Tuesday, 18 May 2010

From Bonds to Bond? Investing in film futures

I premise my following comments with a caveat: I am not much of an expert on the economics of futures, derivatives, hedges and the like. Stocks and bonds have provided enough excitement for me over the last few years; I leave the more exotic stuff to experts, the likes of AIG and Lehman Brothers.

Against that backdrop, an item in the April 24 issue of The Economist, entitled "Box-offce futures: Land of the Lost", caught my eye. The article discusses the approval that has been given by the U.S. Commodity Futures Trading Commisison (CFTC) for two exchanges (one to be administered by Cantor Fitzgerald, the other by Media Derivatives) that would allow trading in contracts that are based on the box-office take from films. The second of these exchanges was approved by the CFTC on April 20.

The appearance of these exchanges can be seen in the light of a perceived problem in Hollywood about how to better to spread risk. It seems to be that, akin to judicial notice, Hollywood has for a long time tended to rely on a small number of box-office hits to both cover the losses incurred by the majority of films, as well as to provide a net overall profit for the studio. This business dynamic, risky in its own right, has been exacerbated by the economic meltdown of recent years. Individual investors have not flocked back to finance films. As well, independent film makers (apparently being other than the six major studios) are finding it much more difficult to sell in advance rights to sums received from foreign box-offices. This appears to have been their preferred means in the past for funding their pictures. But this funding window is much more narrow these days.

However, while the exchanges have been approved, no contracts have been traded and the studios are actively engaged in stopping the exchanges dead in their tracks, both directly and through Congress. As such, they have ramped up their lobbying activities agains the operation of the exchanges. As for getting Congress to focus to enact a legislative ban against box-office futures, one needs to ask how successfully this issue can be pushed in light of the broader Congressional program to reform regulation of the financial markets. Within Congress, opposition has brought together strange bedfellows, including Senator Barbara Boxer, a noted liberal senator from California (who is also, I think, involved in a reelection campaign that might include making nice to Hollywood), and noted conservative Senator Orrin Hatch from Utah.

Hollywood to the rescue?

What are the arguments against the operation of these exchanges? Let's mention several as discussed in the article:

1. Box-office figures are merely estimates and so, presumably, cannot be relied upon. Whatever the accuracy of this metric, still they must certainly be galaxies more precise than either the AAA bond ratings given in connection with subprime financial instruments or Greek fiscal data. On the other hand, one should not dismiss out of hand the impact of the uncertainty of the underlying metric in questioning the effectiveness, if not the very viability, of such an exchange. As Frank Knight taught us nearly a century ago, risk is one thing, uncertainty is quite another.

2. There is an information imbalance in the film business. A study carried out by Thomas Gruca of the University of Iowa found that there was an average error of 31% in predicting revenues. That said, there is a severe assymetry of information between the studios and other investors. As for the studios, they presumably have pre-screening insights gleaned, from contact group viewers, as well as knowledge about marketing plans and budgets and how the film will be rolled out. In the words of The Economist, "almost every trade by a studio would be an insider bet."

3. Studios would never short their own films via trades on the exchanges. The reason for this, as suggested by the article, is that Hollywood moguls can never be seen as somehow acting in a way that undercuts its own persona of success and power, much less affecting the possible commercial success of its films.

Assuming that the studios have their way and the exchanges never get off the ground. The question still remains: is there a better way for them to hedge their risk? Or is the old way also the new way for hedging risk? After all, events of the last three years have shown that one should exercise a healthy skepticism before adopting the latest offering of finanical innovation.

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