Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iima.ac.in

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Thu, 30 May 2013

St Petersburg once again

One and a half years ago, I blogged about a paper by Peters that purported to resolve the paradox by using time averages. I finally got around to writing this up as a working paper (also available at SSRN). The content is broadly similar to the blog post except for some more elaboration and the introduction of a time reversed St Petersburg game as a further rebuttal of the time resolution idea.

Posted at 12:37 on Thu, 30 May 2013     View/Post Comments (0)     permanent link


Tue, 28 May 2013

Currency versus stocks

In India we are accustomed to see the rupee and the stock market moving in the same direction as both respond to foreign investment flows. In recent weeks, the pattern has changed as a weakening rupee has coincided with a rising stock market. Another country with the same pattern is Japan where some commentators have argued that the pattern makes sense if foreign investors are hedging the currency risk while buying stocks. This is an interesting idea with potential relevance to India – foreigners can be long the private sector (equities) and short the government (currency).

Posted at 14:28 on Tue, 28 May 2013     View/Post Comments (4)     permanent link


Mon, 20 May 2013

Macroprudential policy or financial repression

Douglas J. Elliott, Greg Feldberg, and Andreas Lehnert published a FEDS working paper last week entitled The History of Cyclical Macroprudential Policy in the United States. In gory detail, the paper describes every conceivable credit restriction that the US has imposed at some time or the other over some eight decades. It appears to me that most of them are best characterized as financial repression and not macroprudential policy. If one adopts the authors’ logic, one could go back to the middle ages and describe the usury laws as macroprudential policy.

Some two decades ago, we thought that financial repression had been more or less eliminated in the developed world, and was being gradually eliminated in the developing world as well. Post crisis, as much of the developed world deals with the sustainability of sovereign debt, financial repression is back in fashion, and macroprudential regulation provides a wonderful figleaf.

Posted at 12:07 on Mon, 20 May 2013     View/Post Comments (0)     permanent link


Thu, 16 May 2013

The CDO'ization of everything

Six years ago, when the global financial crisis began, Collateralized Debt Obligations (CDOs) were regarded as the villains that were the source of all problems. Today, the clock has turned full circle, and CDO like structures have become the solution to all problems.

The biggest innovation in the CDO was actually a contractual bankruptcy process that is lightning fast and extremely low cost (see my blog posts on the Gorton-Metrick and Squire papers that argue this in detail). The world is gradually coming around to realizing that normal bankruptcy does not work for the financial sector and the contractual CDO alternative is far better. In 2006, I wrote that the invention of CDOs has made banks and other legacy financial institutions unnecessary. The crisis seems to be turning that speculation into reality.

Posted at 11:53 on Thu, 16 May 2013     View/Post Comments (1)     permanent link


Fri, 03 May 2013

Interest rate models and central bank corridors

In my blog post last month about interest rate models at the zero bound, I did not consider the effect of central bank corridor policies. I realized that this is an important omission when I looked at the decision of the European Central Bank (ECB) a couple of days ago to lower the main refinancing rate (the central rate in the corridor) by 0.25% and the marginal lending facility rate (the upper rate in the corridor) by 0.50%. Why was one rate lowered by twice as much as the other? The answer is that with the deposit rate (the lower rate in the corridor) stuck at zero since July 2012, the only way to keep the corridor symmetric is to set the upper rate to be exactly twice the central rate. So the marginal lending facility rate will always change by twice the change in the main refinancing rate!

Of course, despite the deeply (biologically) ingrained love of symmetry, central banks can decide to abandon symmetry and move the central and upper rates independently. In fact, the historical data shows that in the first three months of the ECB’s existence, the corridor was not symmetric around the central rate, but since April 1999, the symmetry has been maintained.

Modelling short term rates in a symmetric corridor floored at zero is problematic. The log normal model has problems because it does not allow rates to be zero. Yet it is the natural way to model the proportionate changes in the central and upper rates.

Posted at 13:46 on Fri, 03 May 2013     View/Post Comments (0)     permanent link