The Taylor Rule and Financial Derivatives: The Case of Options

Abstract

Modern macroeconomics considers the role of financial assets when modelling the behaviour of agents, policy implementing and transmission mechanisms. Financial innovation emerges in markets and exploits new opportunities, giving rise to (new) profits. The most significant financial innovations of the last thirty years have been in the area of derivatives (futures, options, swaps and forwards). The amount of derivatives trading is steadily growing on both exchange traded (ET) markets and OTC, and it is this growth that accounts for the present interest in these areas. According to BIS data, the ratio between the notional amount outstanding of derivatives (exchange traded and OTC) and world GDP was equal to 3.73 in 2001 and to 6.68 in 2004. Options are by far the most common derivatives contracts in ET markets. The role of derivatives in asset pricing is widely known and accepted. Here I shall start from their economic functions (leverage, substitutability, hedging) (Savona, 2003) in order to conduct further macroeconomic analysis.

I wish to thank Rocco Ciciretti, Domenico Cuoco, Giorgio Di Giorgio, Salvatore Nisticò, Alberto Petrucci, Paolo Savona, and Carlo Viviani for their very useful comments. My special thanks go to Cristiano Zazzara for his valuable help. This research has been developed during a visiting period at the Dept. of Finance, Wharton School, University of Pennsylvania, Spring 2005, and presented at the Dept. of Economics of Luiss Guido Carli University in May 2005 and at the International Conference on Keynesian Legacy, at the University of Cassino in September 2005.