the alpha and omega

Event Volatility vs. Structural Volatility

Mahalanobis — 2009-07-04T10:36:00Z

Bill Luby writes (Barron's):

The 30-day VIX time horizon primarily captures what I call "event volatility" that is associated with scheduled events such as important economic data releases, earnings reports, as well as various scenarios associated with high-profile geopolitical and other events which are likely to cast a shadow over the next month.

By comparison, the 93-day time horizon of VXV guarantees it will encompass an entire earnings cycle, a full quarter of the economic-data-release cycle and two FOMC meetings. The VXV is more focused on long-term systemic threats, measuring something akin to "structural volatility" in the markets.

VIX vs. VXV

Investors who trade based on volatility signals usually look for signs that implied volatility is overextended to the upside or downside. This is traditionally done by comparing implied volatility measures such as the VIX to recent historical volatility or to previous implied volatility levels for the same implied volatility measure.

Since the launch of VXV in November 2007, investors have been able to use a third approach: comparing two different volatility indices with different fixed-time horizons to determine the extent to which short-term volatility expectations in the form of the VIX are aligned with longer-term volatility expectations in the form of the VXV.

related items:
VIX:VXV Ratio Sell/Short Signal, Bill Luby
Who is Selling Wholesale Vol and Why?, Zerohedge

Countercyclical Capital Buffers

Mahalanobis — 2009-07-03T08:32:00Z

The crisis has focused attention on mechanisms for ensuring that banks adjust their capital (or loan provisioning) countercyclically, building it up in good times and then drawing it down as stress materialises. Finding a good indicator that signals the time to build up and release the capital buffer won't be easy.

Here's what the BIS Annual Report has to say:

The following discussion covers three macroeconomic indicators: credit spreads, the change in real credit and a composite indicator that combines the credit/GDP ratio and real asset prices. The ideal macroeconomic indicator would reliably identify both the expansion and stress phases of the banking cycle. With that in mind, we present the variables as deviations from their respective neutral levels, measured here by a trend or long-term average; and the phases of the banking cycle are measured by deviations of the charge-off rate from its long-term average.

Credit Spreads

1) Loans and leases removed from the books and charged against loss reserves, as a percentage of average total loans. 2) Deviation of long-term BBB-rated corporate bond spreads from their long-term average, in basis points.

Narrowed credit spreads could be a signal of good times, and a significant widening may indicate the onset of a deterioration. However, the credit spread, measured here with BBB corporate bond spreads, is not a reliable indicator of banking system stress. For example, in contrast to the historical realities of banking stress, this indicator points to more serious financial strains after the collapse of the dotcom bubble than in the early 1990s.

Change in Credit

3) Exponentially weighted five-year average real credit growth minus its 15-year rolling average, in percentage points.

The second candidate indicator is the change in credit, a choice based on the idea that banks tend to overextend credit before crises emerge and deleverage once strains materialise. However, credit growth exhibits considerable inertia, and it remains well above the neutral level even as banking strains begin to emerge. Hence, an indicator based on credit alone is likely to be late in signalling a release of the buffer.

Composite Indicator

4) Deviation of each variable from its one-sided long-term trend (that is, a trend determined only from information available at the time assessments are made); credit/GDP ratio in percentage points, property prices in per cent.

The third potential indicator draws on previous BIS research, which has found that when the credit/GDP ratio and real asset prices simultaneously deviate by large amounts from their respective trends, they provide a fairly reliable signal of impending banking crises with a considerable lead time. Because the composite indicator requires that a real asset price and the ratio of credit to GDP exceed thresholds at the same time, it avoids the late release of the buffer induced by the credit variable, but it may trigger it too early.

Go to page 133 of the report to read about choosing the formula that determines how the indicator will modify the minimum capital requirement.

related items:
Regulation and the Cylce, The Economist, Special Report

AIGFP

Mahalanobis — 2009-07-02T15:59:00Z

Unwinding at AIG Prompts Pasciucco to Ponder Systemic Failur, Bloomberg

related items:
Michael Lewis article on AIGFP

Government Spending Multiplier

Mahalanobis — 2009-07-01T18:21:00Z

In economics the questions are always the same - only the answers change:

Estimated impact on GDP of a permanent increase in government purchases of 1 percent of GDP (Cogan et al.):
Cogan et al. (Feb 2009) conclude:

In this paper we used a modern empirical approach to estimate government spending multipliers.. We focused on an empirically estimated macroeconomic model - the Smets-Wouters model - recently published in the AER.

We find that the government spending multipliers from permanent increases in federal government purchases are much less in new Keynesian models than in old Keynesian models. The differences are even larger when one estimates the impacts of the actual path of government purchases in fiscal packages, such as the one enacted in Feb 2009 in the US or similar ones discussed in other countries. The multipliers are less than 1 as consumption and investment are crowded out. The impact in the first year is very small. And as the government purchases decline in the later years of the simulation, the multiplier turns negative.

The estimates reported here of the impact of such packages are in stark contrast to those reported in the paper by Christina Romer and Jared Bernstein.

Crowding out of consumption and investment in the Feb 2009 stimulus legislation:

Private equity purchaser helps hedgies

Mahalanobis — 2009-07-01T11:01:00Z

FINalternatives writes:

A player in the secondary market for private equity investments, Coller Capital knows all about illiquid investments. And with many a hedge fund desperate to offload theirs, the London-based firm smells an opportunity.

Coller has begun buying illiquid assets from hedge funds, Financial News reports. The firm, which boasts some US$8.5 billion in assets under management, has bought assets from two hedge funds, one in the U.S. and one in Europe, over the past year, and has had talks with about 50 others about similar deals over the past two years.

Hedgies in a Valley of Tears...

ECB's cash injection (EUR 442bn)

Mahalanobis — 2009-06-30T18:18:00Z

The FT writes:

[A]nalysts said the jury was still out on how effectively the ECBs record cash injection would boost the broader economy, as much of the money had so far been parked back at the ECB.

The central bank said the amount placed in its overnight deposit facility on Friday had soared to €236.2bn. This compared with €7.4bn on Wednesday before the 12-month injection had had time to filter through.

Don Smith, economist at inter-dealer broker Icap, said: This shows that the ECBs liquidity operation has been successful in bringing [Euro libor] rates down, but well have to see whether it leads to more activity in terms of lending.

Banks typically hold back from interbank lending in the run-up to the end of the half-year, which is today. We should get a clearer picture at the end of the week.

Lena Komileva, economist at inter-dealer broker Tullet Prebon, said: We still dont know where the extra liquidity from the ECB will end up. If banks use it as a carry trade to buy government bonds, instead of easing credit conditions for companies and individuals and preventing defaults, then it will not stimulate the broader economy. This would be the route to a liquidity trap."

Debt Illiteracy :: Time Value of Money

Mahalanobis — 2009-06-30T17:20:00Z

Lusardi, Tufano and TNS Global asked 1000 U.S. residents the following question:

You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options:

a) Pay 12 monthly installments of $100 each;
b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now.

Which is the more advantageous offer?

Result:

Here are all the results from the survey. Unbelievable. The questioning was done over the phone which could distort the results a bit but it's nevertheless a disaster.

Bespoke Derivatives

Mahalanobis — 2009-06-30T07:47:00Z

Economics of Contempt: Apparently commentators are upset because the administration's financial reform proposal only requires "standardized" derivatives to be cleared through central counterparties (CCPs), and not bespoke derivatives. James Kwak even questions "why we need customized derivatives in the first place." He claims he can't even think of an example of when a firm would legitimately need to use a bespoke derivative. Umm, how about...

via Alea

Efficient Market Hypothesis

Mahalanobis — 2009-06-29T17:32:00Z

It's amazing how many crappy stories you find these days on the EMH. Guys, go and read

Efficient market hypothesis and forecasting, Allan Timmermann, Clive W.J. Granger, International Journal of Forecasting 20 (2004) 15--27

and help Clive Granger stop spinning like a freaking pulsar in his grave.

Implied loss distributions of European IG corporate bonds

Mahalanobis — 2009-06-29T14:56:00Z

The chart shows estimates of market-implied loss rates from five-year on-the-run iTraxx Europe Main CDS indices. These are "risk-neutral" loss rates. In the likely case that investors are averse to risk, the perceived probability of high loss rates would be lower than under the risk-neutral measure.

Source: Bank of England Financial Stability Report June 2009

Method of calculation not reveiled.

1. Invest, 2. Ask

Mahalanobis — 2009-06-27T20:42:00Z

NYSE Loses Trades Fastest in a Year and Nasdaq Isnt the Winner

Mahalanobis — 2009-06-24T11:58:00Z

Bloomberg writes:

NYSE Euronexts control of U.S. stock trading is slipping away.

Two-hundred seventeen years after the New York Stock Exchange was founded under a Wall Street buttonwood tree, its modern-day parent executed a record low 30.2 percent of Mays trades, data compiled by Bloomberg show. That's down 2.8 points from February for the worst three months since June 2008. The beneficiary wasnt Nasdaq OMX Group Inc., the Big Boards main rival for 38 years. It was Direct Edge Holdings LLC and Bats Exchange Inc., which more than doubled their combined share since August to 22.8 percent.

Click here to read the whole story. Click here to watch an interview with DirectEdge CEO Bill O'Brien.

macro-prudential regulation

Mahalanobis — 2009-06-22T11:40:00Z

Respinning the Web, FT

Black Swan: Fallen from the pure faith

Mahalanobis — 2009-06-18T20:23:00Z

Accrued Interest writes:

[W]hat I'm reading about Universa betting on inflation is total incongruous with what I thought was Taleb's philosophy: basically that the big events in life, history, and markets are almost totally unpredictable. Given this, the best way to invest is to bet on change. Not to bother with long-term predictions based on fundamentals as we see them today, because by the time the long term comes around, fundamentals will be wildly different.<>

Mark Spitznagel, who runs Universa, the hedge fund Taleb advises, is betting on inflation? I'm not going to rehash my own view on inflation, that's not the point. The point is that Taleb is known specifically for not betting on markets and economic events. Any market/economic outcome that you can see ahead of time, even as a lesser possibility, it isn't a Black Swan at all.

Second of all, Taleb and Spitznagel aren't economists. They are mathematicians and traders. I don't know that they are especially equipped to make an inflationary call. So it makes you wonder. Is Spitznagel doing this because its his view of markets or his view of what's marketable? <> I remember an interview Taleb gave on CNBC during the winter when he derided the money bank executives had made, specifically arguing that they managed their banks to enrich themselves, not their shareholders...

Btw, here is what Papademos (VP of ECB) says about future inflation:

[A]n issue of relevance for the implementation of the appropriate monetary policy stance in the context of an exit strategy is the careful assessment of the extent to which parts of the monetary policy transmission mechanism have been affected by the financial market turbulence, and the implication of this for the conduct of monetary policy.

For example, during the crisis the ratio of the broad monetary aggregate M3 to the monetary base M0 has dropped rapidly and substantially because the provision of liquidity by the central bank is only partly transmitted and to a much lesser extent than in normal times to the bank credit market and the real economy. Once the economy recovers and the deleveraging of banks balance sheets is complete, the value of this money multiplier will start reverting to normal. Vigilance and appropriate policy responses are therefore needed to avoid an excessive expansion of credit to the economy. These concerns may seem premature at the present juncture of tight financing conditions, but is important to be prepared so that the exit strategy is implemented effectively and we avoid sowing the seeds of credit and asset market excesses in the future that could constitute a risk to price stability.

One attractive feature of most non-standard measures used by the ECB is that they can be easily unwound and that the liquidity provided can be withdrawn automatically at the maturity of the refinancing operations. Of course, the relative advantages of different non-standard measures with regard to their unwinding should be judged against their effectiveness in providing the necessary credit support during the crisis. And the effectiveness of different measures depends on the economys financial structure, for instance the extent to which the financing of the economy relies on the banking system, as is the case in the euro area, or it is market-based, as is the case in certain other advanced economies.

So it seems inflation would only be a big issue in case it is not homegrown (e.g. higher oil price).

CMBS Quote of the Day

Mahalanobis — 2009-06-18T16:33:00Z

From an older FT article:

Should a mortgage become delinquent, the servicer will transfer the loan to a special servicer, Berger said. The special servicer will take any action that yields the highest recovery for the CMBS bond holders, he added.

Those actions include a modification, a restructuring, or a liquidation of the asset, Berger said. In less dysfunctional markets, resolutions dont take too long, but because the current commercial real estate market is so challenging, the resolutions have taken much longer, he said.

Those resolutions could include forbearances on defaults or extensions of the mortgage maturities, Berger said. However, forbearances should not be predicated on the hope that the market turns around and financing becomes available again, he said.

There is a fairly well-known concept:

hope is not an exit strategy,

he warned.