- Long Ringitts, SGD and Taiwanese dollars – all funded by USD.
- Sell pound-sterling against yen.
- Sell gold.
- Borrow in CAD, GBP, USD and buy BRL, RUB, CZK.
- Sell 10-year CAD bond futures and receive fixed on 10-year CHF swaps.
Friday, November 30, 2007
Tuesday, November 20, 2007
- Changes in Terms of Trade (= price of exports divided by price of imports) is a function of changing commodity prices (energy, industrial metals, agriculture, live stock).
- Extract sensitivity estimates (the coefficients in a regression) to predict terms of trade.
- Changes in Real Exchange Rates ( = price of one unit foreign currency in domestic currency * ratio of foreign and domestic price levels) is a function of two key parameters.
- Terms of Trade
- Relative productivity levels -- measured by, say, per-capita output per hour etc.,
My own guess is that there are three key parameters that affect the short term exchange rate fluctuations:
- Global capital flows -- that chase the second-order effects anticipated changes in terms of trade.
- Changes in US deficits (budgetary and trade) -- this is particularly accentuated by the coming US electoral-cycle.
- Idiosyncratic events -- particularly emerging market macroeconomic instabilities.
Friday, November 16, 2007
Standard Black Scholes pricing assumes a constant vol. The underlying implication being that the logarithm of the returns is normally distributed – and thus contained in it, a constant standard deviation (the constant volatility). In the market, there are other factors are play – such as supply/demand, risk-premia etc., -- all that contribute to, what Keynes memorably called “animal spirits” in the option pricing market. Typically, if the market expects a greater likelihood of the underlying exchange rate to go past the strike, the calls on the currency tends to get priced more expensively than the puts.
An option on call USD–CAD put refers to the call on the USD and the put on the CAD. So, the holder of the option has the right to buy the USD (convert the CAD notional at a prespecified rate). Equivalently, the holder of the option has the right to sell the CAD at a prespecified rate.
A spot price of 0.97, i.e., one USD can be exchanged for 0.97 CAD; with a strike of 1.01 on a call USD-CAD put refers to the right to buy one USD in exchange for 1.01 CAD. Tersely, the spot is 0.97 and the strike is 1.01 with a CAD-put. On the expiry date if the spot prices are 1.00, then the buyer of the call (with say 101 CAD in his account) would not exercise his option to buy a USD at 1.01 CAD when he can easily buy the same USD at 1.00 CAD. In this example, the USD is anticipated to appreciate. So, the call option on the USD-CAD is evidently ‘worth more” than a corresponding put option. i.e., if an appreciation is anticipated the corresponding call is priced at a higher level. This supply-demand forces are not a part of the Black Scholes derivation. Since, most parameters are fixed – the only “tweak-able” parameter is the vol – or the implied vol.
A 25-delta call refers to a call option where the strike above the spot (thus an out of the money option). So, in the above – it is clear that a 25-delta call has different implied vol than a 25-delta put. The “25” in the above refers to the fact if the underlying exchange rate increases by 1, the corresponding the call option value rises by 0.25. So, to arrive at a delta-hedge a corresponding position has to be taken in the underlying. The market convention of 25-delta is agreed upon – as one that is sufficient to capture the expectations regarding changing underlying prices. Of course, you can have 10-delta, 50-delta and so on.
A risk reversal is thus, the difference in implied vols between, ceteris paribus, out of the money calls and out of the money puts. Quoted thus, a rise in the risk-reversals means that as the currency appreciates, the volatilities are likely to rise. Instead, if risk-reversal are quoted as put – call. Then a rise in risk-reversal refers to the fact that as currency depreciates the vols are likely to rise.
A useful example of the trade flow is as follows: (courtesy gfmi.com)
Assume an appreciation of the USD against the CAD over the next 3 month period (mean-reversion??). 3-month 25 delta USD-CAD risk reversal of 0.15 -.28% at a vol of 8.5% means:
1. Buy the 25 delta USD call/CAD put at 8.65% and sell the USD put/CAD call at 8.5%. The trader shells out 0.15%. i.e., he is paying a skew-premium of 0.15% in anticipation of a USD rise.
2. Sell the 25 delta USD call/CAD put at 8.78% and buy the USD call/CAD put at 8.5%. The trader earns the .28% spread.
On option desks, rules of thumb Rule! So, to extract the implied skewness, it is pretty standard to (a) calculate the risk-reversal (b) calculate risk-reversal per-unit of ATM vol. Risk reversals.
The big challenge is what to do when appreciations have different vols than depreciations. If you know how to deal with that – then there is some money to be made and a heck-of-career to be had!
Wednesday, November 14, 2007
There is a whole lot of play in the financial press that claims the rising oil demands are due to (a) increased consumption by BRIC and EM (b) lack of refinery capacity (c) rising cost of production of crude in the Persian Gulf (d) geopolitical tensions etc., No doubt some, if not all of these forces are at play in the market.
However, it must be noted that the oil markets across the globe are quoted in USD. So, there is no doubt a linkage between crude, USD values. To think about this more visual, I have plotted the relationship here. Typical the Swiss franc is the defacto currency of choice, when global uncertainity rises. i.e., Investors tend to flock to the Swiss franc or Gold, when they assume the value of the USD is on a decline. I have used USD-CHF exchange rate along with Crude prices -- to arrive at the following. (Note correlation is not causation... but this is pretty interesting). A more formal analysis should control for risk-aversion (proxied by USD-CHF), growth in consumption etc.,
Nevertheless, on a trading floor -- I would be very surprised if the marginal gains from more sophisticated regression analysis are any better over a short period of time. In the long run, of course, more sophisticated analysis might reveal much -- but, by then the underlying structural parameters have changed...
In this simple case, fitting a simple straight line through the data points from 2006 onwards, we get the simple results. At a USD-CHF = 1, the crude prices are expected to be around 97.4. Today the Swiss Franc is around 1.123 and the crude (WTI Cushing) is quoted at 94.09.
Here is the key point. If one assumes that exchange rates tend to overshoot -- i.e., because of rigidities elsewhere in the economy (supply and demand of contracts done in the past), the fastest readjustments tend to happen in temporary misalignments of asset prices. So, if you think the USD-CHF has overshot in its depreciating trend, then one can make a plausible argument that the crude prices have shot through as well.
In essence, the tenuous (but I think, fairly justifiable) relationship is between global risk-aversion (vis-a-vis USD) and crude prices. If risk-aversion rises (i.e., USD appreciates) then crude prices must fall. If risk-aversion decreases, the crude prices must rise. If Jim O'Neill at Goldman is correct (rising capital flows into EM) -- I would read it as fall in risk-aversion.
Presumably then, Crude prices above 100 are to come soon; and ineluctably then the CAD is to rally again.
Monday, November 12, 2007
One area where the effects are demonstrably clear is the exchange rate. Rising investments in the TarSands coupled with rising commodity costs -- causes increased profitability of Canadian firms. The financial herd comes chasing the possibility of a superior return which puts an upward pressure on the CAD. On top, the speculative capital anticipating this upward pressure on the CAD follows through as well, hoping for a quick turn around before month end P&L numbers are issued. There is the obvious sense that the rising CAD affects other Canadian exports -- and to a reasonable degree this is true. However, the rising CAD affects, in the short term, only those purchases made on the margin (for eg., that extra software license from a Canadian firm for eg.,). However, the rising exchange rate over a two-three year period can and will distort the capital formation of the Canadian economy. New investments will divert itself from existing manufacturing base and move towards the paraphernalia required for the oil industry. It is of course critical to distinguish between the dying industries of Canada and the ones forced to close out due to the rising exchange rate. Perhaps, it might be possible to wean that information from the manufacturing data etc.,
My own sense is that that is seems the loonie has found a new home in the 1.05-1.10 USD range. But, this is only a resting point. Over the next six months -- as oil prices continue their climb upwards and US housing numbers deteriorate along with growth -- one should be surprised if the loonie kisses 1.15-1.20 USD.
If I were a Canadian firm earning USD six months, I would be buying some CAD forwards...
Wednesday, November 7, 2007
As per credit market data, the 5-year CDS for Argentina and Venezuela are trading at the same premium rates (around the band of 240bps). Over the past year and half, in order for you buy protection against the possibility of Venezuelan credit event on its loans as opposed to Argentina credit event – the spreads between the two have converged. This convergence in CDS spreads was caused by a greater confidence in Argentina and declining macroeconomic sentiments in Venezuela.
In fact, up until December 2006, Argentina’s spread seems to mimic the directionality of Venezuela’s spread movements. This tango, of sorts, meets an abrupt end in late December when Venezuela begins its nationalization of oil companies. Subsequently, the possibility of Venezuela pulling out of the IMF led to an increased spike in its premiums as well. The credit market fears in late summer led to a serious liquidity crunch (overnight rates climbed to 90%!!). Add to this political tomfoolery by Hugo Chavez (opposition arrests, indiscreet pressuring of central bank officials, closing of television stations etc.,). From a spread in July 2006, of 140bps on notional; today the spread is around 260bps – an approximate increase of 85%. All of this has occurred when oil prices were rampaging from around 55USD per barrel to the approximately 95USD per barrel. i.e., despite the filling of coffers in Venezuela, the credit markets were increasingly apprehensive of the possibility of “some” credit event, or even worsening of credit quality.
In contrast, Argentina has made gingerly adjustments to “normalcy”. This has come in the form of political stability, some swallowing of the bitter financial pill (staying out of the financial markets for a year after paying around 35 cents on the dollar for bonds – for 140bn., bonds!) thanks in part to Nestor Kirchners’ hard nosed bargaining, helped with generic boom in internal aggregate demand as opposed to aggregate global demand (13% of growth) etc., All this said, there is still uncertainty – most keenly evidenced by Argentines emigrating out to Spain, Canada and even Mexico. Unemployment rate has fallen to around 8.4%, inflation hovers around 8-9%. The real story is that year or year surplus has declined by around 60% compared to last year. (i.e., Spending increased. Is it me or do I see a relationship between government spending the election of Cristina Kirchner!)
In essence, the question is – who will the credit markets bet against! A loopy and statist petrocracy run by a junta or preternaturally prone to crises democracy. What has seemed obvious in the past few months is that – (a) every time Venezuela does something silly (claim to nationalize even more industries in the name of the people), the spreads have increased by 10bps or more, only for the rates to stay up there (b) the markets are willing to let Argentina have a pass, (Is it the democracy factor?) and has increasingly found itself comfortable with the non-Washington consensus based policies of the Kirchners. A subtle, but difficult to reason-out-completely-point, is that increasingly the largest holder of on-the-run Argentine bonds are the Venezuelans. So, in some sense, Argentine government spending is financed by the petrocrats in Caracas.
So, now what?
The primary bet are on the following events, and the subjective probabilities:
- Chavez goes to nationalize some more: About 40-60%
- Kirchner can’t control spending:
- Oil prices rally to 120USD in next six months About 45%
- Political turmoil in Venezuela
Over the next six months, I would bet on Venezuela’s spreads rising in the market – and the Argentine spreads trailing behind. So, sell Argentine protection and buy Venezuelan protection. It is imperative to note that in Argentina, one is dealing with credit risk that works its way through government finances. In contrast, in Venezuela one is dealing with “event” risk. So, in the strictest sense – it is not the same underlying propagating mechanism.
This is imperfect knowledge; and hence precisely more fun!
Monday, November 5, 2007
As of yesterday, the 3M TED spreads (for US, UK and Euro) have widened while the 6M TED spreads have reduced thee difference. In the short term, the market continues to price a worsening credit environment; while over the 6M period -- these spreads have declined, because the underlying trades are assumed to be liquid, well executed and easy to offload. In essence, the system is assumed to be working.
So, what to do if you believe that there is an extended stretch of trouble that the market is not pricing? i.e., Systemic crises is likely to worsen. You are then betting on the spreads to widen. Note that, TED = 3M Eurodollar - 3M Treasury. This can happen by Treasury yields falling, EuroDollar futures implied rates rising or both yields moving in opposite direction. Being pessimistic is equivalent to being long TED spreads, which equivalent to buying Treasury futures and short-selling Eurodollar futures.
If you are feeling optimistic about the economy at large, sell Treasury futures and buy Eurodollar futures...
As an aside, I read about Christian Siva-Jothy's monster trades post the first plane attack on 911, predictably he bet on yields on Eurodollars falling (and went long Eurodollar notes). I am not sure what the TED spreads did in those hours of 911... Any guesses?
- Housing shows up in the GDP accounting via employment generation. Price appreciation of houses is not part of GDP; and more importantly, increased land prices today if booked as an asset, a liability has to be entered. Where? Liabilities for future buyers. This is transfer of wealth from future generations to present generations!
- The stickiness of housing prices downwards means, most importantly, price cycles follow sales volume cycle. Also, the volatility of the housing volumes is much higher than the price.
- Sellers develop their expectations of prices from a backward perspective (“what did I pay for it compared to the offer price?”). Buyers have forward looking price expectations (“what will I get for the house 5 years from now”). So, sales only happen when there is a high bid price by sellers.
- In a housing boom, the fastest appreciation happens for small houses with low-income zip codes (and smaller square footage = condos and small homes). Predictably, during a bust – they get hit the most.
- To avoid business cycle fluctuations – one must avoid housing cycle fluctuations and job-losses in consumer durables.
- Monetary policy that acknowledges the two factors – must face up to the fact that if real interest rates fall temporarily, then for equilibrium level of housing stock will return to “normal”, only if production and sales fall and allow a return to the mean. In contrast, if real interest rates fall permanently, then equilibrium levels of housing stock will rise.
- Monetary policy that accounts for housing investment is a difficult inter-temporal resource allocation issue.
- Today, one observes the presence of weak housing starts (new houses being built) and increased inflation – resulting in a conflict for what the “right” policy prescription ought to be.
- In case of policy choices to be made between housing starts and inflation – there is no real conflict.
- The best predictor for Fed Funds rate is the 10-year Treasury bond yields.
- Its the Housing Cycle!
Sunday, November 4, 2007
- Conclusions can be drawn of effects of policy X, if there are control and treatment groups. In macroeconomics, we only have non-experimental data. So, we rely on “story-telling”.
- Monetary policy affects economy via housing-related decisions. Tempering business cycles means figuring out how housing-related choices are affected.
- Inflation is a “daily” phenomenon, while housing is reinforced by a “wave”.
- Monetary policy at different stages of the housing cycle – can exacerbate or diminish the extent of hurt that happens when a boom declines.
- Housing booms are very susceptible to interest rate changes at the end of the boom, rather than in the early and middle stages.
- Historically, the
economy has been growing at 3% over the past 30 years – despite all kinds of real, monetary and technological shocks. Monetary and fiscal policy must restrict itself to smoothening out the cycles (the amplitude and the frequency). US
- Contributions to long run growth are led by, in order of importance from a 2005 perspective, Consumer services, Non Durable Consumer Spending, Durable Consumer Spending, Equipment, State and Local Expenditure, Defense expenditure, Residences etc., i.e., Residences do not contribute substantively in long term growth.
- For business-cycle fluctuations, Residences are very important. Typically, Residences contribute to the weakness in GDP growth before the “recession” starts and contribute above normal before the “recession” ends. This is in contrast to equipment and software sales. i.e., Residential spending is a pro-cyclical predictor of GDP growth. Equipment sales just mirrors GDP growth rate.
- To address decline in GDP growth, one must address the “consumer” side of the equation and not the business side. So, Monetary policy must explicitly take into account Residential and Durables levels and volatilities.
- There have been 10
recessions. Only two were driven by “production” side (i.e., by lack of demand on the business side) – post-Korean war and 2000/01 internet bubble collapse. Rest of the recessions have been caused by lack of consumer demand. U.S.
- Housing prices are sticky downwards – i.e., prices don’t fall all that much. So, the natural way the market clears is by massive reduction in demand. This reduction is demand affects GDP/employment.
Tuesday, October 30, 2007
One, the 'best-ness' criterion is contingent on the information available. So, new information can cause a previous “best” estimate to be a second best or worst estimate. (An extreme example would be, in a non-financial context, American foreign policy on September 10’2001. The next day’s events – led to wildly different prescriptions than most academics/policy wonks had anticipated.) So, the quanta, quality and timing of information is the key.
Second, the estimate itself is a result of some estimating method – an algorithm, a formulae – that econometricians call “estimators”. In essence, it is not just information that is relevant – but the method in which you process the information. It is entirely feasible, and relatively easy to show, that even with the most recent information using a wrong estimator can result in (a) biased estimates (b) unbiased but highly inefficient (c) biased and highly inefficient estimates. By inefficient, one means estimators that contain within itself the possibility of generating widely variant results as the underlying sample increases in size.
As you can imagine, getting oneself tied up in some subtleties is something that many participants on Wall Street have little time for, or worse, just find it plain useless. One of the biggest games is undoubtedly, inspired no doubt by Whack-a-Mole journalism in American media, is watching the Fed’s decisions on rate cuts. (Things are sometimes so absurd that, as Alan Greenspan writes, there are guys dedicated to watching the size of Greenspan’s briefcase!)
The critical aspect is that the generic expectation is that the Fed will continue to accommodate and allow for a 4% rate over the next six months. i.e., 3/4 of a decrease in rates. Implicit in this expectation is
- Inflation, core or otherwise, will not be a problem. This, despite the clear trends to a 100$ barrel.
- The housing conditions will worsen -- i.e., when over 800billion USD worth mortgages are to be reset over the next two months -- expect a lot more defaults.
- The weakening dollar is not really something the Fed worries about. (How to reconcile rising import costs with its inflation hawkishness is a tricky question!)
Again, my thoughts are that the demand for non-USD denominated assets will continue.
Monday, October 29, 2007
Wednesday, October 24, 2007
Central banks (in the emerging markets) control over 5.6 TRILLION dollars of US denominated assets. There are estimates that more than 50% of the
In the FX markets, this diversification towards other asset classes and non-USD ‘majors’ is inevitably linked to a decline in the USD value. (one number thrown around is that around 1,200 billion USD is likely to move out of the dollar denominated assets!) I would very seriously look into buying global blue chips – since while still being “risky”, these will fit within the SWFs criterion of being “risky enough”. I would look seriously at global real estate – buy property in semi-industrialized nations.
The secret, I suspect, is to ride the coat-tails of the global central bank investment philosophy changes. The unspoken, unheard of elephant-in-the-room is the
In essence, I would not be surprised if 5 years from now, a Pulitzer prize winning non-fiction entry is solely geared to explaining the complexities and conspiracies that went behind the spectacular but ultimately unsuccessful management of the Dollar slide.
- Upfront Carry:
- For a 10-year receive fixed swap, the 1 year carry is the net present value of a 10-year swap less the net present value of a 9-year swap starting 1 year from now.
- Upfront roll-down:
- For a 10-year receive fixed swap, the 1 year roll-down is the net present value of a 10-year swap and less net present value of a 9-year swap today.
- Typical documentation will have carry and roll-down for various swap lengths: 1M, 2M, 3M and so on. So a 1 year carry can be provided as 0.45 $ per 100 $ of notional or some other dollar convention.
- Running Carry:
- the Upfront Carry divided by the PV01 of the forward starting 9-year swap.
- Running roll-down:
- the Upfront roll-down divided by the 9-year swap starting today.
- Actual Vol-adjusted Running Carry & Running Roll-down:
- 1Y Running Carry divided by the actual volatility of the 1Y rate over the past 1 year.
How to Read the Quotes:
- Notional Neutral Switch:
- Typically quoted as where one receives fixed for the shorter rate and pays fixed for the longer rate.
- If the expected carry and roll-down is 180bps on a 5s/30s – one should read this as follows. For an investor, who receives fixed on a 5 year swap 1mn notional and pays fixed on a 30 year swap 1mn notional -- expected profit is 180,000.
- Duration Neutral Switch:
- Typically quoted where one receives a short dated swap, and pays a long dated swap.
- The notionals can vary here – such that the durations cancel out.
- Quoted as 2bps on a 3s/4s/15s. Read this as expected roll-down and carry as pay fixed on the 3yr and the 15yr, and receive the 4yr fixed rate.
Tuesday, October 23, 2007
There has been much talk about risk aversion indices rising – indicating that investors are willing to hold to low yielding savings, cash or cash-equivalents instead of high yielding investments. In essence, as the Mafia says, investors have been hitting the mattresses.
Standard global indicator of risk aversion is the EURCHF – with the CHF being the currency of choice when currency investors are unsure of their immediate next move. So, any R.A.I must be correlated to EURCHF. The biggest puzzle however has been that volatility of the difference in returns between stocks and bonds is greater than the volatilities of consumption or t-bill yields. So, what could explain this? One conjecture has been that risk-aversion is a time-varying factor. i.e., Investors at different times in the business cycle demand different risk premia. This has been the thrust of research since at least Lucas (1978). So how to capture this number for risk aversion?
The generic modeling structure has been as follows:
- A fictional investor has a utility function with consumption as a variable and risk aversion and discount factor as constants.
- This investor has intertemporal budge constraint – where delayed gratification is the theme. i.e., decide to consume today or consume tomorrow by investing in risky asset.
- Maximize the expected utility subject to this constraint and arrive at equilibrium conditions for consumption, S&P 500 returns, t-bills returns and risk aversion parameters.
- The equilibrium conditions capture a fictitious state where marginal cost from investing today in risky asset is matched by the marginal benefit of consumption tomorrow.
- Assume t-bill returns and S&P 500 returns are normally distributed.
- Using market data for returns, using root-finding algorithms, solve for the discount factors and risk aversion.
For times of the year, solve for the risk aversion numbers. So, ideally as risk aversion numbers rise, one should observe the EUR-CHF to decrease (i.e., Swiss franc appreciates).
Following the mortgage backed securities which ended up as the underlying payment stream against whose stream of payments commercial paper was issued – prior to the credit crunch – there is a generic aversion today to getting deeply involved in that whole rigmarole again. But, innovation and profits are the life-blood and élan-vital of modern finance. So, bonds backed by microfinance lending are here to stay. Famous CLOs backed by loans to microfinance institutions who in turn lend to thousands of really poor individuals. For eg., see BlueOrchard. The exact fate of such CLOs, in wake of the credit crises, is unclear. Nevertheless, I suspect, this is an instrument that is here to stay.
A key issue here is what are the risks involved in such a setup. i.e., when does repayment risk amongst the really poor kick in. By and large, those individuals who qualify for microfinance are those whose income patterns are only marginally affected by business cycle fluctuations, unlike the middle class. In contrast, the real risk comes from weather extremes, failure in governmental subsidy programs etc., So the crash of the NASDAQ or the Sensex barely affects the villagers in
However, one interesting observation is that many of the borrowers borrow from various lenders. i.e., they might borrow from the microfinance initiative offered by ICICI Bank, by World Bank, by Bill & Melinda Gates Foundation etc. Naturally, this raises the issue of what are the likelihood of payments being made out. One my friend from college, Karuna Krishnaswamy, has written a pretty interesting paper on this phenomenon. He argues that those who end up borrowing from various sources – actually end up having a better payment record as opposed to the single source borrowers. The exact reason is conjectural, and I suspect, untraceable to a single factor.
For those who will eventually model these things, the level of complexity has been increased by an order of magnitude. Typical prepayment structures in the Mortgage world grapple with the issue of a single stream being pre-paid. In contrast, in the MFI backed bonds – any single borrower can decide to prepay one stream over the other!
Awesomely technical challenge!
Given the generic consensus at the G7, US Congress, Rest of the World barring for
1. The econometric evidence on the contributions exchange rates make on competitiveness, productivity investments and thus, trade surplus in
2. One estimate is that the Yuan is undervalued anywhere from 0-50%! Assuming it is 50%, and all other costs remain constant, a 50% revaluation (entirely unlike) will affect varying sectors of the economy differently. So, prices observed in the imports will change according to the demand elasticity for given price change. So, in the countries that import low-complexity Chinese commodities -- pencils, mousepads etc., -- there will be a substitution effect in display.
3. Standard trade theory predicts that as Yuan is revalued, the level and growth rate of the Chinese exports should decline. However, it is important to note that most international trade contracts are 6-12 months set in advance. So a container of toothpaste to be delivered at
4. What a Yuan revaluation does to non-USD currency majors – is very much contingent on the competition for products in domestic markets and in third-party markets.
5. The supply change management in place for goods to and from
6. All of the above assumes the Chinese will continue to produce as always. Then the improvements in the Yuan will provide the results
7. The most understudied aspect is that when the Chinese exports decline (and thus their income declines) – the effect on goods imported to
Now what? When revaluation happens, for a short while the USD will rise, Euro will fall against the USD and the Yen will rise as well (if the USDJPY tracking of 6M USDCNY forwards are to be trusted!).
But, in the intermediate term after the revaluation we will be back here -- singing the same tune.
Monday, October 22, 2007
In the picture above, I have plotted three weighted indices against the
- Major Currencies: The indices in pink are a weighted average of Euro, CAD, YEN, GBP, CHF, AUD, SKK.
- Other Important Trading Partners: The indices in yellow are a weighted average of China, Mexico, Korea, Taiwan, HK, Malaysia, Singapore, BRL, Thai, India, Philippines, Israel, Indonesia, Russia, Saudi Arabia, Chile, Argentina, Colombia, Venezuela.
- Broad: The indices in blue are the entire basket of the two.
These countries have been selected as those that have more than ½ % in 2003 in either exports or imports. The first group (pink) is those currencies that are traded extensively outside their domicile. The second group isn’t traded extensively outside their own markets.
What is most amazing in these numbers is the presence of clear volatility regimes in place. The daily standard deviation of these indices are given here:
2nd Jan ’07 to 16th Mar ‘07
19th Mar ’07 to 19th Jun ‘07
20th Jun’07 to 19th Oct ‘07
- The credit-induced crises of confidence have led to increased volatility in the FX markets.
- The broad reaction has been – flight to safety. i.e., with respect to the Major currencies, the USD has been a “risky” holding. However with respect to the OITP, the USD depreciation has been lesser than expected – partly because the USD continues to be seen, on average, as a “safe” currency.
- The OITP depreciation masks wide variation – where
Venezuelahas done substantially differently than against USD. India
- Coupled with G7 consensus that Asian currencies should be “allowed” to get stronger – the OITP will be where the most diverse kind of action will be.
The coming revaluation of the yuan will make this a really interesting group to think about. Need to think about this a bit more.
Sunday, October 21, 2007
This is a season of the “immigrant” as a piñata for the sons of the soil.
Although I didn’t agree with
With regards to illegal immigrants, research has been sparse -- although an
With regards to illegal immigrants, research has been sparse -- although anexceedingly elegant summary of the complexities is here. The key issues that any study must answer vis-à-vis immigrants are:
- The effect of immigrants on wages – the average and the marginal labor.
- The distributional impact – i.e., does the wage distribution tilt asymmetrically.
- The tax contributions the immigrants make.
- The impact of immigrants on resources within a society (hospitals, schools etc.,)
- The relocation centers of immigrants. i.e., do they choose
Virginiaover ? Montgomery
All this said, one could say “show me the money”. i.e., how does all this enable one to think about where to invest? I have great faith in the intrinsic ability of masses to weed out irrelevant information and identify that what matters at the end. Survival! Surviving today for yet another day. Illegal immigrants in the
- The changing contours of growth-patterns in non-tradeable American goods and services industries.
- The areas of US where economic decline is anticipated. So, for eg., short industries with sales focused in say,
Alabamaand Georgia, and go long on industries with sales in Washingtonand . Oregon
- Given the fact that illegal immigrants ear 2 to 30 time their home wages in the
, an obvious ‘wealth effect’ is to be observed. Thus, invest in industries that cater to their needs: cola, beer, gambling, wire transfers, auto parts manufacturers, super-stores etc., In the coming years, it is fairly clear, that one is likely to see more illegal and legal immigrants in the US – with the tacit consent of various industries – despite the goose-stepping propagandists on the Right and the Left. These industries thus have a growing consumer base with growing needs. US
So, perhaps we'll soon see labor economists being hired on Wall Street!
Friday, October 19, 2007
But, is this portentous for a coming recession or decline? Or worse, does it matter that the US might be hit – if you hold an emerging markets portfolio? The Baltic Index (for shipping) has been a chartbuster and over the past few days the tonnage has shot through the roof, measured by freight forward agreements. The Baltic Indices have hit their historical highs – with indices tracking grain, sugar, coal and other iron ores. (See Reuters – story code QnL 19672363) The underlying theme is that demand for commodities, minerals and other long-dated shipping containers continues to be pushed up by China, India and other emerging behemoths. The increase in demand means: (a) demand for US dollar increases while making payments (b) demand for domestic currencies increases while making international trade payment for value-added exports. Which will dominate? Can India create and sell to the world value added products that result in a net increase in the demand for rupees? Therein lies the rub, as the bard says.
The decoupling of global demand, vis-à-vis, the US economy is here to stay. (To wit, read this. )And the generic trend is towards appreciation of emerging market currencies. Three key factors will contribute to short term reversals and volatility:
- Political trouble resulting in a flight-to-safety!
- Correlation spikes between thickly traded emerging market countries – resulting in portfolio reallocation en-masse.
- Ham-handed policy response in response to FX appreciation. (Participatory notes, anybody!)
In essence, two years from now -- the present set of emerging market exchange rates will seem comically undervalued against the dollar!
Thursday, October 18, 2007
On the run TIPS bonds -- a 5 year issue has a coupon of 2% while a 10 year issue has a coupon of 2 5/8 %. On the run Treasury Notes -- a 5 year issue has a coupon of 4% while 10 year issue has a coupon of 4.25%. Why does the TIPS offer a difference of 62.5 bp as opposed to 25 bp offered by the Treasury Notes?
One conjecture is that perhaps 5 years from now, the bond market is pricing in a reduction in inflation (thus decreased adjustment in the principal component) and thus decreased demand -- resulting in an increased inflation premium to hold onto the 6Bn., dollars worth TIPS issued. If indeed China is expected to increasingly export its inflation, then over the next two-three auctions the 10 yr TIPS must trade at a smaller coupon. Concurrently, the demand for the off-the-run TIPS must increase and the present holders should lockin a nice capital gains!
The financial markets are very much against this – and they claim that capital controls is completely the wrong way to go. The rupee appreciation is a reflection of the increased exporting strength of India – and the appreciation is a self-correcting way to correct for emerging imbalances. No doubt, the appreciation affects the Indian exporter – but profit and loss in an industry is hardly the place for governments to intervene. Further, the Indian exporter is hardly the constituency that needs to be salvaged by government programs like NREGA. On the contrary, the government must create programs/schemes to incentivise productivity improving mechanisms. Exchange rate appreciation is perhaps a blessing in form a curse – at least in parts. The government should use this "faith" imposed by global financial markets -- to make radical changes.
All this said, the Indian government is on a back-foot (note, cricketing term!) and after the nuclear debacle and the Communist party’s rhetoric about alternative “development paths” – one shouldn’t be surprised against imposition of moderate to weak capital controls over the next two months. In essence, prepare for a convulsive fortnight in the equity markets, take your profits and hit the mattresses.
An excellent interview with Dr. Ajay Shah here.
(There might be an advertisement early on.)
Things that make the CDS Basis tighter:
- Other Credit Products launched on Sri Lanka. (Pretty Unlikely)
- Decline in Civil War (Unlikely)
- If Credit Quality improves and Sri Lanka has any reduced coupon clauses. (Unclear)
More thought is required, but if Sri Lanka is met with success -- one could see a rising increasing in issues/CDS from "really small open economies".
Wednesday, October 17, 2007
- FII inflows into a domestic markets (16 emerging markets) has no statistical significance on domestic equity prices.
- Herding (measured by autocorrelation) is observed on longer terms (around 20 days) as opposed to short term (around 1 week). i.e., Investors chase returns in cases where there is a clearly observed profit taking opportunity. Is this because large investors actively influence opinions -- on Bloomberg chats or other trading information circuits.
- Causality is difficult to determine. i.e., Does inflow volatility cause returns volatility? Or is it the other way around?
Participatory notes are like contract notes. These are issued by FIIs to
entities that want to invest in the Indian stock market but do not want to
register themselves with the SEBI. FIIs registered with the SEBI and their
sub-accounts can issue, deal, or hold P-Notes. The underlying security against
these notes would be listed or proposed-to-be-listed securities on any Indian
stock exchange. FIIs issue these notes to investors abroad with details of
scrips that can be bought and expected returns over specific periods of time. If
the client agrees, they deposit the funds with the overseas branch of the FII.
Then, the Indian arm of the FII proceeds with the transaction, buying the
scrips in the Indian market and settling it on its own account. The details of
the ultimate investor are not revealed at all in the Indian market or to the
SEBI. The SEBI rule, however, says that P-Notes can be issued only to
regulated entities (in any country). Further transfer of these can also be made
only to other regulated entities. FIIs are not allowed to issue P-Notes to
Indian nationals, persons of Indian origin or overseas corporate bodies (which
are majority owned or controlled by NRIs). This is done to ensure that the P-Note route is not used for money laundering purposes. FIIs are required to
report to the SEBI on a monthly basis if they issue, renew, cancel, or redeem
P-Notes. The SEBI also seeks some quarterly reports about investing in
- Bio-Environmental: Whether this be the massive dust-storm or porcine disease or avian flu or environmental degradation -- the chain of events are fairly similar. In the short term, there is a spike in demand by consumers, anticipating a decline in supply (thus worsening the actual shortfall) -- coupled with hoarding and supply chain mismanagement --. (See pictures.)
- Structural: The intervention of the State-planners in financing and investment decision (the prototypical infinite horizon, infinitely lived Planner at work) results in suboptimal allocations. Given this mismatch between agricultural output, capital expenditure and urban agglomeration -- over the intermediate to long term, the decline in productive usage of resources is inevitable.
- Monetary: This is perhaps the most obvious and easiest to "fool around" with to induce distorted outputs. See this, for a basic example -- and the temptation to increase output is particularly relevant when the size of the sacrifice ratio (loss in output to obtain a permanent reduction of 1% inflation) is high.
Policy makers can most easily affect #3. To affect #2, it involves a substantial change in the political climate -- and to affect #1, a societal commitment is required. To varying degrees of satisfaction, China has predictably decided to tackle #1, #2 and #3 simultaneously. The flip side to this multi-pronged tackle is that the cost of getting things wrong is a rise in the number of events characterized by disequilibriums. (Bubbles in Food, Asset, Housing etc.,)
Tuesday, October 16, 2007
Following Professors Alesina & Summers -- see page 4 of following link -- it must come as no surprise that we have seen a gradual relaxation of the monetary conditions given the pressures in the year of the Communist convention. Given the obvious conflicts between varying factions (globalizers, isolationists, Hu Jintao type communists, old fashioned Communists etc etc., ) -- it is imperative that the political powers that be must have a "vibrant" economy to push through their candidates over those proposed by other factions within the power struggle!
Friday, October 12, 2007
In an interesting what-if paper, the authors ask what are the effects of a zero Current Account balance on some key variables of interest (nominal, real and relative wages, share of manufacturing, exchange rates etc.,)
To achieve a Current Account balance, their primary "adjustment mechanism" is the Manufacturing Trade Balances(ceteris paribus). Using an iterative root-finding algorithm, they arrive at the numbers required for Manufacturing Balances to fall or rise which would cause the CA = 0. Then, they ask what does this rise or fall in Manufacturing balances mean for real and relative wages, as well as share of manufacturing. All of this is done using (a) a variant of the Dornbusch-Fischer-Samuelson within a General Equilibrium model (b) parameter estimates from rest of the literature.
The results are interesting. Other than the US, all the other Major countries end up needing an increase in nominal wages. The US in contrast must have a 7% decline in wages in order for the current account balances to go to nill. Reasonable, but different, parameters lead to a nominal decline around 17% -20%. In contrast, if wages are held constant -- the a USD depreciation of around 10% is required for the Current Account balances to hit zero.
From the looks of it, this is a work in progress -- and perhaps Professors Dekle, Eaton and Kortum will be modifying it further. A self-admitted critique is that they perform a standard comparative static exercise, i.e., adjust one variable holding all other variables constant and then measure impact -- so caveat lector.
Given the stickiness of wages, the only perceivable channel through which current accounts hit nill are through the exchange rates. Given Washington's "talk strong and let it slide" approach to the USD -- any month on month improvements in the US current account deficits must come through the dollar's slide. However, since current account deficits reflect other mid-to-long term trends (political uncertainty, productivity etc.,) -- changes in CA deficits, I suspect, predict the intermediate and longer trends of the USD (attributable to "real" factors like exports and imports) -- over and beyond the daily ups-and-downs (attributable to speculative capital flows).
It would be interesting to test if lagged changes in current account have any predictive power on the realized exchange rates.
A subtle critique of the above hypothesis is: whether the current account changes can be trusted to predict the trend in the dollar's movement. This is primarily because the USD has a very low (compared to other OECD) exchange rate passthrough (% change in import prices in response to a 1% change in exchange rate) of around 0.42 (with the 1975-2003 data) . Resultantly, a declining dollar might still not affect the net balances of the current account observed.
Friday, October 5, 2007
- By choosing the USD as a "vehicle" currency to invoice -- i.e., the sale price is fixed in USD for the importing country -- when the dollar depreciates, the sale price remains fixed in the US currency and the depreciation eats into the producer's domestic profits. Thus, this doesn't necessarily result in a decline in imports via the price mechanism.
- Given the assymmetric position that the US holds in the global economy (and popular imagination), when it comes to the US the producers may willingly accept lower profits. Also, given the presence of widespread substitutes available -- the exporters to USD prefer to have lower profits today than give that market share away.