News Column

Patent Issued for System and Method for Creating and Trading a Digital Derivative Investment Instrument

August 9, 2014



By a News Reporter-Staff News Editor at Investment Weekly News -- According to news reporting originating from Alexandria, Virginia, by VerticalNews journalists, a patent by the inventor Shalen, Catherine T. (Chicago, IL), filed on October 7, 2009, was published online on July 22, 2014.

The assignee for this patent, patent number 8788381, is Chicago Board Options Exchange, Incorporated (Chicago, IL).

Reporters obtained the following quote from the background information supplied by the inventors: "Traditional derivatives contracts, such as futures and options contracts, are well known investment instruments. In a futures contract, for example, a buyer purchases the right to receive delivery of an underlying commodity or asset on a specified date in the future. Conversely, a seller agrees to deliver the commodity or asset to an agreed location on the specified date. Futures contracts originally developed in the trade of agricultural commodities. Large consumers of agricultural products seeking to secure their future supply of raw ingredients like corn, wheat and other commodities would pay in advance for guaranteed delivery in the future. Producers in turn would sell in advance to raise capital to finance the cost of production. The success of agricultural futures soon led to futures activity surrounding other commodities as well. Today futures contracts are traded on everything from pork bellies to memory chips, and from stock shares to market indices.

"Over the years futures contracts have evolved from simply a means of securing future delivery of a commodity into sophisticated investment instruments. Because futures contracts establish a price for the underlying commodity in advance of the date on which the commodity must be delivered, subsequent changes in the price of the underlying asset will inure to the benefit of one party and to the detriment of the other. If the price rises above the futures price, the seller is obligated to deliver the commodity at the lower agreed upon price. The buyer may then resell the received product at the higher market price to realize a profit. The seller in effect loses the difference between the futures contract price and the market price on the date the goods are delivered. Conversely if the price of the underlying commodity falls below the futures price, the seller can obtain the commodity at the lower market price for delivery to the buyer while retaining the higher futures price. In this case the seller realizes a profit in the amount of the difference between the current market price on the delivery date and the futures contract price. The buyer sees an equivalent loss.

"As the preceding discussion makes clear, futures contracts lend themselves to speculating in price movements of the underlying commodity. Investors may be interested in taking a 'long' position in a commodity, buying today at the present futures price for delivery in the future, in anticipation that prices for the commodity will rise prior to the delivery date. Conversely investors may wish to take a short position, agreeing to deliver the commodity on the delivery date at a price established today, in anticipation of falling prices.

"As futures contracts have evolved away from merely a mechanism for securing future delivery of a commodity into sophisticated investment instruments, they have become more and more abstracted from the underlying assets on which they are based. Whereas futures contracts originally required actual delivery of the underlying commodity on the specified delivery date, today's futures contracts do not necessarily require assets to change hands. Instead, futures contracts may be settled in cash. Rather than delivering the underlying asset, cash settlement requires that the difference between the market price on the delivery date and the contract price be paid by one investor to the other, depending on which direction the market price has moved. If the prevailing market price is higher than the contract price, the investor who has taken a short position in the futures contract must pay the difference between the market price on the delivery date and the contract price to the long investor. Conversely, if the market price has fallen, the long investor must pay the difference between the contract price and the market price to the short investor in order to settle the contract.

"Cash settlement allows further abstraction of futures contracts away from physical commodities or discrete units of an asset such as stock shares. Today futures contracts are traded on such abstract concepts as market indices and interest rates. Futures contracts on market indices are a prime example of the level of abstraction futures contracts have attained. Delivery of the underlying asset is impossible for a futures contract based on a market index such as the S&P 500. No such asset exists. However, cash settlement allows futures contracts to be written which allow investors to take positions relative to future movements in the value of an index, or other variable market indicators. A futures price is established based on a target value of the index on a specified 'delivery' date. The difference between the target value price and the actual value of the index (often multiplied by a specified multiplier) is exchanged between the long and short investors in order to settle the contract. Traditionally, cash settlement occurs on the last day of trading for a particular contract. Thus, if the actual value of the index rises above the target value, the short investor must pay to the long investor an amount equal to the difference between the actual value and the target value times the specified multiplier. Conversely if the actual index value falls below the target value, the long investor must pay to the short investor the difference between the actual value and the target value multiplied by the multiplier.

"The value of traditional futures contracts is inherently tied to the market price or value of the underlying asset and the agreed upon settlement price. The market value of the underlying asset itself, however, may be influenced by any number of external factors. For example, the amount of rainfall in Iowa in June could affect the value of corn futures for September delivery. The latest national productivity report may have a positive or negative impact on S&P 500 futures. If the share price of a particular company reaches a certain value, it may impact the price investors are willing to pay for futures based on that company's shares. The factors that influence the value of traditional futures contracts may also have an impact on other investments and assets. For example, if the share price of a market leader in a certain economic sector were to reach a certain value, it may signal to investors that the whole sector is poised for significant growth and may pull up the share price of other companies in the same sector. Likewise, an unexpected change in interest rates by the Federal Reserve may affect share prices broadly throughout the capital markets.

"When investors wish to take positions based on the occurrence or non-occurrence of various contingent events that may have broad impact across any number of individual investments, they may take a number of positions in various investments that the investor believes will all be affected in the same way by the occurrence or non-occurrence of a specific event. A problem with this approach is that the individual investments in which the investor takes a position may be influenced by factors other than the occurrence or non-occurrence of the specified event. Further, each individual investment may be affected differently by the occurrence or non-occurrence of the specified event. Thus, the investor may not be able to fully isolate the economic impact that the occurrence or non-occurrence of a specified event may have, and directly invest in what he or she perceives to be the likely outcome of the event."

In addition to obtaining background information on this patent, VerticalNews editors also obtained the inventor's summary information for this patent: "In order to provide for investing based on the occurrence or non-occurrence of certain events, methods for creating and trading derivative contracts, as well as methods and systems for trading such contracts on an exchange, such as a parimutuel exchange, are disclosed. A digital options contract is an investment instrument in which investors can take risk positions based on the probable occurrence or non-occurrence of an event. In exchange for receiving a predetermined premium price from the long investor, a short investor in a digital option contract agrees to pay one of two specified settlement amounts to the long investor depending on the state of a binary variable at the expiration of the contract. If the binary variable does not occur, the short investor keeps the option price. However, if the binary variable does occur, the short investor pays the amount specified in the contract to the long investor. Typically the settlement amounts will be $0 and some other value greater than the digital option price. Thus, if the state of the binary variable is a first value, the short investor pays nothing to the long investor, and if the binary variable is a second value, the short investor pays the second amount less the option price.

"One method of creating a financial instrument includes establishing a credit event identification scheme that includes a plurality of credit event categories, where an entity's credit event status is associated with at least one of the credit event categories. The method further includes establishing a digital derivative contract based on the entity and having a premium in which an investor will receive one of a first settlement amount when the entity is assigned a credit event status or a second settlement amount when the entity is not assigned the credit event status. The digital derivative contract is settled according to whether the credit event status is assigned to the entity or not assigned to the entity.

"Another method of creating a financial instrument includes establishing a derivative contract based on an entity and having a premium. The premium is amortized as a periodic premium payment until either a predefined event or a redemption in the debt of the entity is confirmed, or until the expiration of the contract if no predefined event or a redemption is confirmed before expiration.

"Other systems, methods, features and advantages of the invention will be, or will become, apparent to one with skill in the art upon examination of the following figures and detailed description. It is intended that all such additional systems, methods, features and advantages be included within this description, be within the scope of the invention, and be protected by the appended claims."

For more information, see this patent: Shalen, Catherine T.. System and Method for Creating and Trading a Digital Derivative Investment Instrument. U.S. Patent Number 8788381, filed October 7, 2009, and published online on July 22, 2014. Patent URL: http://patft.uspto.gov/netacgi/nph-Parser?Sect1=PTO1&Sect2=HITOFF&d=PALL&p=1&u=%2Fnetahtml%2FPTO%2Fsrchnum.htm&r=1&f=G&l=50&s1=8788381.PN.&OS=PN/8788381RS=PN/8788381

Keywords for this news article include: Finance and Investment, Investment and Finance, Chicago Board Options Exchange Incorporated.

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Source: Investment Weekly News


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