LABOR INCOME INDEXES DESIGNED FOR USE IN CONTRACTS PROMOTING INCOME RISK MANAGEMENT

We propose that labor income indices be used to define settlements in many contracts, such as labor contracts, indexed bonds, or income secu rities. We discuss the issues in producing labor income indices for su ch uses, and develop prototype indices using U.S. data from the Panel Study of Income Dynamics (PSID). People are grouped by a clustering al gorithm based on an estimated transition matrix between jobs, by educa tion level, and by skill category. The groupings are defined so that f ew people move between them. For each grouping we generate a labor inc ome index (1968-87) using a hedonic repeated-measures regression metho d. The indices show substantial variability through time, confirming t he potential importance of the use of such indices in contracts. There is also substantial variability across groupings, as for example betw een the agriculture/labor grouping and other groupings, confirming the importance of using the grouping indices rather than aggregate indice s in contracts.