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How Markets Use Information To Set Prices
The Use of Contingent Contracts
http://economics.about.com/cs/finance/a/pricing_info.htm
By Mike Moffatt, About.com

Markets, when they operate efficiently, can provide a great deal of information on the beliefs of the people who participate in that market. Prices, and changes in prices, convey a lot of information on what traders think is currently happening and what they believe will happen in the future. To see how this works, we’ll look the at the pricing of a simple asset known as a  contingent contract .

A contingent contract in finance generally refers to a contract in which the amount of money one agent pays to another in the future will differ depending on the realization of some future event. A simple example of a contingent contract would be a contract which gave the bearer of that contract nothing if it rains next Thursday but one dollar if it does not rain.

These kinds of contracts are more common than you might believe at first glance. A farmer’s crop may depend rather heavily or whether or not it rains. If it does rain, he has a healthy crop which he can sell on the market. If it does not rain the crop will be ruined and the farmer will having nothing.

The farmer can minimize this risk by buying many of these contingent contracts. If the farmer buys the contingent contracts and it does not rain, his crop will be worthless but he will get $1 for each contract he holds. Of course, if it does rain his crop will be valuable, but he’ll also have paid money for contingent contracts which are now worthless.

If the farmer buys enough of the contracts, he can insure that he receives the same amount of money no matter what the weather does. This sort of risk-minimization is known as hedging and is used quite frequently, particularly in finance.

From an informational standpoint, contingent contracts (also known as  contingent claims ) are very nice because they tell how likely the market thinks some event will happen. Suppose our $1 if it doesn’t rain and $0 if it does rain contingent contract is selling for 70 cents.

This implies that the market believes that there is a 70% chance it will not rain and a 30% chance that it will. This is because we believe that 70% of the time the contingent contract will be worth $1 and 30% of the time the contingent contract will be worth nothing. So on average, we’d expect the contingent contract to be worth 70 cents.

Now suppose a number of people in the  rain  market got a new piece of information (say satellite photos) and now believed that the chance of it not raining on Thursday is now 90%. This would cause them to value the contract at 90 cents, but the price is currently at 70 cents.

So they would buy these contingent contracts as they’d expect to make 20 cents on average. The increase in demand for the contracts will cause the price to rise and if enough people in the market believed the chance of a lack of precipitation was 90%, we’d expect to see the value of the contingent contract to rise to 90 cents.

To see a good example of price changes and contingent contracts, we’ll look at the world of baseball.

While often used for serious purposes, contingent contracts can also be used as a form of entertainment. An Irish based website named TradeSports.com allows people to gamble on sports events using contingent contracts as a basis. You can buy contracts on all sorts of events, from who will win tomorrow’s Blue Jays vs. Red Sox game to who will win the next Superbowl.

The contingent contracts work in a similar fashion as the one in the previous section. If you buy a $1 Blue Jay contingent contract and the Blue Jays win you get $1 but if they do not win the contract pays nothing. At the time of writing, the last trade price of the Tiger Woods contract for the 2003 British Open was 22 cents, meaning that the market believes that Tiger has a 22% chance of winning the tournament.

How Markets Use Information To Set Prices
The Use of Contingent Contracts
http://economics.about.com/cs/finance/a/pricing_info.htm
By Mike Moffatt, About.com

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Housing Starts/Building Permits   chart icon CHART

Privately-owned housing starts in September 2008 were at a seasonally adjusted annual rate of 817,000. This is 6.3 percent below the revised August 2008 estimate of 872,000.

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Manufacturing and Trade Inventories and Sales   chart icon CHART
U.S. total business sales for August were $1,192.3 billion, down 1.8% from last month. Month-end inventories were $1,511.8 billion, up 0.3% from last month.

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Advance Monthly Sales for Retail and Food Services   chart icon CHART

U.S. retail and food service sales for August reached $375.5 billion, a decrease of 1.2 percent from the previous month.

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U.S. International Trade in Goods and Services   chart icon CHART

The Nation’s international deficit in goods and services decreased to $59.1 billion in August from $61.3 billion (revised) in July, as imports decreased more than exports.

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Monthly Wholesale Trade: Sales and Inventories   chart icon CHART

August 2008 sales of merchant wholesalers were $404.9 billion, down 1.0 percent from last month. End-of-month inventories were $445.4 billion, up 0.8 percent from last month.

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Quarterly Financial Report – Retail Trade   chart icon CHART

After-tax profits for retail corporations with assets greater than $50 million averaged 2.3 cents per dollar of sales for the second quarter 2008, up 0.1 (+/- 0.1) cents from the average of 2.2 cents for the first quarter 2008.

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Manufacturers’ Shipments, Inventories, and Orders   chart icon CHART

New orders for manufactured goods in August decreased $18.6 billion or 4.0 percent to $444.4 billion.

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0.7
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Construction Spending   chart icon CHART

Total construction activity for August 2008 ($1,072.1 billion) was nearly the same as the revised July 2008 ($1,071.8 billion). Please see our web site for further details: http://www.census.gov/constructionspending

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New Home Sales   chart icon CHART

Sales of new one-family houses in August 2008 were at a seasonally adjusted annual rate of 460,000. This is 11.5% below the revised July 2008 estimate of 520,000.

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August 2008

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Advance Report on Durable Goods Manufacturers’ Shipments, Inventories, and Orders   chart icon CHART

New orders for manufactured durable goods in August decreased $9.9 billion or 4.5 percent to $208.5 billion.

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Quarterly Services Survey   chart icon CHART

U.S. Information sector revenue for the second quarter of 2008, not adjusted for seasonal variation, holiday or trading-day differences, or price changes, was $284.9 billion, an increase of 2.5 percent (+/- 0.5) from the first quarter of 2008.

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Quarterly Financial Report – Manufacturing, Mining and Trade   chart icon CHART

Manufacturing corporations’ seasonally adjusted after-tax profits averaged 6.1 cents per dollar of sales for the second quarter of 2008, down 1.1 (+/- 0.1) cents from the average of 7.2 cents for the first quarter of 2008.

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Housing Vacancies and Homeownership   chart icon CHART

Homeownership Rate (HR)
The homeownership rate at 68.1 percent for the current quarter was not statistically different from the second quarter 2007 rate (68.2 percent) or the rate last quarter (67.8 percent).

Rental Vacancy Rate (RVR)
National vacancy rates in the second quarter 2008 were 10.0 percent for rental housing, which was higher than the second quarter rate last year (9.5 percent), but was not statistically different from the rate last quarter (10.1 percent).

Homeowner Vacancy Rate (HVR)
For homeowner vacancies, the current rate (2.8 percent) was not statistically different from the second quarter 2007 rate (2.6 percent) or the rate last quarter (2.9 percent).

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A Beginner’s Guide to Economic Indicators
What are Economic Indicators?

By Mike Moffatt, About.com
See More About:

* economic indicators
* unemployment rate
* real gdp
* inflation rate

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Q: I’m constantly hearing about economic indicators in the news, but I’m never sure what they’re talking about. What are economic indicators and why are they important?

A: An economic indicator is simply any economic statistic, such as the unemployment rate, GDP, or the inflation rate, which indicate how well the economy is doing and how well the economy is going to do in the future. As shown in the article  How Markets Use Information To Set Prices  investors use all the information at their disposal to make decisions. If a set of economic indicators suggest that the economy is going to do better or worse in the future than they had previously expected, they may decide to change their investing strategy.

To understand economic indicators, we must understand the ways in which economic indicators differ. There are three major attributes each economic indicator has:

1. Relation to the Business Cycle / Economy
Economic Indicators can have one of three different relationships to the economy:

1. Procyclic: A procyclic (or procyclical) economic indicator is one that moves in the same direction as the economy. So if the economy is doing well, this number is usually increasing, whereas if we’re in a recession this indicator is decreasing. The Gross Domestic Product (GDP) is an example of a procyclic economic indicator.

2. Countercyclic: A countercyclic (or countercyclical) economic indicator is one that moves in the opposite direction as the economy. The unemployment rate gets larger as the economy gets worse so it is a countercyclic economic indicator.

3. Acyclic: An acyclic economic indicator is one that has no relation to the health of the economy and is generally of little use. The number of home runs the Montreal Expos hit in a year generally has no relationship to the health of the economy, so we could say it is an acyclic economic indicator.

2. Frequency of the Data

In most countries GDP figures are released quarterly (every three months) while the unemployment rate is released monthly. Some economic indicators, such as the Dow Jones Index, are available immediately and change every minute.

3. Timing

Economic Indicators can be leading, lagging, or coincident which indicates the timing of their changes relative to how the economy as a whole changes.

1. Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.

2. Lagged: A lagged economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.

3. Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

In the next section we will look at some economic indicators distributed by the U.S. Government.

Be Sure to Continue to Page 2

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