Let's Talk About Binary Derivatives Part Two: Event Derivatives

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...Continued From Part One...

Speculating On Events
The notion of speculating on the outcome of important events is nothingnew. Sports gamblers do it en masse every Super Bowl Sunday. Traders doit whenever they take a position prior to anearnings call or a Federal Reserve announcement.Unfortunately,most of the products that we use to speculate on these major events have onlya loose correlation to the event itself.

For example, many tradersspeculate on changes in the CPI by takingpositions in government bonds or broad stock market indexes. But whatif there was a way to cut out the middleman and trade the CPI itself? Now there is.

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The Dawn of Event Derivatives
While many groups (such as DARPA) have toyed with creating event-based derivatives for years, the ball didn't really start rolling until the Futures IndustryAssociation (FIA) conference in 2005.

In a strange twist of fate, two separate exchanges took advantage of that conference to announce their intentions to bring eventderivatives to the masses. The Philadelphia Stock Exchange (PHLX) and online newcomer HedgeStreet both promised to usher in an age of binary event derivatives. However, in the two years since that conference, neither PHLX nor HedgeStreet has been able to significantly deliver on their promises.

The Struggle For Liquidity
The first exchange to assume the event derivatives mantle was HedgeStreet. This online exchange specializes in binary event contracts known as "hedgelets." Unfortunately, the unique nature of their product line has proven to be a major liability, when it comes to providing liquidity. HedgeStreet has been unable to attract enough market makers to provide deep and liquid markets in their event products. As a result, the bid/ask spreads in their hedgelets are far too wide to be of use to any serious trader.

Many observers hoped that the CBOE's investment in Hedgestreet back in 2006 would  solve their liquidity problem. Unfortunately, that didn't turn out to be the case. Although it held a great deal of promise, the CBOE/Hedgestreet partnership hasn't produced any significant developments in the event derivatives arena.

But Hedgestreet hasn't thrown in the towel just yet. A new CEO, along with a significant investment from Susquehanna Investment Group, may be just the thing to push event derivatives into the mainstream. Susquehanna has a great deal of experience as a derivatives specialist. This specialist experience may finally allow Hedgestreet to offer tight and liquid markets in their core event products.

...To Be Continued in Part Three
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