Vol.Curve

Rethinking the short sentiment on USD...

2008-10-09T20:48:00.000-07:00

Leveraging refers to the simple act of borrowing X USD on the basis of the collateral of Y USD, such that X >> Y. So, X/Y = m refers to the leverage ratio at play. This ratio is assumed to be "stable" over the life time of a trade. However, as the net value of Y as measured in the market reduces, the leverage factor m increases. It is clear over the past year or so, banks have been actively involved in an effort to deleverage. The consequences are unclear in the long run - however, there seems to be emerging consensus that the aftereffects of this are likely to be significant. The effects of this reduction in leverage in the FX market is particularly interesting and complex. The order of complexity is furthered by the squeeze in the credit market. While the sentiment on the US economy is remarkably short -- the question regarding the USD is more complex.

One, particular confluence of credit and FX markets is the freeze up in the lending markets. In a fine essay by Thomas Stolper and others - they hint at the mechanics and the consequences of this relationship. Most banks have short dated FX obligations and longer dated domestic currency obligations. As the overseas short term lending markets freeze -- we get banks scrambling to find assets to pay out their obligations. Since most central bank lending mechanisms only lend in their domestic currencies -- most banks are forced to borrow domestically, convert that into the foreign currency and payout. The dollar denominated debts are the highest in the world, followed by Euro denominated and so on. So, as the US lending market freezes - one should the rising demand in the USD (as counterintuitive as it might seem).

However, this is one piece of the puzzle. The trader is only concerned with the net flow of dollars and changes in value - however, it is important to keep in mind the market imperfection (frozen credit markets) work its way through structural constrains.

Falling Slowly

2008-02-24T20:17:00.001-08:00

Historically, monies have been backed. Typically by Gold; occasionally by a basket of commodities; in more recent times to the value of another base currency. When asked what is the base currency backed by, since 1972, one could say "it's turtles all the way down".

i.e., Modern money is backed by only goodwill of the issuing government and the value that we, the holders, deem it to have. In the past, money was backed by commodities. Cowries, gold, oil, wood , slave girls etc., The Great British Empire was run on backed gold -- of varying quality -- backed by an asset, nevertheless. Since 1945-- the USD which has been the de facto currency of the world. On the extreme de jure currencies might exist but nevertheless be virtually ignored -- as in say, Afghanistan under the Taliban. Alongside, the key historical aspect is there has often only been a single de facto currency, on average, since the Enlightenment. Even the Nazi Germans during the forward stashed away their currencies in GBP.

What is peculiar about past four years is the following. We have two major currencies backed by nothing. And it seems increasingly clear there are two competing de facto currencies. The USD and the Euro. While the two currencies have had differing changes in value relative to other currencies over the past year (and more). See two cool graphs here: Euro & USD. The US is a behemoth with a cashflow problem; the Euro is essentially confederate money in a continent with a demographic problem. (See an interesting paper on confederate money.)

Now, the critical problem is globally: what is the optimal holding between USD and EUR. No ones the answer. In fact, one doesn't know if this is dichotomous choice itself is a false one. Increasingly, there are two other alternatives. Holding Gold itself. And as well, the basket of non-USD and non-EUR currencies. These are tough questions - but one thing is clear. The times have changed -- and we are, perhaps, entering for the first time since 1700s into an era of financial history that isn't very well known or even how to frame the questions correctly.

My own understanding of all this, on a weekend of Oscars, is more or less summarized by the preface to this song...

Some Mortgage Basics

2008-02-21T20:16:00.001-08:00

Last entry was on Nov 30, 2007. Now that I have gotten myself settled, and a rhythm in life has returned -- I should probably be in a position to post more frequently.

At the heart of the present crises that we are three factors: (i) default fears (ii) draining of liquidity (iii) industrial downturn. What has most gotten attention in popular press is default fears -- with default in household mortgages that has captured popular imagination. It is important to thus get briefly acquainted on how mortgage defaults (MD) are understood in most pricing or analytics.

MD is defined, in general, as when both of the following events occur: (i) unable to pay 3 consecutive monthly payments (ii) the equity in the home diminishes to leave no prospects of refinancing. Further, MD rates have a following shape. At first they rise, and then really spike up and then they decline -- graphed over years of mortgage existence.

Typical mortgages made out in the subprime market have been adjustable rate mortgages (ARMs) -- where the coupon is fixed for a while and then begins to reset periodically. Even the 30 year ARM in the regular markets are "5 x 1" (fixed for 5 years, and resets annually). In contrast, the 30 year ARM in a subprime markets are "2 x 28" (fixed for 2 years, resets semiannually for the next 28 years). Typically this reset is based of some pre-agreed index that tracks the cost of money, conditional on borrower quality, across the economy. So, if the generic interest rates begin to rise in the economy -- associated payable rates by the mortgage borrower are reset at a higher rate. What makes things worse is that most of these ARMs have an early "interest only" feature. Resultantly, as the "interest only" period finishes off -- the mortgage borrower has to start paying off for the principal component as well.

One of the critical issues every mortgage lender worries about is the prepayment of the lent amount. Typically, most of the pricing is done with some sort of prepayment model. The prepayment is a function of (i) available refinancing (ii) housing turnover (iii) curtailments (paying more every month than obligated) (iv) defaults. Typical modeling efforts of prepayment are applicable to a tranche of loans. As opposed to modeling prepayment for each loan.

Another layer of complication is to wonder about how to model the extent of loss that occurs as a mortgage defaults.

Now imagine writing securitized tranches that are sold which contain slices of mortgage backed securities -- i.e., CDOs on MBSs. It is not surprising then that we end up having this situation.

In essence, things get hairy pretty fast...

Top Recommendations by “the most profitable Bank”

2007-11-30T08:47:00.001-08:00

Recently, following recommendations have been provided:

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.

How the "Masters of the Universe" think about Exchange Rates!

2007-11-20T09:04:00.000-08:00

In a recent excellent, if perhaps deliciously short, report issued by the most profitable bank this year entitled "The Foreign Exchange Market" -- one of the sub-reports attempts to forecast the exchange rates for the coming year. What struck me about it is -- other than the predictions they make (I have my issues with that... see below) -- is the elegance of the underlying method. The way do is as follows:

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.,

Perform regressions on #3, using #2 to arrive at new estimates for real-exchange rates.
Convert real exchange rates into nominal exchange rates.

Amongst key predictions are USD-CAD = 1.10; USD-INR = 50.1. i.e., their model supposedly predicts that the the Canadian dollar is expected to depreciate from the present levels, and so is the USD expected to appreciate against the Indian Rupee. Since, they do not explicitly mention all the concerned control variables in the exchange rate attribution -- it is difficult to really validate their claims, even intuitively.

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.

So, I suspect their analysis are largely driven by "true" long term economic factors, while the intermediate fluctuations are more complicated beasts -- and therein lies, as Shakespeare writes, the rub.

Mathematics for Derivatives

2007-11-20T09:00:00.000-08:00

Often while reading about financial derivatives -- a lot of terminology comes to fore. Some are financial while the more esoteric ones are often mathematical. This document has some of them. Probability(errors) = 1 almost.surely.

Risk in the Times of Reversal

2007-11-16T14:16:00.000-08:00

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!

Dollar Got the Blues... by Clarence "Gatemouth" Brown

2007-11-14T16:02:00.000-08:00

excellent riffs, and great music... (courtesy -- dealbreaker)
the lyrics are:

dollar got the blues
getting lower every day
dollar got the blues
getting lower every day
i wanna do something about it
folks if i only had my way

used to be 2 for 1
now it's 1 for 2
used to be 2 for 1
now it's 1 for 2
what in the world are we poor people gonna do?

CAD, Crude and Risk Aversion... A conjecture

2007-11-14T15:48:00.000-08:00

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.

Loonie Tunes...

2007-11-12T18:43:00.000-08:00

I first heard about the TarSands, courtesy the ever generous Leigh Shankland. He was super excited about it, but I was in highschool and I had other things to be excited about. The latest NewYorker has an wholesome piece about the TarSands in Alberta. It deals with the energy costs in producing a barrel of oil (around 1/3 a barrel! -- without dipping into the subtleties...); the environmental impacts (pollution, cancer) and the GoldRush spirit at work that trampels most voices. There are clear reasons why this phenomenon will last. Extracting oil from tarsands costs between 30-40USD per barrel, around 174 billion barrels of recoverable oil, etc etc., While reading, it is clear that this phenomenon is here to stay -- over the next 30-50 years. And to some extent, it is suffice to say that the TarSands are only getting started -- there are other firms coming into the mining industry, firms keen on supplying energy to the mining firms, firms that are laying pipelines and so on and so forth. Over 3/4th of a percentge of Canadian GDP is expected to be spent in 2008. It is fair to say, I think, before the lifetime of most readers of this note the long term impact of the TarSands -- environmentally and in raising global supply of oil is dramatic.

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...

Hugo Chavez and Cristina Kirchner: Hot or Not Hot?

2007-11-07T12:34:00.000-08:00

Venezuela and Argentina are different countries (duh!); but for the credit-markets and emerging markets portfolios, they are reasonably close and different! Sort of like the Cain and Abel of the Latin-American fixed income portfolios. Who's who, who knows. They are all (grand) children of God (or at least, Simon Bolivar). And in recent times, one has been more volatile than the other -- depending on what time-frame you investigate.

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: About 60%

Oil prices rally to 120USD in next six months About 45%

Political turmoil in Venezuela About 10%

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!

Decomposing Credit & Systemic Fears

2007-11-05T19:04:00.000-08:00

A useful measure of how to think about how the market prices two key "unknowns" -- idiosyncratic credit risk and system wide disturbance -- is to use the TED spreads. The TED spread can be created by trading Futures positions in US Treasuries and Eurodollar markets. Implicit in the prices quoted (via the IMM convention) are interest rates implied. So a Eurodollar quoted at 98, implies a rate of 100-98 = 2%. The USD TED Spreads are thus created by going long US Treasury futures and short Eurodollar futures -- thus creating a spread. For more details see here.

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?

Lessons from Leamer: Part 2

2007-11-05T10:55:00.000-08:00

Continuing from previous post.

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!

Lessons from Leamer (Part 1)

2007-11-04T19:31:00.000-08:00

Professor Edward Leamer has written a very interesting paper; and was presented at the Jackson Hole conference. I have been going through it in detail -- and I must admit it is a remarkable piece of analytical detective work. Following two posts are dedicated to his work. Although the original is nearly 70+ pages -- it is written in a very reader friendly style. So, worth the effort. For the rest, here is a quick summary. Caveat Lector!

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 US 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).
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 U.S. 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.
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.

Predicting the Fed

2007-10-30T08:53:00.000-07:00

The problem with best estimates is two fold.
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!)

One of the well observed predicting markets is the Fed Fund Futures (FFF) market. The FFF is a futures contract written on the “average of the daily effective FF rate”. The FF rate is the rate that the Federal Bank of New York charges to federal fund brokers. The “effective” part in the earlier definition arrives from the fact, for any given day, different brokers who deal with differing transactional sizes, might be charged differently. So, the “effective” is the same as ‘weighted average’. A heuristic reason is that the Fed Funds market participants are likely to take into account all the factors that might affect the path of the interest rates that the fed sets. The rates implied by this market can be thought of as a first-order prediction. There are various issues – as of yesterday, the one month rates are given as below.

7-Oct 95.255
7-Nov 95.495
7-Dec 96.61
8-Jan 95.665
8-Feb 95.785
8-Mar 95.82
8-Apr 95.895
8-May 95.925
8-Jun 95.92

The implied 1-Month rates are given above.

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!)

I think, this will be a very difficult time for Bernanke and Co., primarily because with rising inflation (via oil, via imports, via China, via protectionist lobbies) and worsening labor markets -- the short end of the curve will have substantive volatility.

Again, my thoughts are that the demand for non-USD denominated assets will continue.

India -- Some Graphs

2007-10-29T09:15:00.000-07:00

Sovereign Wealth Funds -- Behemoths at the DoorStep

2007-10-24T22:15:00.000-07:00

With rising US current accounts deficits – resulting in increased demand for foreign denominated assets and foreign currencies, the pressures on the CNY, INR, BRL etc., is well known. Predictably, the sterilization (complete or incomplete) has led to CB intervening in the FX markets – selling their own currencies and buying foreign currencies (typically USD denominated assets). To put this accumulation in perspective, some numbers (in millions) are:

China: 1,334,590

Japan 907,346

Russia 407,495

Taiwan 266,287

Korea 250,667

India 220,223

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 US current account deficit was financed by these Emerging Market Treasuries. This financing is slowly declining – because one of the, only (?), benefits of the present credit crises is that the US domestic savings are expected to improve, primarily because they are so far in the hole – there seems to be only one way to go! This financing is also slowly declining because the Central Banks have two primary options – opt for other “major” currencies (Euro, Yen) or opt for more risky ventures (like China investing in BlackStone, Norway’s Global Pension Fund, Dubai in global Ports etc.,) “Sovereign Wealth Funds” are explicitly mandated subsection of foreign Treasury holdings that act on behalf of the domestic Treasuries – and are more likely to invest in non-standard asset classes. i.e., they are likely to be the primary agents that drive the risk premium lower in the coming years across the globe. The size of the numbers being projected is beyond my comprehension (in any meaningful sense). Where are these risky returns like to come from? Potentially innovative financing deals and projects like those done by Macquarie!

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 United States government. Excessive decline of the dollar, with no perceptible change in consumption/savings in the US, might result in, to use a Lou Dobbs phrase, “selling America to foreigners”.

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.

Carry and Roll-Down: back to the basics

2007-10-24T06:54:00.000-07:00

Interest Rate Traders and salespeople talk about carry and roll-down all the time. It is useful to remember what they are talking about.

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.

Butterfly:

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.

Risk Aversion -- a pseudocode!

2007-10-23T11:29:00.000-07:00

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).

Microfinance Bonds! - Liberal Goals through Conservative Means!

2007-10-23T07:46:00.000-07:00

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 Guntur, Andhra Pradesh – but the increase in rationed rice and sugar prices due to governmental policies will affect their income and repayment abilities. So, the bonds/CLOs issued by Wall Street can be a useful market mechanism tool with governmental subsidies to alleviate poverty!

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!

Revaluation of the Yuan...

2007-10-23T06:28:00.000-07:00

Given the generic consensus at the G7, US Congress, Rest of the World barring for Sudan and Myanmar that the Yuan is under-valued against all global majors, particularly the USD – it is a question of when, rather than if at all, the Yuan will be revalued. Given the smooth change of guard at the Communist party meeting – it seems fairly certain that the Yuan will be revalued, perhaps not as much as the Treasury officials deem necessary, but in the “right” direction. What does this do to global trade flows?

Some preliminary conclusions/thoughts/conjectures are:

1. The econometric evidence on the contributions exchange rates make on competitiveness, productivity investments and thus, trade surplus in China is too varied to really be of much use in a week-on-week assessment.

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 Seattle port set at 1USD, will make the Chinese exporter temporarily better off. In contrast, US exporters of products invoiced in Yuan, will be worse off given the new USD-Yuan rate. The trade deficit numbers will do exactly the opposite as Washington expects in the two-three month period. (The opposite of a J-Curve observed during a devaluation.)

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 China is a well-oiled machine, and changing trade flows will take longer than perhaps one anticipates. There are economies of scale in place and productivity gaining measures in place – that the willingness to abandon China as a primary sourcing place is unlikely to change all that much. Of course, the trade deficit numbers will seem more palatable for political purposes, but whether a substantive quanta of imports declines is unlikely.

6. All of the above assumes the Chinese will continue to produce as always. Then the improvements in the Yuan will provide the results Washington wants. But, all that is unrealistic. If the pricing pressures increase on Chinese products, then it is silly to not expect them to improve their productivity.

7. The most understudied aspect is that when the Chinese exports decline (and thus their income declines) – the effect on goods imported to China. It is easily conceivable that services from India and Europe can replace services and goods offered by the US. The elasticity of Chinese imports to income changes is perhaps the most important, and unclear, aspect of this whole issue.

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.

USD vs Other Major Trading Currencies

2007-10-22T12:03:00.001-07:00

In the picture above, I have plotted three weighted indices against the US$. (The weights and their calculations are given here.)

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:

Dates

Broad Index

Major Currencies

OITP

2^nd Jan ’07 to 16^th Mar ‘07

0.357%

0.612%

0.230%

19^th Mar ’07 to 19^th Jun ‘07

0.766%

0.933%

0.646%

20^th Jun’07 to 19^th Oct ‘07

1.261%

1.853%

0.792%

Some conclusions:

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 Venezuela has done substantially differently than India against USD.
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.

What does this portend for the future? My guess is that till the US economy picks up – the dollar slide against the Majors will continue. This is further aided by the Treasury’s policy of letting the dollar slide. The coming revaluation of the yuan will make this a really interesting group to think about. Need to think about this a bit more.

Rethinking portfolio allocation at El Paso, Texas.

2007-10-21T20:00:00.000-07:00

This is a season of the “immigrant” as a piñata for the sons of the soil.

In an interesting summary of how silly some of the statistics being touted around in the immigration debate is, Christopher Caldwell has furthered my suspicion at publicly bandied about numbers. This following Marc Faber’s report filled with his own suspicions on the meaningfulness of government statistics – I must confess, I am more pessimistic than last week about “key figures” quoted. Watching the US politicians debate for the Presidential primaries convinces me in the sagacity of the old Benjamin Disraeli line, “there are three kinds of lies: lies, damn lies and statistics”.

Although I didn’t agree with Caldwell’s argument that when talking about immigrants, one must concentrate on their contributions to GDP per capita – the underlying message that one ought to debate the utility of immigrants in any society within an economic framework, as opposed to a cultural, is a wise remark. This is so, because other aspects like cultural compatibility, understanding of ‘core-values’ etc., are provably true or false – depending on who is mining the data.

With regards to illegal immigrants, research has been sparse -- although an exceedingly 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 Virginia over 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 United States are perhaps the starkest example of that. Undereducated, without documentation and limited employment opportunities. Their choices of locations and industries are directly connected to the amount of food they consume, the anticipated monies they expect to earn and the growth potential in monetary terms. Not withstanding the legitimate concerns about security and income dynamics -- I think, one must have the humility to learn from their survival skills. Like migratory patterns of birds can predict the deterioration in quality of their homing grounds, the migratory flow of illegal immigrants can enable investors to learn more about “unsexy” industries like construction, fruits and vegetables, waste disposal amongst others. For those seeking to diversify, and find value in firms in these sectors -- I believe, thinking about illegal immigrant movements might be a useful indicator. Illegal immigrants predict, I believe,

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, Alabama and Georgia, and go long on industries with sales in Washington and Oregon.
Given the fact that illegal immigrants ear 2 to 30 time their home wages in the US, 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.

So, perhaps we'll soon see labor economists being hired on Wall Street!

Contract types and Financial Cycles.

2007-10-21T18:28:00.000-07:00

Weekends, like war, are filled with long stretches of the mundane and brief moments of the unexpected. That said, there are few moments of fun as well. Like this blog entry about arranged marriage that I stumbled upon. In her own charming way, she writes about the razor’s edge that arranged marriages can be. The stolidity of this type of marital institution is an historical fact; but perhaps the material conditions in which such a marriage flourished are changing. I don't know. Perhaps, the uneasiness lies in the modern belief that love and marriage can be found within the same institution. If not this marriage, then Hallmark and Cosmpolitan promises you it in the next one. The irony is that I spent this weekend reading about securitization (particularly about asset back commercial paper market) by Vinod Kothari. One of the early remarks he makes is that marriage is one of the oldest relationship contracts, as opposed to innumerable “friendships” that we find in modern society that can be thought of as transactional contracts. The degree of replaceability of buyers-and-sellers of contracts, the sunk costs involved in arriving at a trading decision etc., distinguish such contracts. While for humans I am convinced that ‘relationship contracts’ are better; for financial markets ‘transactional contracts’ have been a stupendous blessing. These market mechanisms allow you and I to buy and sell stocks, participate in the fortunes of publicly traded companies etc., without necessarily being privy to a specific information or part of some restricted group of people. However, the flip side has been that ‘transactional contracts’ (exemplified by the securitization) business has led to innovation, and with innovation comes possibility of excessive profits. Lured by this specter of excessive profit comes easy credit. Soon, entrepreneurs, con-artists and revolutionaries all agree on one sole idea – this time it’s different. Thereafter, human, all too human sentiments follow like clockwork: greed, hype, irresponsibility, disaster and finally despair. Till yet another cycle begins, perpetuates and finally dies out. The best read on the inevitability of such bubbles and busts is still the one by the late J.K. Galbraith.

Ahab and Sea Freight Prices...

2007-10-19T15:13:00.000-07:00

In the past few weeks, there has been a surge in the number of commentators claiming that recession is near, including Julian Robertson. The primary reason is ostensibly the credit crises – with data from the ABX (credit quality indices that track housing mortgages) tranches of the lower most quality trading at their historical lows. Funds that presently are long on the lowest-quality tranches and have exposure to the underlying, the housing market, via CDOs will basically have to incur serious capital losses – or just fold. Fair enough, big banks will have to buckle their belts and spending on corporate jets will fall.

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!

TIPSy on Inflation

2007-10-18T20:38:00.000-07:00

The TIPS (Treasury Inflation Protection Securities) , like Canada's Real Interest Bond, has a constant coupon declared at issuance -- but over the life of the bond, the principal is upward/downward adjusted as per the inflation numbers. An interesting point of comparison between numbers is the following:
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!

Chronicle of a Capital Control Foretold?

2007-10-18T07:12:00.000-07:00

In India today, there seems to be a cloak-and-dagger game at hand between the export lobby (“real” economy) and the financial markets (“monetary” economy) – in so far as capital controls are concerned. The appreciation of the rupee against the USD has threatened to bite seriously into the profits of the Indian exporters. This is particularly true of the small manufacturers, as it is, compete tooth and nail with the Chinese, Malays etc., in the manufacturing sector. Predictably, this interest group wants the government to “do” something to stem the dollar slide. Predictably, a throwback to the eras gone by, one hamhanded response has been to force FIIs to register with the SEBI – this is an old Indian (bureaucratic?) trick. If in doubt, drown them in paperwork. Given the obvious daftness of this effort to control global capital surges and retreats, the next best thing seems to be issue “capital controls”. i.e., devise mechanisms by which FIIs can participate in the Indian equity markets only through very limited, thus rationed (thus corrupt) schemes.

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.)

CDS on Sri Lanka!!

2007-10-18T05:40:00.000-07:00

Last week, Sri Lanka issued its first international bond for $500 million. Predictably, a CDS market has evolved – with the 5 yr CDS trading at 360 b.p. I am not sure if there has been any study that decomposes this spread into: (a) Sri Lanka’s abilities to repay given increased hikes in domestic rates and decline in economic growth locally (b) sustained international risk-appetite? Theoretically, CDS is equivalent to a bond financed with an hedge on it -- thus making it an unfunded deal (can you see that?). Thus, CDS premium is compared to a asset swap -- and not to a bond's spread on the treasuries. More loosely, in cases like Sri Lanka where an asset swap market are not known to trade actively, CDS premiums tend to lead Bond premiums – and given the highly volatile political and economic climate – there can be substantial divergence in the intermediate term spreads quoted in the CDS and the Bond market. Typically, the CDS premia are on average higher over time than the Bond risk-premia. This CDS Basis (i.e., strictly speaking CDS Basis = CDS spreads - Asset Swap Spreads) can fluctuate substantially -- and Sri Lanka should be no different.
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".

Does FII sway Domestic Equity Markets?

2007-10-17T13:43:00.000-07:00

Yes. No. Maybe... says IMF. Using high-frequency data, some of the conclusions are:

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... an Introduction.

2007-10-17T09:10:00.000-07:00

Yesterday, the Indian equity markets had a over 7% decline. The ostenible reason has that the SEBI (Securities and Exchange Board of India) issued a recommendation (position paper) to the Finance Ministry that Foreign Institutional/semi-Institutional Investors, or their sub-accounts, shouldn't be allowed to issue participatory notes where (a) derivatives are the underlying (b) the notional value of the participatory note is greater than 40% of assets under custody. It is useful to recap what participatory notes are in this context. (From the Hindu Business Line)

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
P-Notes.

It is unclear whether re-routing of laundered money is that big a concern to warrant this move? According to Arun Kejriwal, it is! and as per Tushar Poddar of Goldman Sachs (India Views, October 17 2007. Available at https://portal.gs.com/), it is not.

Sources of China's Inflation... A Menu

2007-10-17T05:38:00.000-07:00

Chinese aggregate output distortions has lead to a disequilibrium in the food sector which has thus affected the core-CPI measures. From a proverbial "bigger picture", there are three categories into which one can source these fluctuations into: Bio-environmental, Structural and Monetary.

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.,)

Politically Calibrated Chinese Overheating?

2007-10-16T14:18:00.000-07:00

Is there a coincidence that the quinquennial Chinese Communist party meetings are underway this year -- and concurrently over the past six months -- one has observed the decline in the sterilization ratio by the Chinese central banks? (As per Tim Bond of BarCap (no link available), this ratio has fallen to around 34%. i.e., sterilization ratio = balance of payment surplus less outstanding governmental bond sales). As Krugman and Obstfeld tell us, increased pressure on the currency to appreciate can be met by selling more domestic currency and thus accumulate foreign reserves. The rise in domestic currency must be met with sale of government bonds -- resulting in reduction in outstanding monies in the hands of the "real" economy. The incomplete sterilization that Tim Bond reports on starkly has contributed to increased growth, albeit from a monetary side and ignoring Professor Bob Lucas's writings, which has in turn led to a creeping inflation.

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!

Lowered US wages & Current Account

2007-10-12T08:41:00.000-07:00

Counterfactual exercises are fun.

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.

Failure of Expected Current Account Moves...

2007-10-05T07:26:00.000-07:00

A depreciation of the dollar should, at least theoretically, to decline in imports. However, it might not be borne out by reality. The primary reason has to do with the fact that the US has a lower exchange rate passthrough (percentage change in import prices to a 1 percentage change in exchange rates) than most OECD countries. The key issue is why does the US have an e.r.p (around 0.42 with the 1975-2003 data) that is lower than most other OECD countries. Two reasons, amongst others:

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.

Of course, in recent months -- the USD imports have declined -- but, it is useful to read this and keep the generic case argued here in mind.