Monetization vs Sterilization

Sterilization is usually discussed in the context of currency intervention, but it’s functionally the same when a central bank wants to drain cash from the system.

It’s the process of selling longer-dated assets in exchange for zero-maturity money. This locks money up for a time, effectively removing it from current circulation. Usually, this would be done by selling off some of the Treasuries on the Fed’s own books for cash. The Fed will take the cash it receives and sit on it.

If the Fed doesn’t own enough treasuries, it might not be able to do this in large enough scale on its own. Now, the Treasury could just issue more treasuries and sell them to the Fed.

But the new ability to pay arbitrary interest rates to banks on their deposits is quite similar and can be used for sterilization. The banks deposit their cash with the Fed, which locks it up, taking it out of circulation.

The big difference is maturity: these deposits are generally just overnight, while a Treasury has a much longer term, up to 30 years, but with whatever maturity the government wants. Perhaps the Fed could start offering CD’s, essentially, to remove even this distinction...

The Federal Funds Rate

The Fed maintains the federal funds rate - the interest rate at which US banks make overnight loans to each other - at (or close to) the Fed's chose target by injecting (the rate falls) and extracting (the rate rises) liquidity from the banking system. The Fed does this through repurchase agreements (repos) or by manipulating the stock of Treasuries on its balance sheet.

However, when the Fed wants to keep the federal funds rate unchanged but add liquidity by other means (perhaps by auctioning off funds), the Fed sterilizes the effects of the new liquidity on the monetary base by performing an offsetting open market operation - an overnight repo or selling Treasuries outright.

Leaving money in the banking system as excess reserves increases the supply of federal funds & reduces the federal funds rates (below the Fed's target). The increased money supply is inflationary-too much money chasing the same number of goods & services.

Understanding The Yield Curve

What is it?

The graph you get when you plot the rates for 1-month T-Bills to 30-year T-Bonds.

When people think about interest rate changes, they generally are discussing a parallel change in interest rates, where rates change by the same amount across the yield curve.

When yield curve changes are discussed from a bearish or bullish standpoint...

Rising rates are considered bearish.

Falling rates are considered bullish.

Non-parallel shifts are generally discussed as yield curve twists.

The shape of the yield curve is simply the difference in yield between two maturities. The "rule of thumb" is to look at the 2-year to 10-year Treasury curve slope. If the 10-year rate less the 2-year rate is positive, the yield curve is normal, or positively sloped. If it were negative, it is called an inverted yield curve. If the difference is relatively small, it's considered flat.

Non-parallel shifts

Steepeners... when the difference between the long end & the short end increases

Bull steepener... short interest rates are falling faster than long rates

Bear steepener... long rates are rising faster than short rates.

Flatteners... when the difference between the long & short end decreases

Bull flattener... long interest rates are falling faster than short rates

Bear flattener... short rates rise faster than long rates

Measuring Performance

IC, information coefficient - A correlation value that measures the relatinoship between a variable's predicted & actual values, used for evaluating forecasting skill.

In our active quant strategies, an IR of .10 in considered excellent. An IR of .05 would be considered good.

IR, information ratio - A measure of the risk-adjusted return of a financial security (or asset or portfolio), defined as expected active return divided by tracking error. Top-quartile investment managers typically achieve information ratios of about one-half.

tracking error - the standard deviation of the active return

Why we use log returns

Log Returns

If $100 grows to $120, what is the single period return?

Discretely... +20% because 120/100-1 = 20%

Continuously... log return is given by LN(P1/P0) or ~18.2%. (If the asset paid dividends, they are included in the numerator).

Period log returns are typically used in quantitative finance

Benefits of log return

* Time additive: Note that the two-period log return is identical to the sum of the each period’s log return. To get the n-period log return, we can simply add the consecutive single period log returns. Conversely, notice the simple return is not time additive.

* Mathematically convenient: logs and exponents are easier to manipulate with calculus. Theoretical models tend to assume, unrealistically but conveniently, continuously compounded rates of return. For example, if LogReturn = LN(P1/P0), then EXP[LogReturn] = P1/P0. If f(y) = EXP[LogReturn] then the first derivative, f’(y) is quite wonderfully also EXP[LogReturn]. In short, d/dx EXP[x] = EXP[x].

* Approximately good: for short periods (e.g., daily), the log return approximates the discrete return anyway

Drawbacks of log return

* Not "linear" in portfolio return: We would like to be able to say that portfolio return is a weighted sum of components (assets). However, we cannot say this under log returns: the log return is not linearly additive across portfolio components. But, the discrete return is linearly additive.

* Unrealistic: Markets tend to quote discrete returns

Trade Finance Definitions

Export Credit Agencies (ECAs)

Are private or quasi-governmental institutions that act as intermediaries between national governments & exporters to issue export financing, in the form of credits (financial support) or credit insurance and guarantees (pure cover) or both, much like normal banking activities

letter of credit

* Document issued which usually provides an irrevocable payment undertaking; can be source of payment for a transaction (i.e. redeeming the letter of credit will pay an exporter)

* Parties involved:

+ beneficiary - who is to receive the money

+ issuing bank - of whom the applicant is a client

+ advising bank - of whom the beneficiary is a client

* bill of landing (BOL or B/L) - document issued by carrier to shipper acknowledging that specified goods have been received on board as cargo for conveyance toa named place for delivery to the consignee

factoring

* Financial transaction where by business sells its accounts receivables to a third party (called a factor) at a discount in exchange for immediate money w/which to finance continued business

* Firm based operation (i.e. firm sells all its receivables); vs. forfaiting, which is a transaction based operation

* Parties involved:

+ seller of receivables

+ debtor

+ factor

Bonds and Inflation

Inflation breakeven rate refers to the difference between the nominal yield on a conventional bond and the real yield on an inflation-indexed bond of the same maturity. It has been used extensively as a tool to obtain the expected inflation.

If the breakevens are rolling over... one possible explanation is that, while the real yield holds steady, yields on conventional bonds are falling (i.e. conventional bonds are being bid higher) (hence the difference between the two yields is also falling). Funds could be flowing into bonds because deflation is considered more of a threat than inflation.