Dsquared on Political Event Swaps

Commenter dsquared has made a couple of good points in response to my post about political event swaps.

Firstly, the specific example I gave, where ADM tries to hedge the risk of corn subsidies falling, is not great. Part of the reasons is that there's a clear capital-markets correlation, in ADM shares -- which means that the hedge fund taking on the risk would itself hedge that risk by going short ADM. And it's not clear that ADM would want to buy an insurance contract from a firm which was shorting its stock. (On the other hand, companies regularly issue convertible bonds, which are almost always hedged with a short stock position, so it's hardly unthinkable.)

There's a pat answer to this question, which is "OK, just replace ADM with Cargill". But it's a weak answer, because a hedge fund could still hedge a political event swap with Cargill by going short ADM. In other words, the trade is not as uncorrelated to the market as all that, and a hedge fund wanting to take on this kind of risk could conceivably replicate it by selling out-of-the-money puts on ADM.

On the other hand, there are many more situations where a company might want to hedge some kind of political event risk which could cost it money without necessarily having such a clear effect on its share price. Maybe an accountancy firm or a private-banking operation would want to hedge against the estate tax being abolished, thereby depriving it of income from tax-planning services. And indeed, once there was a market in estate-tax-abolition futures or the like, individuals with large estates could even start to hedge their own future tax liabilities. And there's no market proxy for a rich individual's after-tax inheritance.

Dsquared makes another point: that hedge funds holding these kind of contracts might become lobbyists, which is "not obviously a sensible thing to do". To which I say firstly that there are a few hedge funds which already are lobbyists. And, secondly, that if a real market develops in these things, then that market's liquidity might start to replace lobbying expenditures. But that, admittedly, is a very long way in the future.

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