Volatility insurance and exchange rate predictability

January 26, 2014

The cost of insuring against currency volatility can be measured as the difference between (options-based) implied volatility and (swaps-based) forward expected realized volatility. A case can be made that this insurance premium determines how much exposure risk-averse institutions are willing to accept. A new paper and blog post by Della Corte, Ramadorai, and Sarno claim that variations in volatility insurance costs can be the basis for a profitable currency trading strategy.

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Estimating China’s augmented fiscal debt and deficit

January 25, 2014

The IMF, like other institutions, estimates that China’s fiscal position is much weaker than suggested by headline statistics. A new paper sees the augmented fiscal debt at around to 45% of GDP and the augmented fiscal deficit at close to 10% of GDP. Financial stability risks arise from dependence on a favorable ratio of growth to real interest rates, the reliance of local budgets on real estate sales, and the refinancing of local government financing vehicles’ debt.

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The concept of “real financial exchange rates”

January 11, 2014

A Bundesbank paper proposes a new type of real exchange rate index. Rather than measuring the competitiveness of goods markets, this “real financial exchange rate” would measure the competitiveness of asset markets. There is some evidence that this indicator helps detecting overvaluation.

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Trend following in U.S. equities

January 8, 2014

Trend following is a systematic investment style that takes directional positions in accordance with the difference between the current price and a moving average. For longer moving averages most trend following strategies would have outperformed simple buy-and-hold and value-based strategies in U.S. equities for many decades. Moreover, the simplest rules have been the best: there has been no benefit in high-frequency trading, stop losses, and conventional complications.

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Excessive public debt and financial repression

January 2, 2014

The central government debt ratio in the advanced economies has reached a 200-year high watermark. Other levels of government debt, unfunded pension and health care liabilities, and a huge external debt stocks add to scale and complexity of the problem. A historical analysis of Carmen Reinhart and Kenneth Rogoff suggests that developed countries, like emerging markets, are prone to taking recourse to aggressive financial repression and even debt restructuring.

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Concerns about bank assets’ risk weights

December 21, 2013

Hagendorff and Vallascas argue that the risk weights used to calculate banks’ capital adequacy fall significantly short of true portfolio risks. Capital arbitrage may have undermined Basel II capital regulation and could do the same for Basel III in the future.

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Central banks and equity market distress

December 17, 2013

A short Bundesbank paper presents evidence that the Federal Reserve, the ECB, and the Bank of England have long used policy rates to stabilize financial markets in times of distress. This would suggest that implicit ‘central bank puts’ are not new and that central banks’ tendency to stabilize markets in the past has not prevented serious market dislocations.

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How fear of disaster affects financial markets

December 14, 2013

Fear of economic disasters, such as depressions, is more frequent than their actual occurrence. People tend to perceive a growing risk of disaster as they see economic conditions deteriorate. A new Federal Reserve paper illustrates that this pro-cyclicality of fears can trigger fluctuations in equity prices that go well beyond the actual changes in economic conditions, consistent with actual historical experience. Disaster fears also can make asset returns partly predictable.

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The importance of central bank collateral frameworks

December 11, 2013

A new ECB paper illustrates the power of a central bank’s collateral framework as a policy tool. The collateral framework influences overall monetary conditions, helps preserving financial stability, and functions even at the zero lower bound for policy rates. Liquidity regulation can be an important complement, since by themselves generous collateral buffers might invite moral hazard and encourage excessive reliance on short-term funding.

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The ultimate policy options of the European Central Bank

December 7, 2013

In case of further negative shocks the ECB has three final policy options. First, it could nudge its refinancing rate close to zero and become the first large central bank to introduce a negative deposit rate. Second, it could revive long-term repo operations, probably with a link to private credit and collateral enhancement, and accompanying cuts in minimum reserves and sterilization operations. Third, as a final recourse, the ECB could invoke its right to buy both public and private securities for the purpose of preserving price stability. This final step would raise most difficult operational issues, far more so than quantitative easing in other currency areas.

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