By Winton Bates, on October 29th, 2010
Somewhere in Africa more than 100,000 years ago, a phenomenon new to the planet was born. A Species began to add to its habits, generation by generation, without (much) changing its genes. What made this possible was exchange, the swapping of things and services between individuals. That gave the Species an external, collective intelligence far greater than anything it could hold in its admittedly capricious brain. Two individuals could each have two tools or two ideas while each knowing how to make only one. … In this way, exchange encouraged specialization, which further increased the number of different habits the Species could have, while shrinking the number of things that each individual knew how to make. Consumption could grow more diversified, while production grew more specialized (Matt Ridley, ‘The Rational Optimist’, 2010: 350).
 Ridley’s bold claim is that human progress can be explained mainly in terms of exchange and specialization. Eric Jones, a scholar who has written extensively on the history of human progress, considers that Ridley makes the case very well, based ‘on the few knowns of early pre-history’. Jones also considers that Ridley gets the story of the industrial revolution ‘mostly right’ (Review in ‘Policy’, Spring 2010, 26 (3)).
The weight that we can place on exchange and specialization as explanations of human progress depends importantly on the extent to which advance of knowledge and innovation can be attributed to exchange and specialization. It is possible to go some distance in explaining technological progress as a consequence of specialization. As Bill Easterly points out in his NYT review, however, many breakthroughs come from creative outsiders who combine technologies generated by different specialties.
Ridley mentions that government actions of various kinds in different countries have often inhibited innovation, particularly the introduction of new products and new ways of doing things that threaten the survival of established patterns of production. The implication is that freedom is a necessary condition for progress comes through clearly in Ridley’s recent contribution to Cato Unbound:
‘I am saying that there have always been liberals, who want to be free to trade in ideas as well as things, and there have always been predators, who want to extract rents by force if necessary. The grand theme of history is how the crushing dominance of the latter has repeatedly stifled the former. As Joel Mokyr puts it: “Prosperity and success led to the emergence of predators and parasites in various forms and guises who eventually slaughtered the geese that laid the golden eggs”. The wonder of the last 200 years is not the outbreak of liberalism, but the fact that it has so far fought off the rent-seeking predators by the skin of its teeth: the continuing triumph of the Bourgeoisie’ (p. 252).
I can’t help thinking that this sounds more like rational pessimism than rational optimism. According to Ridley, the industrial revolution is largely a story about coal – and progress since then has been possible mainly because of abundant cheap energy from fossil fuels. He notes that his optimism wobbles when he looks at the politics of carbon emissions reduction and the potential this has to load economies with further rules, restrictions, subsidies, distortions and corruption (p. 347).
Cartoon by Nicholson from “The Australian” newspaper: http://www.nicholsoncartoons.com.au/
The optimistic note on which Ridley ends his book comes from his view that innovation is such an evolutionary, bottom-up phenomenon that it will continue as long as exchange and specialization are allowed to thrive somewhere in the world.
In the end, it would seem that the gains from innovation, exchange and specialization all depend on liberty – liberty is the key to human progress.
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By Ajay Shah, on October 29th, 2010
In a few minutes, NSE and USE will start trading in currency options. This will be the first exchange-traded options in India on a non-equity underlying.
Currency options are obviously useful as a risk-management tool. I feel that futures are nice simple linear contracts: they ask the person to make only one decision — are you long or are you short. But once a futures position is entered into, the person needs the ability to manage the position since daily marking-to-market is done, and since there can be large losses for either the futures long or the futures short.
Compared with this, long positions on call or put options appeal to the kind of person that is willing to think carefully about a position at the outset, but after that it is fire and forget. This better describes the life of many firms exposed to currency risk, particularly those with relatively weak treasuries.
Currency options have, of course, been traded OTC for some time now. But there are real problems with this market. Customers have sometimes been ripped off by banks on pricing, given the lack of a liquid and transparent comparison point. While currency options are offered by banks to customers, there is not much by way of an inter-bank market.
As far as I know, there is relatively little by way of a build-up of human and systems capability in the banks for currency options trading (whether OTC or on exchange).
In contrast, there is a remarkable build-up of human and systems capability in the world of Nifty options trading. Options on Nifty have shaped up as one of the biggest options markets in the world. This involves end-users who think and trade options, staff working for securities firms who understand options (and understand issues about their credit risk when their customer has an options position), analytical software systems, and (most importantly) algorithmic trading systems. Options trading inevitably involves trading in a large number of underlyings. Strong computer systems which are able to think about, and place orders in, all the underlyings at one shot are of essence in achieving option liquidity. Such capabilities are now found in the world of Nifty options, and are absent in banks or in the OTC currency options market.
It is fairly easy for a person trading Nifty options to move to trading currency options. Hence, the brainpower and systems that have made Nifty options one of the world’s top contracts will easily be able to move to currency options trading, and make it work. I expect that the securities firms who dominate Nifty options trading will now dominate currency options trading.
I think three kinds of stories will now kick in:
- Liquidity in currency options will fuel liquidity in currency futures, and vice versa. Corporate hedgers will be more interested in either, given that the other is also a possibility.
- Skills and systems from Nifty options will flow into currency options. Banks will be able to rapidly bulk up their options capabilities by recruiting from the world of Nifty options, and by purchasing the software systems that have sprung up in that space.
- Conversely, trading in both currency options and Nifty options will generate an increased business size for people who build knowledge and systems for options; it will also improve knowledge of options trading through an understanding and comparison of the nuances of two different underlyings. The number of FRM and PRM certified people in India will go up.
Of great interest will be the question of currency volatility. On one hand, the currency options market will generate an implied volatility for the currency, which will represent a market-based forecast for what future currency vol will be. This will be a big new piece of information which will inform macro policy and monetary policy, and thus diminish the extent to which we are flying blind in thinking about Indian macroeconomics. In recent years, RBI has mostly stayed off from foreign exchange trading in the currency market, so the volatility of the INR/USD is a true market volatility. If, in the future, RBI thinks that it wants to give subsidised currency risk management services to the private sector, one way in which it would be able to do that is to do `intervention’ on the currency options market so as to force down the implied vol of the market. I.e., RBI would sell ATM calls and ATM puts and thus drive down that price, and thus give cheaper risk management services to the market. This would represent the first operational intervention strategy for RBI through which it can pursue the goal of reducing volatility without distorting the INR/USD exchange rate. If RBI gets into actively trading the currency market again and trying to push the rupee into a de facto pegged exchange rate, we will see this clearly in the currency options market as a sharply reduced implied vol. 
By B.P.T., on October 29th, 2010
At 8:30 AM EDT, the Employment Cost Index for the third quarter of 2010 will be announced. The consensus is an increase of 0.5%, which is the same as the second quarter of 2010.
Also at 8:30 AM EDT, the advance GDP report for the second quarter of 2010 will be announced. The consensus is an increase of 2.0% in real GDP and an increase of 2.0% in the GDP price index. The real GDP estimate is slightly higher than the final estimate for the previous quarter, and these levels indicate moderate economic growth.
At 9:45 AM EDT, the Chicago PMI Index for October will be announced. The consensus index value is 57.6, which is 2.8 points lower than last month, but is still well above the break-even level at 50.
At 9:55 AM EDT, Consumer Sentiment for the second half of October will be announced. The consensus is that the index will be at 68, which is 0.1 points higher than the value reported in the first half of the month.
At 3:00 PM EDT, the Farm Prices report for September will be released, giving investors and economists an indication of the direction of food prices in the coming months.
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