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Hedging the Art Market: Creating Art Derivatives

A number of inefficiencies in the art market stress the fact that art remains a highly risky investment. The art market is characterized by high illiquidity, inefficient market information, high transaction costs, long transaction time and the absence of a hedging mechanism. Therefore, unlike investments in other sectors, investors cannot calculate the risk and return profile of art. More importantly, this currently makes it very difficult to hedge, or protect against possible losses. Applying a hedging strategy to art will bring the liquidity and regulation needed as well as stimulate future investment. This dissertation will explore the opportunity for derivative products in art. In order to create a 'true' hedge for art, derivatives with art as the 'underlying' should be developed. I propose a model for a total return art swap which will allow investors to protect themselves against movements in the art market. The need for tradable art indexes, which are crucial for the successful creation of art derivatives, will also be discussed. These aims will be achieved by exploring the recent emergence of property derivatives due to its marked resemblance as an asset class. In my study, I find that art derivatives have enormous market potential. They can bring liquidity and efficiency to the market and provide numerous benefits to investors. These potential benefits include removing the high transaction costs associated with art purchases, limited start-up cost with a low financial commitment, customized transactions and quick executions. A discussion surrounding derivatives is particularly relevant amid the recent financial turmoil since investors are reminded of the advantages of hedging. Art derivatives can revolutionize the art market by offering a simpler and easier way to manage the risk and return of art. My hope is that this paper will begin a debate among the worlds of art and finance on the advantages of creating art derivatives.