Recent Posts

Sunday, April 23, 2017

SFC Models And Introductory MMT-Style Fiscal Analysis

The usefulness of Stock-Flow Consistent (SFC) models is that they allow us to illustrate concepts in economics without relying solely on verbal descriptions. In this article, I will discuss my interpretation of some of the ideas floating around in Modern Monetary Theory (MMT). I will note that these are my interpretations of statements made by others, illustrated by an extremely simple model. The key is that even simple models can be used to clarify our thinking.

Wednesday, April 19, 2017

Weaknesses Of Term Premium Estimates Derived From Yield Curve Models

Term structure models have been a growth industry for researchers in academia and at central banks. These models can be structured in many different ways, which makes generalisations about them difficult. For the purposes of this article, I am only concerned about the use of these models to estimate a term premium that is embedded in nominal yields (although my comments can be extended to cover related exercises, such as calculating an inflation risk premium). When I examine individual models, the term premium estimates appear unsatisfactory, but the issues are different for each model. I believe that the root problems for this exercise are fundamental, and we need to understand these fundamental problems before looking at individual models.

Saturday, April 15, 2017

Book Review: The Road To Ruin

James Rickards recently published The Road to Ruin: The Global Elites' Secret Plan for the Next Financial Crisis. His argument is that the risks of a financial crisis is building (possibly hitting in 2018), and that the financial system will be locked down as a result. (He argues that you need to buy gold to hedge against this.) The book is awkward, but has some interesting features. He describes various pop mathematics techniques for economic and financial analysis, although the book does not provide enough details to be able to evaluate them. James Rickards joined the LTCM hedge fund in 1994, and provides an insider's take on its collapse. He is also nostalgic for the economic framework of the 1950s, which parallels the views of a lot of post-Keynesians; the issue is that he is fixated on the gold peg, which was arguably an incidental feature of the 1950s economic institutions.

Wednesday, April 12, 2017

Low Bond Volatility Not Surprising

Chart: 10-year Treasury Historical Volatility

The low levels of implied volatility in the bond market has attracted a fair amount of commentary. Although it seems reasonable to believe that volatility selling strategies have reduced market volatility, there's no fundamental reason to expect a big reversal (outside of another crisis).

Monday, April 10, 2017

How To Approach The Term Premium

The term premium is an important concept in fixed income analysis. For our own analysis, there are a few ways of using the term premium. Unfortunately, there is no way of extending the analysis for an individual to the market in general, as there is no need for market participants to agree on the term premium before undertaking a transaction. As a result, we should not expect to be able to infer an average term premium implied by market pricing using any algorithm.

Saturday, April 8, 2017

Primer: Fixed Income Arbitrage

The concept of arbitrage is important in financial theory, particularly in the bond market. For example, term premium estimates are derived from arbitrage-free term structure models. The simplest definition of arbitrage is the ability to lock-in risk-free profits (above the cost of capital); the usual efficient markets story is that arbitrageurs will trade in such a way to squash out such profits. This article explains how the term arbitrage is used in fixed income markets, and how this relates to ideas like arbitrage-free yield curve models. The discussion here avoids the use of mathematics, on the theory that anyone who understands financial market mathematics has already been introduced to the technical definition of arbitrage.

Friday, April 7, 2017

The Term Premium Problem

Discussions of the behaviour of term premia have come up recently in online discussion. (For example, among people I follow on Twitter.) When we discuss the term premium, we are usually discussing the estimates derived from arbitrage-free term structure models (such as affine term structure models). I am not a fan of these term premium estimates, but explaining my views has always been difficult. I have come to the conclusion that the mathematics behind these models is part of the problem, not part of the solution.