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REAL (INFLATION ADJUSTED) DERIVATIES
June 5, 2017
Real Return Methodologies System (RRM) &
Derivatives (Futures, Options, Swaps)
As market acceptance of real return securities, that is, securities that adjust for inflation, grows there will be a need for derivative contracts to facilitate risk transference. Issuers of inflation-indexed securities who do not have a natural hedge in their businesses will wish to transfer risk into derivative contracts.
Traditional derivatives include exchange-traded futures contracts, exchange-traded option contracts, and forwards and options that are not traded on an exchange. The advantage of trading on an exchange is that it supports a liquid secondary market. Forward contracts and non-exchange options have the advantage of allowing for full customization, while being illiquid.
Futures contracts have traded in the U.S. since the mid-1800s and are actively traded today on many underlying commodities, currencies, and financial instruments and interest rates. Futures contracts have also traded such other disparate other things as an inflation index, freight rates, and weather-related measures.
An underlying RRM instrument for a futures contract requires use of our patent(s) to calculate prices, and computers are used by the clearing house to match orders, perform reporting functions, billing, margin calculations and delivery notification for contracts not cash-settled. Futures contracts using RRM technology will have as their underlying instrument an actual or notional RRM security or portfolio of RRM securities.
Long and short futures contract positions will trade on one or both of a physical exchange or electronically. The exchange clearing house will have to communicate with our computer or perform the calculations under license on their computers. Trading can be done in nominal dollars or real, fully-inflation-indexed dollars. In both cases computers will be needed to perform the calculations necessary to convert between real and nominal dollars. Contract settlement of necessity will be in nominal dollars.
Computers will be required to access data from us or to license software to run on the exchange clearing house’s computers.
In addition to contracts on RRM financial instruments and portfolios, real price contracts on other futures and commodity contracts may be traded. Other futures can be traded under real dollar pricing also. For example, a currency can be traded in real dollars, and at settlement either delivery be made or settlement payment be made in nominal dollars. Again RRM technology will be required to perform the computerized calculations.
Option contracts on RRM-based futures contracts will require computer links to us and/or to be licensed. These options on futures contracts, like other options on futures, will be for one long or short futures position if exercised, at a futures entry price equal to the option strike price.
Exchange traded options on RRM financial instruments—analogous to exchange traded options of shares of corporate stock—will require computers to calculate the conversion from real dollars to nominal and from nominal dollars to real. Exchange traded options on real value currencies will similarly require RRM technology and data links.
Variations of exchange put and call options—so-called “exotic options”—will require use of RRM technology and computer data links.
Options that are exercised will require conversion between real and nominal dollars. For example, an option to buy or sell an item for a strike price of 100 real, fully-inflation-indexed dollars will have to be converted into equivalent nominal dollars on the exercise date.
Options for real, fully-inflation-indexed currency transactions will require that for both country A and country B the real, fully-inflation-indexed currency will have to be calculated by computer and the equivalent nominal currencies exchanged.
Forward Contracts and Over-the-Counter Option Contracts
Forward contracts and over-the-counter option contracts are not traded on exchanges. They are customized contracts between the counterparties and thus lack liquidity. They will also require the use of patented RRM-based technology and computer links and/or licensed software.
Swap Contracts Using RRM-based Patented Technology
Swap contracts are between two counterparties who exchange (usually just) notional principal amounts of some specified item, financial or otherwise. Swaps may be designed to exchange real interest payments in a single currency, where one stream of payments is on a money market, short-term funds basis (usually at floating LIBOR rate) and the counter party’s payment stream is on a longer term note or bond market basis. Such a simple swap is termed a “plain vanilla” swap deal. Computer calculations will be required to calculate the net real payment for each payment interval, and for the re-exchange of principal at the swaps termination.
Swaps for real (that is fully inflation adjusted) currency exchange will develop to fill market need. These can include swaps that use one or more currencies, interbank forward currency contracts, and issues of sovereign states and international agencies.
A real currency swap may be set up according to any rationale for exchanging a stream of real payments in country A’s currency for counterparty real payments stream in country B’s currency. A common rationale for a real currency swap will be to exchange real loan repayment streams.
Currency contracts based on RRM patented technology will be less risky than nominal currency contracts. The reason for this is that currency exchange rates respond to differences in inflation rates between nations. RRM patented technology eliminates the inflation effects between currencies and thus stabilizes the exchange rates in real, inflation-adjusted terms. The logic of this assertion is supported by the widely known Fisher and International Fisher effects in financial economics.
RRM patented technology will have to be used on swap dealers’ computers, and via data links to us to perform the bookkeeping and billing services that the dealer (usually a large bank) performs for nominal rate and nominal currency swaps.
 Commercial real estate has a natural hedge in the sense that rents tend to rise as inflation in general rises. This means that cash outflows that increase as inflation rises will be compensated by rents that rise. There may be a lag, but in general rents will rise in reasonable synchrony with debt service cash outflows.