The Threat of Deflation

There has been some coverage in the news of the potential threat of deflation, an area of which we know less:

Here are links to Fed speeches and papers on deflation (from Dave Backus):


On deflation, here is a recent speech:

http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2002/20021121/default.htm

Here are some academic sources:


http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3350

http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=931

The Perils of Picking a Bottom (or Top)

The chart above is of the volatility index (from finance.yahoo.com). It measures the implied volatility of different options traded on the CBOE. It tells you the rough costs of purchasing options (for example, high volatility means a higher likelihood a call or put option will be used and hence more expensive). If you believe volatility (and the VIX) is likely to decline in future, it makes sense to sell options. If you believe it is likely to increase (it makes sense to purchase them). In this sense, the VIX is an indicator of market risk.

Two interesting aspects of this chart of the VIX.

1) It is very hard to tell where the peak is (and thus attempt to get into this market). March and August of 2007 appear to be new highs as do April of 2008 and notice several mini peaks in October of 2008. (You would also be in a period where you would definitely have to consider counter-party risk very carefully if you are purchaser of options.)

Historically a value above 30 indicated market stress. Look at the last two months!

The chart of the S&P 500 (below) is also from finance.yahoo.com. You can see that despite several attempts to call a bottom, no one really knows where the bottom is.



2) You can also observe a potential behaviorial problem for financial market participants from this VIX index. If you earn income from selling options, your income declines on a per option basis (securing risk is cheap and you earn less by agreeing to take it on from others). This should be a market signal to be a net buyer rather than seller of such options and indeed some hedge funds are likely to move in and out of this business accordingly.

However, a bread and butter firm that sells options is likely to have to respond by sell more options to generate the same revenue (which their bosses are probably demanding). So although it might seem in stable periods that things can only get riskier (and your income from accepting such risk by writing an option is at record lows), you may be ironically respond by taking on even more risk.

This is an aspect of the "chasing yield" story. In times when yields are down (indicating little reward taking on for risk), investors often respond by investing in ever riskier assets (be they junk bonds or CDO equity tranches) as these are the only investments at the time that are yielding high returns.

The irony is that while a particularly risky junk bond may be yielding close to 8% and few other assets yield close to that, the true value of that bond when taking into account the risks may be closer to 12% Instead of walking away, if a firm had a target of a 12% return, they would borrow money and lever up on more of these bonds until they were able to reach their targeted return. Of course, they are taking on a tremendous risk and are likely to get burned.

In reality, they should sit out the market or "short" the market. For example, the could just invest in purchasing put options on the underlying asset (a right to sell at a fixed price, hoping these assets become riskier and their value fall so that you can buy at the cheap price and immediately resell at the high price you previously arranged to lock in).