Tuesday, June 16, 2009

Krugman vs Ferguson

Freakonomics discusses the rise in treasury yields via options on the t-bond. It appears that the increase in yields has more to do with the cutback in deflation risk than the increase in inflation risk in the future.

The graph below plots the probability of different outcomes for the yield on 25-year Treasuries on two different dates — late February and the end of last week. I calculated these probabilities using the technique I discussed in my last post, which extracts the probabilities implied by option prices on those dates. (Wonkish detail: I used the January 2011 options on the iShares Barclays 20+ Year Treasury Bond exchange-traded fund (TLT) and converted bond prices to yields using the portfolio average data reported by iShares.)

Friday, June 12, 2009


BBC story about piracy and what it means for bands and music.
The Fleet Foxes say that it is good for small bands. There is a suggestion that it hurts the large established bands but opens more doors for the smaller, unknown bands. Does it reduce barriers and encourage innovation?

Wednesday, June 03, 2009

Interest rate swaps

Felix Salmon with a practical application of the interest rate swap.

With interest rates low, GM was actually making money on these swaps: the banks would pay it the difference, every six months or so, between the higher fixed rate and the lower floating rate. But now that GM is bankrupt, the swaps have been torn up, and all those future payments which the banks were expecting to make no longer have to be made.

Of course, banks always hedge their positions — which means that some other counterparty will continue to pay them the money they were expecting to have to pay to GM. That's what Jansen means when he says that the bank “is long”. Now that money isn't going to GM, the bank will want to hedge its new long position, which essentially means selling that cashflow in the swap market.

A cashflow is like a bond, and when you sell bonds their yields rise. Similarly, here, when a bank hedges its new long position, yields — which in this case are swap spreads — go up. That's what Jansen means when he says they're “under pressure”. (A swap spread is the difference between the yield on the cashflow the bank is selling, and the yield on Treasury bonds of the same maturity.)

Brad DeLong on the use of finance

Brad DeLong
Of course, investors who believe that their wealth is securely liquid, and that they are adding value for themselves by buying and selling are suffering from a delusion. Our financial wealth is not liquid in an emergency. And when we buy and sell, we are enriching not ourselves, but the specialists and market makers.

But we benefit from these delusions. Psychologically, we are naturally impatient, so it is good for us to believe that our wealth is safe and secure, and that we can add to it through skillful acts of investment, because that delusion makes us behave less impatiently. And, collectively, that delusion boosts our savings, and thus our capital stock, which in turn boosts all of our wages and salaries as well.

Seventy-three years ago, John Maynard Keynes thought about the reform and regulation of financial markets from the perspective of the first three purposes and found himself "moved toward... mak[ing] the purchase of an investment permanent and indissoluble, like marriage...." But he immediately drew back: the fact "that each individual investor flatters himself that his commitment is ’liquid’ (though this cannot be true for all investors collectively) calms his nerves and makes him much more willing to run a risk...."

Moreover, for Keynes, "[t]he game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll...."