May 16, 2014

Tail-Wagging-the-Dog | Structured Products Edition

A recent article in Risk Magazine (subs required) reports that banks traders are allegedly taking large positions in derivatives markets in order to move underlying spot markets just before structured products pay out to clients.

The notion that derivatives markets drive the underlying spot prices, and not vice versa, is colloquially known as the "tail-wagging-the-dog". The validity of this phenomenon has been debated in the press for many years, as this New York Times article from 1982 goes to show. As far as academic literature on the subject is concerned, the jury's still out. I have chosen two relatively recent papers on the topic to illustrate the level of disagreement. According to a 2007 BIS paper, "the information share of the … [German Bond] future is considerably higher than that of the underlying bonds." However, according to a 2009 International Journal of Business and Management paper, "there is no consensus among the empirical studies on the direction of information flow between the stock and option markets … there is surprisingly little direct evidence that new information is reflected in option prices before stock prices". 

The tail-wagging-the-dog effect is a sensitive point for futures and options exchanges, which are occasionally blamed for causing a material effect on spot prices. One such incident occurred in 2011, when CME raised their margin requirements for silver futures and spot prices subsequently fell sharply. This clip from Bloomberg News (posted on CME's website) shows a Bloomberg presenter sparring with the managing director for CME Group Metals over the cause of the price drop.

What's your opinion on the tail-wagging-the-dog phenomenon? Please post your comments and continue the debate!

-Ben L.

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