Hedges: Concept and Pricing

Abstract

Let us consider a world in which a market in claims contingent on each possible reality existed.¹ The rational saver would, by transacting in this market, ensure that the expected marginal utility from income in each possible reality (combination of states of the world) was equal to its price (in terms of current consumption). Thus, in a world described wholly by the state-variables of belligerency (varying between the extremes of war and peace), economic activity (varying between slump and boom), and liquidity (varying between banking crisis and perfect liquidity), a particular individual may find that he has very little natural endowment in the combination of war, boom, and banking crisis. He would go into the market place and buy income contingent on war-boom-banking crisis in exchange for either present consumption or income contingent on other combinations.