Internet-based web server, which provides a world-wide-web (WWW)
accessible user interface and software to implement the unique
functions of the present invention.
[0423] FIG. 1 shows a general internet-based webserver which
implements the present invention. Main Computer 100 is connected
either directly, or indirectly via a local-area network (LAN) or
wide-area network (WAN), to the Internet 200. Main Computer 100 is
programmed with webserver software 400 so as to be able to (i)
serve data out in response to received Internet user requests; (ii)
accept account login and other account management and trade
instructions from Internet users; (iii) communicate users'
instructions to the trade engine and computers associated with the
trade engine; and (iv) serve data and respond to instructions from
the Market Authority 500. The Web Server Software 400, Market
Authority 500, Account Management Engine 600, Trade Engine 300,
Market Database 390, Account Database 610 and Clearance and
Settlement 690 will be discussed later. Note, while the Market
Authority 500, Trade Engine 300, Account Management Engine 600 and
other functions are shown in FIG. 1 as being directly attached to
Main Computer 100, each of these functions can also be connected to
the Main Computer 100 indirectly via a LAN, WAN, Internet or other
computer connection.
[0424] In FIG. 1, the market database 390 is designed to collect
and organize exchange data. This data will not include any private
information such as member identification, but will consist
primarily of executed trade prices and volumes. The majority of
this information will be available to members and reported to
government regulatory authorities in accordance with applicable
regulations. Further, the government regulatory authority may
require access to all of this information should it deem such
access necessary for surveillance or other purposes. Information
will be available on all orders placed on the system in order to
provide members with histories and data points as to the state of
various contract markets.
[0425] The Account Database 610 contains data on individual members
and their accounts, which allow the Account Management Engine 600
to function. By way of example, and not limitation, the Account
Database 610 preferably consists of at least the following items of
information: [0426] information identifying each member, including
his or her name, account number, web login name, login password,
any other account-related IDs or secret passwords; [0427] member
contact information (e.g., mail, Email, telephone number); [0428]
status of the account (e.g., active, suspended, deactivated);
[0429] history of the account, including activation date(s),
suspension history, dates and amounts of all money transfers, dates
and amounts of all market transactions, dates and description of
all bids and offers entered, dates and amounts of all transactions
with the settlement bank, dates and amounts of all interaction with
the Market Authority 500, dates and balances at each date, and any
remarks about the account entered by the Market Authority 500.
[0430] FIG. 2 shows an expanded view of the Market Authority 500.
The Market Authority 500 contains a New Instrument Application 510.
The New Instrument Application 510 is used to introduce new and
different hedging instruments to the exchange (i.e., new types of
contracts to be traded). It will enable authorized personnel to,
among other things, inform members of new instruments, post
messages regarding the terms and conditions of new instruments, and
list new instruments on the market.
[0431] Specifically, the New Instrument Application 510 will
provide the capability for both Members 10 and the Market Authority
500 to design and list new instruments as well as modify existing
instruments. During operation of a market according to the present
invention, preferably the Market Authority and its members will be
continually developing new instruments for the exchange. The New
Instrument Application 510 allows users to quickly define critical
components of a contract, thus enabling the rapid rollout of
millions of potential instruments. The New Instrument Application
510 provides an easy to use interface through which the terms of a
contract are identified, described, and defined and which are then
sent to the appropriate market administrative personnel for
approval. Upon approval, the new instrument is preferably
immediately listed in the portal, trading, and clearing systems,
however, the system can also provide for a delayed listing of new
instruments. For example, and not by way of limitation, the New
Instrument Application 510 may require the following information
for a new instrument:
[0432] Tracking Information: e.g., Contract Id Number Etc.
Ownership Information
[0433] Underlying Event or Item
[0434] Unit of Original Issuance
[0435] Contract Bundle Issuance & Redemption Price
[0436] Contract Payout Criteria
[0437] Unit of Trading: e.g., 1 Contract
[0438] Contract Price Quotation
[0439] Min. Price Increment: e.g., $0.01
[0440] Max. Contract Duration: e.g., 1 Yr
[0441] First Trading Day
[0442] Last Trading Day
[0443] Trading Hours: e.g., 24.times.7.times.365
[0444] Expiration Date: e.g., 2 Days After Last Trading Date
[0445] Settlement Date: e.g., 2 Days After Expiration Date
[0446] Expiration Value
[0447] Settlement Value
[0448] Settlement Method
[0449] The market authority 500 contains two additional
applications: an Administrative Application 520 and a Surveillance
Application 530. The Administrative Application 520 will allow
administrative personnel to: [0450] undertake limited inquiry into
all market transactions; [0451] suspend and resume trading in
particular contracts or the market as a whole; [0452] suspend and
resume or terminate account privileges based on the rules of the
exchange; [0453] suspend contract payouts in the event of an
emergency or some other eventuality detailed in market rules;
[0454] amend and override calculated settlement prices and
redistribute funds in the event of an unforeseen system error or an
event identified in the rules of the exchange; and [0455]
distribute announcements to all or selected market
participants.
[0456] The Surveillance Application 530 will provide compliance
staff with view-only access to all current and historic transaction
data input into the exchange by members, from order placement to
message posting on the electronic bulletin boards. The system will
be programmable to draw attention to specific events of interest to
the compliance staff. The system allows the staff to investigate
specific transactions and trade patterns and will permit the staff
to view member identification information along with order
information. More specifically, the Surveillance Application 530
will allow the staff to: [0457] view the complete depth of the
market for all contracts (i.e., the listing of all pending bid and
offer orders); [0458] view the details of all transactions
including counter-party identities, which are hidden from market
participants; [0459] view all electronic bulletin board postings;
[0460] define and track a set of alerts that will highlight the
occurrence of specific events and transaction patterns; and [0461]
investigate any alerts or activity that has potential to violate
rules of the exchange.
[0462] FIG. 3 shows an expanded view of the Clearance and
Settlement 690 function. The Clearance and Settlement 690 function
includes the Clearance Application 692, Settlement Bank 694 and
Settlement Interface 696.
[0463] As depicted in FIG. 3, one component of Clearance and
Settlement 690 is the Clearing Application 692. As the sole
clearing agent for the exchange, the Clearing Application 692
enables the Market Authority 500 to monitor all transactions and
record all transaction data necessary for the clearing and
settlement of every trade on the exchange. Clearing Application 692
gives the Market Authority 500 access to member specific
transaction data including member account information as well as
the details and status of all orders. Further, the Clearing
Application 692 will communicate with the Settlement Bank 694 to
provide instructions, review settlement account information for all
members, and reconcile clearing information with settlement account
information.
[0464] The second component of Clearance and Settlement 690 is the
Settlement Interface System 696. The Settlement Interface System
696 will be the link through which the trading system communicates
with the Settlement Bank 694 (See also FIG. 7). The Settlement
Interface System 696 will work with the various components of the
OMPS (See FIG. J) and the Clearing Application 692 to automatically
provide instructions to the Settlement Bank 694 such as blocking
funds needed to execute an outstanding trade, moving funds between
accounts due to purchases and sales of contract bundles and
contracts, and crediting funds to accounts when in-the-money
contracts expire. Settlement Interface System 696 queues
instructions in chronological order and either (i) sends the queue
in batch mode to the Settlement Bank 694 for processing at
intervals throughout the day, or (ii) maintains continuous,
real-time settlement through an on-line bank. The settlement
interface will also perform periodic tests to ensure that the
clearing records maintained by the Account Management Engine 600
are consistent with the settlement account records maintained by
the Settlement Bank 694. If there are any discrepancies, Account
Management Engine 600 will take all necessary steps to accurately
reconcile the two records. To ensure maximum efficiency and
reliability, the Settlement Interface System 696 is designed in
cooperation with the Settlement Bank 694.
[0465] As illustrated in FIG. 3 and as described below, the Market
Authority 500 will preferably maintain three types of accounts with
one or more settlement banks. The first type of account is a
Custodial Account 695a, which the Market Authority 500 maintains
for each of its members. These accounts are for the benefit of the
individual members and all funds and instruments held in these
accounts will be owned by the member. However, these accounts will
respond only to the instructions of the market clearing system. The
second type of account is a Market Authority Account 695b, which is
a proprietary account that will hold all unencumbered funds owned
by the Market Authority 500. This is the account into which trading
fees, structuring fees and the like are deposited. The third type
of account is a Settlement Account 695c which is essentially an
escrow account. Proceeds from the sale of bundles are deposited
into the settlement account and are held there until the expiration
of the contracts which make up that bundle. Upon expiration, these
funds are used to pay off in-the-money contracts.
[0466] FIG. 4 shows a general top level web-site design in
accordance with a preferred embodiment of the present invention.
FIG. 4 generally illustrates the main levels of the website and
identifies some of the categories of pages which are provided in
the preferred embodiment. The Home Page 410 is the front page to
which new and some existing users will go as the starting point for
interacting with the present system. Home Page 410 provides links
down to pages at lower levels. At a level below Home Page 410 are:
Log In Page 420, to which registered users go to log in (some
registered users may prefer to use Log In Page 420 as their initial
page); Public Pages 470 contain general introductory and
administrative information about the site for users (see FIG. 6);
New User Registration Page 450, which provides online registration
forms and information for prospective registrants (see FIG. 5); My
Account Page 422, which is the customizable home page for a
registered user who has logged in; Contract Center Page 424, which
provides a list--by event or subject matter--of contracts being
traded and a pathway for users to access a catalogue of contracts
via the Underlying Info and Contracts Page 430; and Underlying Info
and Contracts Page 430, which provides an organized catalogue of
contracts being traded, including links to updated market data
pertaining to trading activity on each contract.
[0467] Each contract has a corresponding electronic bulletin board
or Chat Page 432 to which users can post information and voice
personal opinions; a News Page 434 which contains recent pertinent
newsfeeds from commercial wire services; Executive Summary Page 436
and General Reports Page 438 which contain summary historical and
background information on recent trading, price, and volume
activity on the contract. Each contract also has a corresponding
Contract Description and Order Form Page 440. From the Contract
Description and Order Form Page 440 the user may access a Detail
Terms and Conditions Page 442, and an Order Confirmation Page 444,
should the user elect to execute an order using the order form.
[0468] The Executive Summary Page 436 for each contract bundle will
display real time quotes for the best bid and offer for each
contract in each outstanding series of the contract bundle. The
Executive Summary Page 436 will also show the expiration date for
each outstanding series, the payout criterion for each contract,
and the current rate, level, or value of the underlying. The
Executive Summary Page 436 will also allow the member to hyperlink
to the rules describing the contract bundle and contracts, charts
showing the trading history of all the contracts, and a glossary of
terms related to the contract bundles, contracts, and the
underlying.
[0469] FIG. 5 shows an expanded view of the pages which are located
below the New User Registration Page 450. Specifically, below the
New User Registration Page 450, are Observer Basic Info (1) Page
452 and Member Basic Info (1) Page 460. Beneath Observer Basic Info
(1) Page 452 are the Service Agmt. Page 454 and the Open Acct.
Confirmation Page 456. Beneath Open Acct Confirmation Page 456 are
the Contract Center Page 424 and Getting Started Page 458.
[0470] Similarly, beneath the Member Basic Info (1) Page 460 are
the Method of Deposit (2) Page 462, the Source Acct. Info Page 464,
the Service Agmt. Page 466, and the Open Acct. Confirmation Page
456. Note that there are some pages, such as the Open Acct.
Confirmation Page 456, which can be accessed by more than one page.
Beneath the Open Acct Confirmation page 456 are the Getting Started
Page 458, the My Account Page 422, and the Contract Center Page
424, all of which are accessible from other pages.
[0471] FIG. 6. shows an expanded view of some of the pages that
belong to the Public Pages 470, which are located below the Home
Page 410. Specifically, below the Home Page 410 are: the
Introduction Page 472; the FAQ Page 474; the Media Page 476; and
the About The Company Page 478. As noted in regard to FIG. 5, other
pages which are located below the Home Page 410 are the Log In Page
420 and a New Users Registration Page 450. Below the Introduction
Page 472 are: the Overview Page 480; the Description of Contracts
Page 482; the Exchange Page 484; and the Page About You 486. Below
the About The Company Page 478 is the Contact Us Page 488, which
provides information about how retail users can contact the
company.
[0472] FIG. 7 shows a flow chart of a member interacting with the
Trade Engine 300 function of FIG. 1. Specifically, as shown in FIG.
7, a Member 10 accesses the Trade Engine 300 via a computer
connection such as the Internet and the Web Server Software 400.
When the Member 10 places an order via the Order Placement
Application 310, the order is verified by the Validater 320. If the
order is accepted, it is routed to the Order Router 330.
[0473] As depicted, the Order Placement Application 310, the
Validater 320, the Order Router 330, the Order Matcher 340, the
Settlement Bank 694, and the Contract Expiration Manager 360
comprises an integrated system, the "Order Management and
Processing System 370 (OMPS)." The OMPS 370 is the engine
supporting the front end application and provides all the automated
functions necessary for the execution of valid orders and the
settlement and payout of all contracts. The OMPS 370 accepts orders
from the interface system and returns status information as the
order is processed throughout the system. This processing system
consists of the following functions: validating orders, routing
valid orders to the appropriate order matching engine, prioritizing
orders, and matching orders as appropriate. Every action taken on
an order will be recorded to provide a clear audit trail of system
activity and to ensure accurate clearing of all transactions. At
different points in the processing, the OMPS 370 will communicate
with the settlement bank or the clearing application, providing
settlement instructions and periodically reconciling settlement
bank records with OMPS records. In the preferred embodiment, the
OMPS 370 is maintained on a UNIX platform and all logged records
will be time stamped accurately to the millisecond (the maximum
precision currently available within UNIX).
[0474] The Order Placement Application 310 is used by members to
place and track orders for contracts and bundles. The trading
system will only accept limit orders (orders which require price
and quantity to be specified). The Order Placement Application 310
will allow members to perform the following activities: [0475]
place a new order to purchase or sell a contract; [0476] place a
new order to purchase or redeem a bundle; [0477] cancel or change a
pending order which has not either expired or been executed; [0478]
track the status of an order; [0479] view real-time the best bid
and offer; and [0480] view last trade price, trading volume, and
trading history.
[0481] If it is an order to purchase or sell a bundle, the order is
sent to the Bundle Manager Application 345, which is responsible
for bundle sale, redemption and expiration management. The Market
Authority 500 stands ready to sell and redeem bundles at a fixed
price of $10. Such transactions will be executed by a fully
automated system that will be overseen by the market authority. The
Bundle Manager Application 345 will execute and allow the Market
Authority 500 to monitor these types of transactions.
[0482] Upon immediate acceptance by the Market Authority 500, an
order to purchase or redeem a bundle is routed to the Settlement
Bank 694 for settlement and clearance. On the other hand, if the
order is a limit order to buy or sell a contract, then it is routed
to Order Matcher 340, which places the order into a queue. The
priority that the order assumes in the queue depends on the market
trading rules, which takes into account factors such as the time of
order placement, price, and number of contracts. When the Order
Matcher 340 matches the order with a suitable counteroffer, and the
order is first in the queue for orders of its type, then the order
is routed to the Settlement Bank 694 for settlement and clearance.
As described previously, several accounts are maintained at the
Settlement Bank 694, including Custodial Accounts 695a, which the
market authority maintains for each of its members, the Market
Authority Account 695b, which is a proprietary account that holds
all unencumbered funds owned by the Market Authority 500, and the
Settlement Account 695c, which is an escrow account that holds
proceeds from the sale of bundles until the expiration of the
contracts which make up that bundle and from which funds are taken
to pay off in-the-money contracts.
[0483] At a time determined by contractually prespecified rules,
contracts expire. When a contract expires, either it is worth $10
or $0 depending on the realization of the outcome of the underlying
event. The Contract Expiration Manager 360 expires contracts and
determines the final liquidation value. Upon expiry, the Contract
Expiration Manager 360 notifies all holders of the contract. It
halts trading by freezing the Order Matcher 340 for that particular
contract. If the contract expires worthless, the Contract
Expiration Manager 360 removes the expired contract from traders
accounts. If the contract expires worth $10, the Contract
Expiration Manager 360 notifies the Settlement Bank 694 to credit
the account of the holder of each contract which is worth $10.
[0484] Before an order is processed by the OMPS 370, it must first
be designated a legitimate order. The validation subsystem of the
Validater 320 will determine whether an order is legitimate by:
[0485] (i) making sure the member has permission to trade. Any
member wishing to place an order must log in to the system by
providing a valid ID and password combination. The validation
subsystem will check the privileges of the account from which the
order originates to ensure that the account holder is (1) allowed
to purchase the contract identified in the order and (2) that the
account holder is not already logged in to the system;
[0486] (ii) reviewing the order information to make sure it is
complete and identifying existing contracts or bundles that may be
traded; and
[0487] (iii) checking order originating account information to
ensure that the account has the necessary cash and/or contracts to
fulfill the order. If it does, then the system blocks the
appropriate assets so that the member cannot use these assets for a
second order or other activities.
[0488] If any of these three tests are not satisfied, the
validation subsystem of the Validater 320 will send a message to
the Member 10 rejecting the order and providing a brief explanation
as to why the order was rejected. If all three tests are satisfied,
then the order is validated, the status of the order is updated to
reflect validation, and the order is transmitted to the order
routing subsystem. Simultaneously, the Member 10 receives an order
confirmation notice.
[0489] The Order Router 330 acts as a switch, directing orders
received from the Validater 320, the Order Matcher 340 or other
specific subsystems. If the order is for a contract (as opposed to
a contract bundle), then the Order Router 330 directs the order to
the order matching subsystem for that particular contract. If the
order is for purchase or redemption of a bundle, then no order
matching is necessary because this is a direct transaction with a
fixed price of $10. Consequently, the Order Router 330 will send
instructions to the Settlement Bank 694 or to the Clearance and
Settlement Application 690 to transfer funds appropriately, and
will simultaneously update the Market Authority 500 and the
member's accounts for the change in values of their portfolios. The
Order Router 330 will also maintain and keep current a full audit
history for each order passed on by the Validater 320. It will
provide (1) a status history recording every change in the state of
an order thus providing a complete system audit trail and (2) an
execution history recording all executions made against an order.
User accounts will be updated for all changes in the status of an
order and histories will be accessible for audit purposes.
[0490] There is an order matching subsystem within the Order
Matcher 340 for each contract traded on the Exchange. The order
matching subsystem will maintain a complete list of all bid and
offer orders on a particular contract (the order book). The orders
in these order books will be prioritized first by price and second
by the time the order was placed. All orders will be anonymous and
the order matching subsystem will match orders based only on price,
quantity, order expiration time/date, and time the order was
placed. Each order matching subsystem will process a new order
received from the order routing subsystem according to the
following standard price-time priority algorithm: [0491] If the
price of the new order is not better than or equal to the best
contra order listed in the order book, then the new order will be
added to the order book in a unique position reflecting its price
and time priority information; [0492] If the price of the new order
is better than or equal to the best contra order listed in the
order book, then the new order will be matched against that contra
order at the price of that resting contra order; [0493] If this
does not fill the quantity of the new order, then the subsystem
will match the remainder of the new order with lower priority
contra orders in the order book until the quantity of the new order
has been satisfied or there are no orders remaining on the contra
side at a price equal to or better than the price of the new order;
and [0494] Any remaining quantity after all possible executions
have been generated will be placed into the order book in the
position reflecting its price and time order placed priority.
[0495] Each order matching subsystem will process one order at a
time to preserve order prioritization. One of ordinary skill in the
art will appreciate that the above-described price-time priority
algorithm, while preferred, is but one possible set of priority
features and priorities and is provided by way of example and not
by way of limitation.
[0496] Once an order is matched, it cannot be amended or canceled.
However, if it is still in the order book, the order matching
subsystem will accept cancellation and amendment instructions from
the interface system. If the order is amended, the order matching
subsystem will treat it as a new order, and the new order will have
a time priority corresponding to when it was amended.
[0497] An order will be removed from the order matching subsystem
if: [0498] the order is matched with a contra order; [0499] the
order is canceled by either the member who originated the order or
administrative staff in accordance with the rules of the exchange;
[0500] the contract specified in the order expires before the order
is matched; or the order expires by its terms before it is
matched.
[0501] The member will be notified of any of these events, and all
order histories will be updated to reflect the occurrence of any of
these events.
[0502] Working with the order management subsystem, the Contract
Expiration Manager 360 will record the change of ownership of all
contracts traded on the exchange. Upon expiration of a set of
contracts, the Contract Expiration Manager 360 will accept
instruction from the Market Authority 500 as to which contracts are
in-the-money, notify all owners of the expiring contracts of the
expiration, and credit member accounts in the amount of the value
of the contract upon expiration (which is either $0 or $10).
Simultaneously, the Contract Expiration Manager 360 sends
instructions to the Settlement Bank 694, identifying the accounts
of members holding contracts which expired in-the-money and
directing the Settlement Bank 694 to transfer funds to those
accounts.
[0503] The above description of an apparatus according to present
invention illustrates and describes a computer-based system in
terms of functional block diagrams and website page structures. One
of skill in the art will appreciate that once the desired
functionality of the computer system is defined (as has been
outlined above), and/or the basic contents of the web pages have
been identified (as has been outlined above), the acts of
programming one or more computers or computer systems to perform
these functions is considered to be within the ordinary skill in
the art for computer programmers. Moreover, while the above
description of an apparatus according to present invention
illustrates and describes a computer-based system based on certain
functional block diagrams and website page structures where
specific functionality is partitioned in discrete portions, one of
ordinary skill in the art will appreciate that the computer code
may be partitioned and/or combined in different discrete portions
without changing the overall functionality of the system or
departing from the spirit of the invention.
III. How Potential Registrants and Members Use the System
[0504] Thus far we have described some of the types of risk hedging
contracts which can be traded and have also described a preferred
embodiment of an overall system for offering, trading, redeeming
and settling these contracts. Next, the method of the present
invention in accordance with the operation and function of a
preferred embodiment of the invention will be described with
reference to the figures. In the following, certain functions and
processes of the system will be described, but the present
invention is not limited to this set of functions and processes and
some of the functions can be omitted or modified and other
functions and/or processes added without departing from the spirit
of the invention.
[0505] Registration Function
[0506] As noted above "Member" refers to a client who is registered
with the market. In addition to having trading and account
privileges, members will be able to view the market, post and read
messages using electronic message boards, and read news reports
relating to the market, the contract bundles and contracts, or the
underlying measures.
[0507] In addition to its members, the Market Authority 500 will
allow the general public to access specific areas of the web site
which are designated to be public and read descriptions of the
exchange, review organization and rules, read the descriptions of
contract bundles and contracts, view the daily bid and offer prices
and trading volume figures for the various contracts, and, if they
so elect, fill out member applications. Non-members are prohibited
from participating in the market. Thus, non-members will not be
allowed to purchase or sell instruments or add messages to
electronic bulletin board(s).
[0508] In the computer-based implementation of the present
invention, to become a Member 10, an applicant must access the Main
Computer 100 through the Internet 200. As depicted in FIGS. B and
C, the applicant can access the New User Registration Page 450 from
the Home Page 410. From there, the applicant must follow the
directions, read the information, print and fill out the necessary
forms, and mail in the forms with his signature and an initial
deposit.
[0509] An applicant is required to certify in writing that he is
(1) a citizen or permanent resident of the United States and (2)
old enough to enter into a legally enforceable contract. If the
applicant is an organization, it must reside in the United States
and be validly organized, in good standing, and authorized by its
charter to trade futures contracts. Before being designated as a
member, an applicant will be required to read, and certify that
they have read, the risk disclosure document. Member applicants
must also agree to be bound by the site rules and to certify that
they will only trade for themselves or the company for whom they
are registering and will not trade as an intermediary for others.
Finally, in order to become a member, an applicant will be required
to open an account at the clearing agent. The minimum initial
deposit to open an account is a standard amount, for instance
$500.
[0510] After the Market Authority 500 approves an application for
membership, the Market Authority 500 will: (1) assign the member an
account number; (2) require the member to select a password; and
(3) require the member to select an identification code ("ID") for
use in conjunction with electronic bulletin board and messaging
system. In order to access the exchange, a member need only log
onto the Internet 200, go via the Internet 200 to the website Home
Page 410, and enter his or her account number and password. Members
will be prohibited from maintaining more than one account. To
police the one-account-per-member rule, the market authority will
routinely scan its account database for identical names, telephone
numbers, social security numbers, and other identifying
characteristics.
[0511] The contract rules allow the market authority to suspend or
terminate, wholly or in-part, the privileges of members who violate
the rules of the exchange in any way, including by supplying false
information in an application for an account. Other grounds for
suspension or termination of member privileges will include trading
for someone other than themselves or the company for whom they are
registered to trade on the market, behaving in a manner that
affects the integrity of the market or its underlying systems, or
any other reason necessary to protect the market, its members, or
the public.
[0512] Logon Process
[0513] In order to log into the system, a member or registrant must
access the Main Computer 100 via the Internet 200. The member or
registrant must provide a valid account number and initial password
combination not already logged onto the system. Members will be
required to police their account number, ID, and password to ensure
that no one has improperly accessed their account. The Main
Computer 100 system will record all log ins and attempted log ins.
If five consecutive failed log in attempts are recorded for a
particular account (due to incorrect password), then the
appropriate software module working in cooperation with the Web
Server Software 400 will automatically suspend that account. The
Web Server Software 400 will then send an e-mail to the address
registered to that account informing the user of the account
suspension and asking the user to log into a uniquely generated
reactivate account link. Upon successful log in, the user will be
required to select a new password for the account and may change
other aspects of his/her user profile (e.g., e-mail address).
Logout Process
[0514] For a user to close access to his account and the system,
the user must actively log out. To minimize the possibility of
unauthorized access, the appropriate software working in
cooperation with the Web Server Software 400 can also log out a
user if the system loses contact with the user's computer or if the
user is not active on the system (and does not respond to a system
request) for more than an predetermined time, for instance 10
minutes. In this case, the user's session is automatically "timed
out".
[0515] Account Set Up Process
[0516] After completing, signing, and mailing in the registration
application together with some cash amount that is at least the
required minimum initial deposit of $500, the applicant must wait
for formal approval of his application.
[0517] Once the Market Authority 500 approves a new user
application, the member is notified by mail and Email, and the
member is authorized to log in to his account for the first time.
Thereupon, the member is authorized to access his account on the
Main Computer 100 via the Internet 200. In the Log In Page 420 the
member types in his user ID and initial password. If the member
successfully logs in, he will be required to change his initial
password by typing in (twice for confirmation) a new password. The
new password will be active each time he logs in thereafter until
he changes it.
[0518] When a new member logs in to his account for the first time,
he will be asked to set up a personal home page. To this end, the
member is offered a menu of items he can choose to include in his
personal home page, and is asked to answer questions about the
layout of those items on his personal page. Some of these items to
be included are mandatory. The mandatory items include cash
balance, the market value of the members contracts held in the
account, and the per contract prices of each of the types of
contracts in the member's portfolio. Other items are discretionary.
Discretionary menu items include a list of links to updated
information about contracts the member may be interested in, news
headlines (general and specifically tailored), market indices,
alert items concerning the market, links to bulletin boards, and
other links of interest.
[0519] Existing members may change the items and layout of their
personal pages at any time by clicking on a "change homepage"
link.
[0520] Adding and Removing Funds from an Account
[0521] The first time a new member logs in, his account will have
only his initial deposit, which is some amount at least $500. From
time to time, members will want to either add or remove funds from
their account.
[0522] Funds in member accounts as well as funds credited to the
account of the Market Authority 500 in payment for contracts will
be credited to an account at a bank (i.e., the Settlement Bank
694). Members will be permitted to fund their trading accounts by
electronic check, wire transfer, or other means. Funds will not be
available for trading purposes in a member's account until the
member's deposit has cleared.
[0523] A member may withdraw funds from the credit balance in his
trading account by making an appropriate request. On the same or
the next business day following receipt of an appropriate request,
the clearing agent will direct the Settlement Bank 694 to transmit
the funds by check or other means to the member. The funds will be
withdrawn from the account of the Market Authority 500 within three
business days of the request, and will be electronically
transmitted to a destination account specified by the member. In
the event that a member attempts to withdraw funds exceeding the
available cash balance in his account (i.e., the cash in the
account that is not blocked or otherwise set aside to cover a
pending purchase order), the request will be rejected and the
member will be informed of the reason the request was rejected. To
the extent that the request is rejected because funds in the
account are blocked, the member will be so informed and may unblock
the funds by canceling the pending order for which the funds have
been blocked.
[0524] View Market Data Process
[0525] The Executive Summary Page 436 summarizes the current
activity on each actively traded contract. The Executive Summary
Page 436 may be accessed in many ways. As depicted in FIG. 4, the
user has several alternate ways of accessing the Executive Summary
Page 436 for each given contract. First, the user may simply go via
the Internet 200 to the Home Page 410. From the Home Page 410, the
user can go to the Underlying Info and Contracts Page 430, select
the contract link he is interested in, and click on that to get an
Executive Summary Page 436 of the market activity on that contract.
Without logging in, however, the user cannot place a trade in this
contract.
[0526] Alternatively, the user can proceed from the Home Page 410
to the Log In Page 420. After logging in, he will see his Personal
Home Page 422 (i.e., My Account Page 422). From his Personal Home
Page 422 (i.e., My Account Page 422), the user will either be able
to directly access the Executive Summary Page 436 (if he has chosen
to include the link for this contract on his Personal Home Page 422
(i.e., My Account Page 422)), or he can access the Underlying Info
and Contracts Page 430, from which he can access the Executive
Summary Page 436 pertaining to a particular contract.
[0527] Order Placement and Execution
[0528] Trading Hours
[0529] The site will be open for trading 24 hours a day, seven days
a week. This continuous trading cycle avoids the need to develop
rules for ordering and executing member orders placed while the
market is closed. The continuous trading cycle also avoids the need
to develop rules for setting opening prices and eliminates, by
definition, the possibility of a gap between closing and opening
prices sometimes experienced on traditional markets.
[0530] Accessing the Market
[0531] To access the market, the member will access the Internet
200, proceed to the website Home Page 410, enter his or her account
number and password, and hyperlink to the trading page for the
contract bundle and contracts he or she wants to trade.
Additionally, on the My Account Page 422 the member will have
access to his or her current account balance and current open
positions, and the page will provide the member with a variety of
text, pull-down, and check boxes that the member can use to
purchase or redeem a contract bundle or to enter an order to buy or
sell a contract.
[0532] Viewing Orders and Depth of the Market
[0533] To ensure equality of access to market information, all
members will be able to view the size and price of the same number
of recently executed trades and the same number of outstanding bids
and offers. At a minimum, all members will be able to view records
of all trades executed within the last hour as well as a real time
updated listing of the size and price of the best outstanding bid
and offer. Although all members will have access to this market
information when they enter an order, this information may, of
course, change between the time the member submits an order and the
time the market receives and processes it.
[0534] Placing an Order
[0535] To place an order, the member proceeds to the Contract
Description and Order Form Page 440 (shown in FIG. 4). The only
type of orders that the trading system will accept will be limit
orders, which are orders to buy or sell a specified number of
contracts at a specified price or better. The member will be able
to choose from the following different types of limit orders:
[0536] Time Specified: A limit order with an expiration date
designated by the member, not to exceed a fixed time, for instance
sixty days, from the date the order is placed. [0537] Immediate Or
Cancel: A limit order that is to be executed in whole or in part
within a short time, for instance five minutes, of being placed on
the market, and any portion of the order not executed within that
time limit is cancelled. [0538] All Or Nothing: A limit order that
is to be executed only in whole, and not in part, within the time
period designated by the member, not to exceed a predetermined
time, for instance sixty days, from the time the order is placed.
[0539] Cancel If Bettered: A limit order that is automatically
cancelled if the price bid or offered is not the best price for the
contract in the orders resting on the market.
[0540] If the member places an order to either buy a contract
trading in the market or to buy a new contract bundle, the Order
Placement Application 310 (FIG. 7) will automatically confirm that
the member has sufficient funds in his or her account to execute
the trade prior to adding the order to the order book. If the
member has insufficient funds, the Order Placement Application 310
will inform the member of the shortfall and ask the member if he or
she wants to execute the amount of the order that can be satisfied
with existing funds. In accordance with the member's answer, the
Order Placement Application 310 will either adjust the size of the
order or cancel it. To ensure that a member cannot place an order
that he or she does not have sufficient funds to cover, it is
presently anticipated that the Order Placement Application 310 will
permit only limit orders and not market orders. Additionally, funds
from the member's account that would be needed to fill unexecuted
limit orders will be "blocked" when the order is accepted so that
they are excluded from the funds the system uses to determine if
the member has the funds necessary to place another buy order. If a
member seeks to withdraw blocked funds from an account, the member
will first be required to cancel pending orders sufficient to
remove the block.
[0541] Once the order is accepted, the member will be required to
confirm it, and the order will then be placed in the order book.
After an order is placed in the order book, it will remain
outstanding until the earliest of its execution, its cancellation
by the member (or by in limited circumstances such as the
termination of a series), the expiration of the time limit placed
on the order by the member, for instance sixty days, or the
expiration of that contract series. A member may cancel an order at
any time prior to execution of the order by entering a cancellation
order, and if the order has not been executed before the Order
Placement Application 310 can withdraw it, the member will be
notified that the order has been canceled.
[0542] All orders will be anonymous, and orders will be prioritized
for execution according to predetermined criteria. For instance,
orders will be prioritized for execution first by price and then by
time, meaning that the best bid or offer will have priority over
all other bids or offers, and bids or offers entered at the same
price will be executed in the order they were received by the
system. If orders with the same price are received at exactly the
same time (if such an occurrence is technologically possible) one
will be randomly assigned time priority over the other using the
minimum incremental unit of time in the system.
[0543] A newly entered bid that is higher than the best outstanding
offer or a newly entered offer that is lower than the best
outstanding bid will be executed at the price represented by the
preexisting bid or offer to the extent that the size of the resting
bid or offer is adequate to fill the new order. If the order is
only partially filled by the resting contra order, then the
remainder of the order will remain in the Order Book at its limit
price and will execute against subsequently listed contra orders at
its limit price.
[0544] After the Order Placement Application 310 confirms that the
member has the funds necessary to buy a contract bundle or contract
and executes the buy order, the Order Placement Application 310
will, in the case of a contract bundle purchase, open positions in
one of each of the contract bundle's contracts in the member's
account and instruct the Settlement Bank 694 to debit $10 per
contract bundle purchased from the member's account and to credit
that money to the settlement funds account. In the case of a
contract purchase, the Order Placement Application 310 will open
the contract position in the purchasing member's account and close
the position in the selling member's account and will instruct the
Settlement Bank 694 to debit the cost of the purchase from the
member's account and credit the value of the purchase to the
selling member's account. Trading fees will also be debited from
the member's account and credited to an account at the Settlement
Bank 694.
[0545] When an order is executed, the member will be sent
confirmation by electronic mail. Upon execution of an order, the
system will adjust the open positions in the members' accounts and
inform the settlement agent, which will make the necessary account
adjustments. If for some reason a member wishes to dispute an order
that he or she entered and confirmed, the member will be required
to provide the confirmation number issued with the order and any
subsequent confirmation numbers (such as a cancellation
confirmation number) associated with the order.
[0546] Two Ways to Establish the Same Position
[0547] A member can establish the same position in each contract in
two ways. For instance, suppose the member wants to own one A
contract. One way to do this is to place a limit order to buy one A
contract. Then, when that order is settled, his desired position is
realized.
[0548] But there is an alternative route the member can use to
establish the same position. He can (1) purchase a bundle that
contains the A contract; (2) put limit orders to sell every
contract in that bundle EXCEPT the A contract. Then, upon execution
of all his limit sell orders, the member will own exactly one A
contract.
[0549] Trading Fees
[0550] While the presently preferred embodiment contemplates that
interest will be paid to members based on the free cash balance in
their accounts. However, the presently preferred embodiment does
not presently anticipate paying interest on either funds paid to
market authority for the purchase of contract bundles, or on
blocked cash balances (i.e., balances blocked by the system because
they would be needed to execute orders resting on the market).
Income from investment of these funds, as described in more detail
below, will accrue to the benefit of market authority. Thus, the
foregone investment return on these funds represents a cost to
members of dealing in the exchange. The presently preferred
embodiment also contemplates charging transaction fees for
transactions in contract bundles and contracts. The fee per trade
will be at least a minimum fee set by the market authority based on
the cost to market authority of processing a trade. The fee may be
higher than the minimum fee based on the number of contract bundles
purchased or redeemed or the number of contracts traded.
[0551] Cancellation and Modification of Orders
[0552] Once an order is executed, it may not be cancelled or
modified. However, members will be able to cancel or modify an
order at any time before it is executed. All pending orders which a
member has outstanding will be listed on the member's account page.
To cancel or modify a pending order, the member will select the
order to be changed and using prompts, either (1) cancel the order,
(2) amend the order, or (3) leave the order unchanged. If the
member chooses to cancel the order and if the order has not been
executed before the system can withdraw it, the member will be
notified that market authority has canceled the order. If the
member chooses to modify the pending order, the member will be
shown the details of the existing order and be allowed to change
any order variables (with the exception of the underlying event to
which the contract pertains). The member will also be informed that
a modified order will be treated by the order book as a new order,
causing the order to lose its original time priority.
[0553] Record Keeping and Retention
[0554] The Order Placement Application 310 will automatically
record all orders placed on the market, and all trades executed, by
date, time, quantity, contract bundle or contract type, underlying,
price, expiration month, payout criterion, and member account
number. In conjunction with the Market Database 390, the Order
Placement Application 310 will record all settlements by time,
amount, and member account number. The system will also record by
time all changes in the best bid or offer for a contract.
[0555] As noted above, the Market Database 390 is an electronic
database from which internal (nonpublic) market data, market data
to be shown members, and publicly disseminated market data may be
electronically retrieved and disseminated interactively. The
internal market data preferably includes, but is not limited to,
records of all orders, executions, cancellations, and other
transactions entered into the Trade Engine 300, trading volume,
changes in bids and offers for all contracts, and reports generated
by the Market Authority 500. The market data to be shown members
includes, but is not limited to, a list of (preferably about 5)
recently executed orders, the best current and offer on the market,
and periodic trading volume updates. The publicly disseminated
market data, disseminated to vendors of market data and reported to
government authorities, consists of a list of recent trades, trade
volumes, and the best bid and offers.
[0556] The system will transfer this information, and all other
statistical information gathered from its market, to a searchable
database (i.e., the Market Database 390) for retention for a
predetermined period, for instance a time of not less than five
years. Using its database, the system will be able to reconstruct
rapidly and accurately transactions executed on the trading system
and provide that information to the CFTC upon request. As part of
its record retention program, market authority will also maintain
for five years full records of all activity undertaken pursuant to
its affirmative action program to secure compliance with the
relevant provisions of Sections 5, 5a(a), 5b, 6(b), 6b, 8a(7),
8a(9) and 8c of the CEA.
[0557] Trade Process--Split
[0558] A member does not have to do anything during a contract
split. The member's account is automatically updated and the split
contract is replaced with the new set of post-split contracts. The
original pre-split contract is no longer actively traded, so all
existing limit orders on that contract are cancelled. The member is
automatically authorized to trade on the post-split contracts if he
desires.
[0559] Trade Process--Combined Contracts
[0560] A member does not have to do anything during a contract
combination. If the member does not do anything, any entire set of
contracts he owns designated for recombination will be
automatically combined. If he owns some, but not all, of the
contracts designated for recombination, those unmatched contracts
will not be recombined and he is permitted to continue trading in
those individual contracts as if there were no recombination. At
expiry, those contracts will be settled as if there were no
recombination.
[0561] Redemption Process Details
[0562] As will be explained in the following, there are two kinds
of redemption: the redemption of bundles, and the redemption of
contracts at expiry.
[0563] Complete bundles may be redeemed at any time. The Market
Authority 500 stands ready to purchase for $10 complete bundles at
any time from any member. To redeem a bundle, all the member does
is submit the order on the Contract Description and Order Page 440
(Illustrated on FIG. 4). Such redemption orders are executed
instantly.
[0564] If the member places an order to redeem a contract bundle or
to sell an existing contract in the member's account, the Order
Placement Application 310 will automatically confirm that the
member has the number of contracts he or she wishes to redeem or
sell and, if so, redeem the contract bundle or place the order on
the market. If the member does not have the appropriate number of
contracts, the trading system will inform the member of the
shortfall and ask the member whether he or she would like to redeem
or sell all or a portion of the contracts the member does have, or
cancel the order. Based on the member's answer, the system will
redeem or enter a sell order representing the correct number of
contracts designated by the member, or cancel the order. A pending
sell order will block the number of contracts subject to the order
so that the same contracts cannot be subject to more than one
pending sell order.
[0565] At expiry, contracts are settled automatically. By
definition, every contract is worth either $10 or $0 at expiry. If
a contract is worth $10 at expiry, the Contract Expiration Manager
360 (which is illustrated in FIG. 7) removes the contract and
replaces it with $10 cash balance in the member's account. If the
contract is worth $0 at expiry, the Contract Expiration Manager 360
simply removes the contract from the member's account.
IV. News, Bulletin Boards, Other Services
[0566] Another one of the innovations of the present system and
method according to the present invention is that such a system
provides a one-stop information and "discount" brokerage service.
As such, it can aggregate all relevant news, information,
instruction, educational, and discount brokerage services on its
website to stimulate the interest of and communication between
traders.
V. Hedge Market Account Card
[0567] A Hedge Market Account Card ("HMAC") is an optional but
preferred component in a risk hedging market and system according
to the present invention. The HMAC works like a bank debit card. A
HMAC carries information identifying the holder's trading account
number and, together with a password that must be entered
separately, allows the cardholder to access his account from
portable machines. While the HMAC is described as a "card" for the
sake of illustration, in fact it can be a radio frequency tag, or
any other type of indicator of identity including merely an account
number to be entered on a keypad, or otherwise.
[0568] One use of the HMAC is to redeem tickets at box office. If
the holder shows up at the concert with his card, swipes the card
through a card reader (also referred to hereinafter as a "point of
sale terminal") and enters a password, the reader (which can be
connected to the Internet or to a computer directly connected to a
suitable database) allows the cardholder to redeem the appropriate
futures contracts in his account for concert tickets on the spot.
The Market Authority electronically deducts the contracts from the
holder's account, and issues tickets for the concert.
[0569] One can imagine other related uses for the HMAC. For
example, card holders who don't have tickets could just show up at
the box office with their card. They can use their card to log in
to their hedging account and bid for tickets that are still trading
in the appropriate futures market.
[0570] Another scenario is a "delivery on demand". For instance, a
futures coupon for "a Spagos dinner in November" could have an
"American" style expiration. The holder can get his meal any time
during November by presenting his HMAC at Spagos. Spagos would have
a card reader to enable settlement of the appropriate futures
coupon.
[0571] "Member" refers to a client who is registered with the
market. In addition to trading and account privileges, members will
be able to view the market, post and read messages using electronic
message boards, and read news reports relating to the market, the
contract bundles and contracts, or the underlying measures. Members
will also have a HMAC.
[0572] While the HMAC has uses for all types of trading, the HMAC
is particularly useful for trading Type II (coupon) contracts, as
described above.
[0573] The procedure for becoming a member is the same as that
described above in the Section pertaining to Type I contracts and
the Market Authority mails members who desire to trade coupons, a
HMAC.
[0574] Regarding the adding and removing of funds from an account,
in addition to the procedure described above for Type I contracts,
members may be allowed to purchase a limited number of coupons
using their credit card.
[0575] Regarding the view market data process, in addition to the
procedure described above for Type I contracts, the Market
Authority and its partners may provide special terminals for
interfacing with the market at the venues where coupons are
redeemed.
[0576] In addition to the procedure described above for Type I
contracts, the Market Authority and its partners may provide
special terminals for interfacing with the market at the venues
where coupons are redeemed.
[0577] Ticket Redemption
[0578] Many implementations of the HMAC idea are possible. Two
examples are given below.
[0579] Redemption Method I
[0580] In this method, the box office has Internet-connected HMAC
readers. HMAC holders may use these readers to redeem their futures
coupons for tickets in "real" time. However, HMAC holders may also
do much more via the card readers, including giving orders to place
last minute trades of their unused coupons. An outline of the
procedure for using the card reader follows: [0581] 1. Every venue
which uses the hedge market's services is equipped with HMAC card
readers at its box office. The card readers are hooked up to the
hedge market's computers via a fast Internet connection, and they
also have the ability to dispense tickets on demand (like how bank
teller machines can issue cash). Coupon holders use these readers
to redeem their tickets when they come to the concert (ball game,
play, etc). [0582] 2. Card holder swipes his HMAC on the card
reader and enters his secret PIN. [0583] 3. Card holder enters the
number, N, of tickets he would like to redeem. [0584] 4. If the
card holder has at least N of the corresponding coupons in his
account, the Market Authority automatically settles N of the
coupons, and immediately issues N tickets to the card holder.
[0585] 5. If the cardholder has less than N redeemable coupons in
his account, he is prompted to buy more coupons to make up the
difference. Suppose the cardholder needs M additional coupons. Then
he is told the best ask prices in the market for M coupons, and is
asked if he would like to place a limit order to meet those asking
prices.
[0586] If he says "yes" and there are sufficient funds in his
account to make the purchase, the M coupons are purchased, his
final total of N coupons are redeemed, and N tickets are
immediately issued. If he says "yes" but his account lacks
sufficient funds to purchase M coupons, he is given the option to
purchase fewer than M, or to insert a credit card, from which funds
may be debited to cover the difference. In either case, the HMAC
cardholder determines how many tickets he wants to redeem, pays one
way or the other, the necessary coupons are purchased and redeemed,
and the tickets are issued on the spot. [0587] 1. Any HMAC holder
may, even if he starts with zero coupons in his account, purchase
the necessary coupons in Step 5 and, therefore, buy N
tickets--assuming that there are enough tickets offered for sale in
the limit sell queue. Towards the hour of very high demand events
like the SuperBowl, it could very well be that the limit sell queue
is empty. If the limit sell queue is empty, or it does not contain
any asking prices the HMAC holder is willing to meet, the HMAC
holder is prompted to enter limit buy order(s), and to check back
in a few minutes to see if his order(s) is(are) met. [0588] 2. If
the HMAC card holder's account has coupons remaining in his account
after redeeming his N tickets, he is prompted and asked to indicate
if he wants to sell the remaining coupons in the market. If it is
near show time, the card holder will have no reason NOT to sell. If
the card holder indicates he wants to sell, he is given information
on recent transaction and offer prices, and asked to indicate his
asking price(s), and then the appropriate sell orders are placed in
the queue. [0589] 3. Coupons can continue trading as long as the
tickets have any value. After the tickets lose value, the coupons
themselves become worthless and the Market Authority will
automatically terminate the market. This means the coupons market
can continue trading even after the concert starts, because
latecomers may still want to buy tickets. However, after the
concert ends, there is no point to trading the coupons (unless the
promoters have additional provisions for refunding unused
tickets).
[0590] Alternative Redemption Method II
[0591] Method I demands a live Internet (or other speedy)
connection to the central market databases. It may be that this
connectivity is not always cost-effective. When that is the case,
an alternative is to (a) pre-announce ahead of time that the
Internet connected market stops trading H hours before the concert
(or play, game, etc); (b) H hours before trading, freeze all
Internet trading; and (c) the box office downloads (via the
Internet or private secure connection) the records of all market
information (including which account owns which position, and all
the queue information) down to local computers.
[0592] With all the information downloaded into local computers,
the theatre box office can now handle all trading and redemption
with local computers without having to communicate with the Market
Authority computers.
[0593] After downloading the market information, the theatre box
office may handle redemptions in two alternative methods.
[0594] First, the box office may not support any additional coupon
trading. In this case, it will simply allow HMAC card holders to
redeem at the site whatever coupons the cardholder owns. Unredeemed
coupons either expire worthless, or are refunded a pre-stated cash
amount.
[0595] Alternatively, the box office computer may support a
continuation of market trading with the local (non-Internet
connected) computers. In this case, the original limit bid/ask
queues are still active. However, to place or cancel queue orders,
an account owner MUST show up at the box office with an HMAC card
and use one of the local terminals.
[0596] HMAC card holders who show up at the box office may redeem
their coupons, or place trades in accordance with Steps 1-8
described in Method #1 above. The only difference is the absence of
an Internet connection to allow offsite members to place or change
their limit orders.
[0597] Compared to Method #2, the advantage of Method #1 is that it
allows last minute trading of coupons up to and during show time
from anywhere in the world, which benefits "scalpers" and
speculators. Its disadvantage is that it encourages scalping and
speculation, and the cost (to the Market Authority) of Internet
connectivity.
V. Open Source
[0598] The present inventors are considering open sourcing the
invention and design of new types of futures contracts to academics
and industry-specific experts as part of the inventive market
implementation and operation.
[0599] In one implementation, the Market Authority would employ a
person responsible for managing the outsource developers. The
outsource developers design the financial instruments (i.e., types
of futures contracts) in their own time, and submit their products
to the Market Authority. The Market Authority retains the rights of
final approval and acceptance. Submitters of approved and accepted
instruments are compensated by a fee and, possibly, a royalty
arrangement on their instrument.
[0600] To stimulate the outsource development community, the Market
Authority may sponsor and operate specialty conferences, mailing
lists, task listings, Internet bulletin boards, and other forums
where academics and other experts can discuss and debate their
ideas. The Market Authority may also operate virtual chat rooms and
appoint moderators to moderate the forums and ultimately oversee
the finished system.
[0601] Product Design.
[0602] A working list of candidate contracts can be published on a
web site by the Market Authority for contract developers. Comments
and input can be solicited from the general public about candidate
contracts on this list. The Market Authority can take into account
public comments before selecting contracts from this list for
trading. The Market Authority may develop a more granular design
process along the lines of an N-step process that all products go
through before they are marketed to the general public.
[0603] Benefits of OpenSource
[0604] OpenSource gives the Market Authority direct access to a
wide intellectual talent pool. By collectively harnessing the
intellectual resources of a wider pool of academics, OpenSource
will generate great ideas that a small group of employees couldn't
possibly imagine, regardless of how smart they are.
[0605] The Market Authority can immediately get involvement from
the corporate experts in the Industry. These corporate experts
better understand their company's risk management needs than
external experts.
[0606] OpenSource provides the Market Authority with visibility and
credibility, which from a marketing perspective is impressive.
There is potential for a viral contagion effect to some degree, and
it gives the Market Authority which exploits OpenSource, the
potential for an evangelical advantage (like Linux).
[0607] OpenSource is likely less expensive than hiring internal
experts.
[0608] OpenSource leverages the power of the Internet.
[0609] OpenSource lends cache, public identification and awareness,
and momentum, and hence creates a greater barrier to entry for a
market developer who does not use OpenSource.
[0610] In summary, OpenSource in our financial context is loosely
analogous to the development of Linux in the software context. The
U.S. has several thousand universities, and most of them have an
economics and/or finance department. The relevant academics and
their graduate students are relatively easy to identify and contact
to be the first OpenSource contributors.
* * * * *
References