Extracting information from finance

Business Standard, 2 August 2006

After surprising markets twice, Dr. Reddy's monetary policy announcement of July 25 was in line with market expectations. He raised short term interest rates as expected. What do we expect him to do next? Unfortunately, the markets that would have given us this information don't exist.

The consensus view of the market now holds that the US Fed rate hikes have ended: it is felt that there is a 70% chance that the August and September meetings will leave the US short rate at 5.25%. How am I able to make this statement? First, the US Fed has built up a long track record of its behaviour, it has clarity of objectives, and communicates these effectively to the market.

Second, there is a remarkable financial market which trades "options on the fed fund futures", using which the consensus views of the market are made transparently visible. This is an options market, on future fluctuations of the futures market, on the fed funds rate. It is a speculative derivatives market, where traders express views about outlook for the Fed rate. Using financial economics, the market prices of these options can be converted into probabilities of future rate hikes. Through this, the operations of the derivatives market reveals new information to the economy. The Federal Reserve Bank of Cleveland has setup a free service on the Internet, where the world is given daily updates about the outlook for the next two Fed meetings.

This idea has been kicking around in finance since the 1970s. In a series of situations, traded prices of financial products constitute a new element of the statistical system. The observed market prices (with a bit of value added calculations) reveal extremely valuable information to the economy. This is a new function of financial markets, over and beyond the traditional tasks of speculative price discovery, liquidity provision, and risk management.

A well established research literature finds that these forward-looking estimates, based on the market, are superior to the best econometric models. The reason for this is simple: some of the top economists are wielding the best econometric models, and trading on the financial markets! If you believe that the August meeting will generate a rate hike - i.e. you do not share the consensus view - you can adopt a position on the options market, and earn enormous profits if you are right and the market is wrong.

Options on the equity index reveal the market's view about future equity index volatility. In the US, the S&P 500 index options market is extremely liquid. The future equity volatility embedded in these prices is released as an index called VIX which is easily observed. It is the best estimator of future global macroeconomic uncertainty.

In similar fashion, every stock options market reveals information about what the market believes will happen for the volatility of the stock. This can be a valuable input for many applications, such as credit risk analysis. In similar fashion, options markets on interest rates reveal future interest rate volatility.

When there is trading on inflation indexed bonds alongside trading in nominal bonds, the two yield curves can be easily combined to come up with the market's view about future inflation. This shows inflationary expectations in the economy, which are important in their own right. In addition, these expectations have a long track record of being fairly accurate.

Market prices from the currency options market can be used to infer expectations in the market about future currency volatility. This is obviously extremely useful, both for people who face currency risk, and for macroeconomic policy making. A famous episode in this field took place in Israel, where there was an exchange which traded currency options, but this market had limited speculative trading, so the information obtained from it was viewed as relatively untrustworthy. In order to elicit information, the Israeli central bank (which is widely reputed to be the smartest central bank in the world) initiated a program of regularly auctioning currency options, simply so as to discover the future currency volatility. Over the years, this helped the exchange to become liquid, after which the central bank's auction program was discontinued.

In India, RBI has been repeatedly criticised for surprising the market with interest rate changes. The old view of monetary policy was that there should be a "mystique of central banking", that an impassive central bank must hurl thunderbolts from the blue which would keep the market guessing. It is now well understood that an inscrutable and mysterious central bank is one that is less effective. The effectiveness of monetary policy is increased when financial markets have sound expectations about the future trajectory of monetary policy. A modern framework hence contains two elements : transparency by the central bank about its goals and its views about the future, coupled with organised derivatives trading, through which the views of the financial market are made manifestly visible to all.

This perspective sheds new light on financial repression. The traditional approach in India has been to use levers of policy and regulation to prevent well functioning markets for currencies and interest rates. This has been based on a philosophy of control: a liquid financial market is viewed as a threat to control.

But in the modern world, this is not how monetary policy is conducted. In mature market economies worldwide, there is no contradiction between vibrant, liquid financial markets; central banks do not engage in repressive efforts at blocking sophisticated finance.

Instead, the effectiveness of monetary policy comes through the actions of financial markets. Information sources derived from financial markets are accepted and embraced as an integral part of the game. A central bank might feel in control, tightly gripping the wheel, after it has ensured that none of these sophisticated markets exist. But it is flying blind.

One of the simplest and most useful pieces of economic reform in the country today is to initiate trading in currency futures and currency options, which would simultaneously make it possible for myriad financial agents to cope with currency fluctuations better, and simultaneously give the economy -- and RBI and MOF -- a continuously updated estimate of future currency volatility.

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