Average Absolute Return Financial Instrument for Market Risk Hedging
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Solution Overview
Problem
Existing financial instruments, such as VIX futures and variance swaps, are complex and expose users to significant risks due to their reliance on implied volatility, which can lead to losses during market turmoil, and are not easily understood by non-professional market participants, making them ineffective as hedges against market sell-offs.
Innovation Solution
The introduction of financial instruments based on average absolute returns (AR), which are designed to be more intuitive and less risky, with features like an Observation Cap to limit potential losses and a linear payoff structure, allowing for a futures product with minimal contract specification complexity, simulating options trading with both forward implied and realized components.
Engineering Contradictions & Design Principles
Engineering Contradiction Analysis
1Reliability
If volatility-related products like VIX futures and variance swaps are used to hedge against market sell-offs, then protection against market downturns is provided, but the complexity of the products and their reliance on implied volatility make them difficult to understand and manage for non-professional market participants
Solution Approach 1:
The patent changes the fundamental parameter from implied volatility to realized volatility measurement. By using average absolute returns as the settlement metric, the product transforms from a complex derivative based on option pricing models to a straightforward measurement of actual market movements, making it accessible to non-professional participants while maintaining hedging effectiveness
Solution Approach 2:
The patent extracts the essential hedging function from complex volatility products by isolating the core mechanism: paying out when actual market volatility occurs. This removes the unnecessary complexity of implied volatility calculations, option Greeks, and dynamic hedging requirements, leaving a clean, intuitive product structure
2Reliability
If products relying on strong negative correlation to the market are used as hedges, then protection during market sell-offs is attempted, but the timing decisions required expose users to losses due to common human psychology
Solution Approach 1:
The patent makes the hedging product self-activating by design. The average absolute returns mechanism automatically triggers payouts when market volatility occurs, eliminating the need for users to make timing decisions about when to buy or sell protection. The product serves itself by detecting market stress and providing coverage automatically
Solution Approach 2:
The patent structures the product to provide protection in advance through forward-starting contracts. Users can purchase protection that will automatically activate when market volatility reaches certain levels, removing the psychological burden of timing decisions while maintaining the benefit of having protection ready before market crashes occur
3Loss of information
If VIX index levels are used as a proxy for implied market forward volatility, then market anxiety can be measured, but the complexity of the VIX concept and its calculation make it difficult for market participants to understand and use effectively
Solution Approach 1:
The patent creates a simplified copy of the volatility measurement concept. Instead of using the complex VIX calculation based on option prices across multiple strikes and expirations, the patent uses a direct copy of actual market movements through average absolute returns. This preserves the essential information about market anxiety while eliminating the mathematical complexity
Solution Approach 2:
The patent inverts the approach to measuring volatility. Rather than calculating implied volatility from option prices (forward-looking), the patent uses realized volatility from actual price movements (backward-looking). This inversion simplifies the measurement while still providing valuable information about market conditions
4Reliability
If standard options strategies are used as insurance against market sell-offs, then protection is provided, but the expensive premium outlay and expiration cycle complications deter many market participants
Solution Approach 1:
The patent changes the settlement parameter from binary option payoffs to continuous average absolute returns measurement. This transformation allows for more flexible pricing and eliminates the waste associated with options expiring worthless, as the average returns mechanism captures volatility even when individual options do not reach their strike prices
Solution Approach 2:
The patent uses partial action by measuring only the average absolute returns over the observation period rather than requiring full option payoff structures. This partial measurement approach reduces the premium cost while still providing effective hedging coverage, making the product accessible to more market participants
Data Source
AI summary
A financial instrument exchange, system and method based upon the intensity of an underlying index. The instrument having a predetermined formula for a settlement price based at least in part on the formula:AR=[1N∑j=1Nrj]×Cwhere: N=a number of total observation periods; C=a constant multiplier; and rj=a capped absolute period return calculated using the formula:rj=min(d,|xj|);where: d=a contract period observation cap; and xj=a period return based on a formula of the group consisting of:xj=ln(IjIj-1);andxj=(IjIj-1)-1;where: Ij=a reference index reported price/level j observation periods after an initial observation date/time. The periods can variable and measured in days, weeks, months, quarters and years. The instrument is traded at a market-determined price from creation through the date of expiration.