Using prospect theory to figure today’s monetary policy and its impact on markets..

Prof Jayant Varma of IIM Ahmedabad has a nice post which gets to the crux of the negative interest rate issue.

He says as bonds have negative rates, the concept of yield/coupon etc is lost. So, investors are looking at bonds in terms of prices alone just like stocks. Whereas, investors are looking at stocks as bonds as they give dividends. So bonds are the new equities and equities are the new bonds.

This is like the prospect theory applying in monetary policy as risk averse bond investors are seeking risks in wake of losses:

A year and a half ago, I wrote a blog post about loss aversion and negative interest rates. That post argued that if prospect theory is true, then the most loss averse investors who traditionally invest in bonds would now become risk seeking when confronted with certain loss of principal induced by negative interest rates. I also raised the possibility that the most loss averse investors would switch to equities and the less loss averse investors would stay in bonds. As we look around at investor behaviour under negative rates, we can see evidence of loss aversion at work though perhaps not quite in the way that I hypothesized earlier.

The most loss averse investors have become risk seeking by taking on duration risk rather than equity risk. If you buy a bond maturing beyond your investment horizon, then there is a possibility of a capital appreciation if interest rates become even more negative in the meantime. For example, suppose your investment horizon is 4 years and you put your money in a 10-year zero coupon bond yielding -0.1%. You would have to pay 100 × 0.999-10 = 101.0055 for such a bond with a face value of 100. At the end of 4 years, when you sell your bond, suppose the 6-year yield is -0.17%. the price of the bond would be 100 × 0.9983-6 = 101.0261, and you would have sold the bond at a profit! (You would break even if the 6-year yield is -0.1666%). You may think that there is a good chance that the 6-year yield will be more negative than -0.1666% for two reasons. First, since the yield curve is usually upward sloping, the yield is likely to drop as the residual maturity shortens from 10 years today to 6 years at the time of sale. Second, you may hope that central banks would become more aggressive with ultra loose monetary policy and push the entire yield curve deeper into negative territory.

In some sense, this is similar to the flight to equity markets that I postulated in my 2015 blog post. Equity investors traditionally tended to chase capital gains and tended to be relatively unconcerned about yields. Now it is bond market investors who are behaving in this way. There is no coupon anymore and they are hoping for redemption through capital gains by selling the bond before maturity. That is the best explanation that I can think of for bond yields turning negative at very long maturities – for example, the Swiss 50 year bond has been trading at negative yields.

On the other hand, there is a sizeable group of equity market investors who are today enamoured of the high dividend yield on some “safe” value stocks. Some of them are actually crossover investors from the bond market who see these dividends as the replacement for the coupons that they used to get on their bonds. These investors are buying equities for their yield rather than their capital appreciation.

In this sense, my original blog post may have got things upside down – bonds are the new equities (home to risk seeking investors hoping for capital appreciation) and at least some equities are the new bonds (home to risk averse investors hoping for a steady yield). If this is so, prospect theory is critical for understanding the effectiveness of unconventional monetary policy.

Hmm..

4 Responses to “Using prospect theory to figure today’s monetary policy and its impact on markets..”

  1. Anil Says:

    Dear Amol,
    Can you please refer me to some source, which can help me understand neutrality position in liquidity. Not able to understand this being refered to since april mon pol statement.
    Regards,
    Anil

    • Amol Agrawal Says:

      Hi Anil,

      Much of this liquidity bit is central banking jargon and noise. No one has a clue on the levels at one can say liquidity is neutral. It is the same case for neutral interest rate as well. One only know surplus and deficit liquidity based on daily repo borrowing and call/cblo rates.

  2. Anil Says:

    Thanks Amol……………. this such such an intresting take on jargon bit………… Meanwhile thanks for making wonderful contribution to blog. Its quite fascinating to see 1949 article from EPW weekly, The situation hasnt change much, only hubris being added.

    • Amol Agrawal Says:

      Hey Anil, thanks for the kind comments. It is mainly due to comments from people like you that keeps the blog rolling. Yeah nothing much has changed since 1949 except for hubris..

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