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Economic Review

Economic Review
C O N T E N T S
First Quarter 2000/Volume 85, Number 1

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

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PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
B. FRANK KING
Vice President and
Associate Director of Research

THOMAS J. CUNNINGHAM
Vice President, Regional

GERALD P. DWYER JR.
Vice President, Financial

ELLIS W. TALLMAN
Assistant Vice President, Macropolicy

ROBERTO CHANG
Research Officer, Macropolicy

WILLIAM ROBERDS
Research Officer, Macropolicy

LARRY D. WALL
Research Officer, Financial

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

JOYCELYN TRIGG WOOLFOLK
Editor

LYNN H. FOLEY
Managing Editor

ELLEN TABER
Editorial Assistant

CAROLE L. STARKEY AND
CEDRIC MOHR
Designers

LYNNE ANSERVITZ
Marketing and Circulation

LINDA MUNDY AND
LISA LEE-FOGARTY
Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.

Material may be reprinted or abstracted if the Review and author are credited. Please provide the Bank's Public Affairs Department with a copy of any publication containing reprinted material.

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ISSN 0732-1813

A Primer and Assessment of Social Security Reform in Mexico

Recent projections of a number of countries with pay-as-you-go pension systems have shown significant future actuarial imbalances. As a consequence, several of these countries, including Mexico, are engaged in redesigning their pension systems.

From the U.S. perspective, Mexico's reform is of particular interest because of the similarities of its program to some proposals for the U.S. system. The Mexican government claims that it has started a move to a fully funded system. As proof, it points out that since 1997 Mexico has adopted a privately managed defined-contribution system. However, a pension system can be privately administered without being fully funded. It is the adoption of a fully funded system that would have the most significant macroeconomic effects in an economy: an increase in domestic savings and a drop in interest rates.

The authors of this article contend that after reviewing the new system, one cannot tell whether the government is switching to a fully funded system. They review some potential gains and losses of the change in style of the system. However, they argue that regardless of whether the reform is a change of style or substance, additional information is required to effectively assess its net gains. They conclude that Mexico is in dire need of further research to guide it through its decision of whether and how to switch to a fully funded pension system.


Issues in Hedging Options Positions
Saikat Nandi and Daniel F. Waggoner

Many financial institutions hold derivative securities in their portfolios, and frequently these securities need to be hedged for extended periods of time. Failure to hedge properly can expose an institution to sudden swings in the values of derivatives, such as options, resulting from large, unanticipated changes in the levels or volatilities of the underlying asset. Understanding the basic techniques employed for hedging derivative securities and their advantages and pitfalls is therefore of crucial importance.

This article examines the popular valuation model for options developed by Black and Scholes (1973) and Merton (1973). The model, while elegant from a theoretical perspective, is often fraught with problems when implemented in the real world. Nevertheless, because of its simplicity and tractability, the model is widely used by options traders and investors.

The authors consider ways that users try to circumvent some of these problems—for example, with certain ad hoc pricing rules. Using the Standard and Poor's 500 index options market, the authors compare the hedging efficacies of various models. Their findings suggest that ad hoc rules do not always result in better hedges than a very simple and internally consistent implementation of the Black-Scholes-Merton model.


Evidence on the Efficiency of Index Options Markets
Lucy F. Ackert and Yisong S. Tian

Index options have been one of the most successful of the many innovative financial instruments introduced over the last few decades, as their high trading volume indicates. Given their prominence, the pricing efficiency of these markets is of great importance.

Detecting inefficient pricing, or mispricing, requires comparing a theoretically efficient price with prices of options traded in financial markets. One popular approach to deriving pricing relationships is based on a principle called no-arbitrage, which simply assumes that arbitrageurs enter the market and quickly eliminate mispricing if a profit opportunity without risk exists. However, in a well-functioning economy there is no such opportunity; arbitrage is critical for ensuring market efficiency.

The authors analyze earlier evidence that has been taken to indicate that options markets are inefficient and that casts doubt on whether options markets contribute to price discovery, hedging, and efficient capital allocation. The article presents new evidence on index option pricing, examining arbitrage strategies that do not involve trading a stock index and relationships that hold for any given value of the underlying asset. This approach avoids some of the difficulties that can arise from impediments to arbitrage. The article also examines the efficiency of the market for the popular Standard and Poor's 500 index options. While the results indicate that these options are frequently mispriced, the mispricing may not indicate market inefficiency because there are limits to arbitrage.