A Parimutuel Market Microstructure for Contingent Claims.docVIP

A Parimutuel Market Microstructure for Contingent Claims Trading By Jeffrey Lange* and Nicholas Economides** November 21, 2001 Abstract A parimutuel market microstructure for contingent claims trading is proposed and analyzed. A parimutuel microstructure is a call auction where relative equilibrium prices of contingent claims are endogenously determined using a specific mechanism. We propose a market microstructure incorporating parimutuel principles which provides for notional derivatives transactions, limit orders, and bundling of contingent claims across states. This microstructure will be used by Longitude Inc.’s clients to transact derivatives on economic statistics, weather, insurance losses and other types of risks. JPMorgan Chase and Deutsche Bank are some of the financial institutions that will be holding parimutuel auctions in early 2002. * Longitude Inc., (212) 468-8509, (212) 468-8509(fax), email: jlange@. www: /. ** Stern School of Business, New York University, (212) 998-0864, fax (212) 995-4218, email: neconomi@, www: /networks/. Acknowledgements: We would like to thank Ken Baron of Longitude, Darrell Duffie of Stanford University, and Michael Overton of the Courant Institute at NYU for providing critical insight and support.  Contents I. Introduction 3 II. Parimutuel Microstructure and Market Games 5 III. Parimutuel Microstructure for Contingent Claims Trading 13 A. Development of the Parimutuel Microstructure: Definitions 14 B. Parimutuel Equilibrium Pricing Conditions 17 C. Parimutuel Limit Order Book Equilibrium 20 1. Limit Order Book Equilibrium 21 2. An Example of Limit Order Book Equilibrium 23 III. Parimutuel Microstructure: Arbitrage and Efficiency Considerations 24 A. Risk Neutrality 25 B. Arbitrage-free Claims 26 C. Efficiency of Parimutuel Price Discovery 27 D. Price Uniqueness 28 E. Multilateral Order-Matching 29 F. Information Production 30 IV. Conclusion 31 Appendix I: Equilibrium Solution Techniques 33 Appendix II: Proof