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Economic Review

Economic Review
C O N T E N T S
Second Quarter 2002/Volume 87, Number 2

Economic Review articles are posted on the Web as they become available. Page numbers in the PDF file posted here may not reflect the page numbers of the printed version.

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PRESIDENT
JACK GUYNN

SENIOR VICE PRESIDENT AND
DIRECTOR OF RESEARCH

ROBERT A. EISENBEIS

RESEARCH DEPARTMENT
THOMAS J. CUNNINGHAM
Vice President and
Associate Director of Research

GERALD P. DWYER JR.
Vice President, Financial

WILLIAM ROBERDS
Vice President, Macropolicy

LARRY D. WALL
Research Officer, Financial

JOHN C. ROBERTSON
Assistant Vice President, Regional

ELLIS W. TALLMAN
Assistant Vice President, Macropolicy

TAO ZHA
Assistant Vice President, Macropolicy

PUBLIC AFFAIRS
BOBBIE H. MCCRACKIN
Vice President

LYNN H. FOLEY
Editor

NANCY PEVEY
Managing Editor

CAROLE L. STARKEY,
PETER HAMILTON, AND JILL DIBLE
Designers

ALISON BOUNDS
Marketing and Circulation

CHARLOTTE WESSELS
Administrative Assistance

The Economic Review of the Federal Reserve Bank of Atlanta, published quarterly, presents analysis of economic and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.

Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.

Material may be reprinted or abstracted if the Review and author are credited. Please provide the Bank's Public Affairs Department with a copy of any publication containing reprinted material.

Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470 (404/498-8020). Internet: http://www.frbatlanta.org. Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new information.

ISSN 0732-1813

The Economics of Payment Finality
Charles M. Kahn and William Roberds

Payment finality is critical to decentralized exchange. By specifying how the transfer of one type of claim extinguishes another, the rules governing finality minimize opportunities for default along credit chains and allocate other risks.

The authors provide a basic analysis of finality and its role in facilitating exchange. They first present a simple, historically based model of transferable debt and finality. The discussion demonstrates the desirability of transferable debt and why rules governing payment finality are needed to sort out who will bear the losses in the event of default. Over time, the introduction of such rules helped establish the concept of negotiability, which greatly increased the efficiency of trade.

A second model shows how a more modern payment system works. The large volume and scope of payments in modern systems have resulted in disparate sets of finality rules. For example, the finality of check payments is generally tentative, and the risks are often concentrated on a single party. Credit and debit card payments are generally more final, and the liability for potential losses tends to be shared among participants. Choosing the degree of finality for a given situation involves a trade-off between the benefits of finality and the costs of an erroneous or fraudulent transfer. The introduction of new technologies for payments may improve these trade-offs, but finality will remain the essential service provided.


Asset Returns and Economic Risk
Cesare Robotti

The capital asset pricing model (CAPM), favored by financial researchers and practitioners fifteen years ago, holds that the extra return on a risky asset comes from bearing market risk only. But newer evidence supports the intertemporal CAPM (I-CAPM) theory (Merton 1973), which suggests that the premium on any risky asset is related not only to market risk but also to additional economic variables.

This article reviews and interprets recent advances in the asset pricing literature. The study seeks to shed light on the sources of economic risk that investors should track and hedge against and the sign of the risk premia commanded by economic and financial risks.

The author empirically measures the impact of prespecified financial and economic variables on the risk-return trade-off by looking at how they affect (or predict) the mean and the variance of asset returns. The analysis shows that variables such as the market portfolio, the term structure, the default premium, and the consumption-aggregate wealth ratio positively affect average asset returns and command positive risk premia while the inflation portfolio negatively affects returns and commands a negative premium.

The article also provides extensive evidence of time variation in economic risk premia, showing that expected compensation for bearing different sorts of risk is larger at some times and smaller at others depending on economic conditions.


Special Repo Rates: An Introduction
Mark Fisher

Transactions involving repurchase agreements (known as repos and reverses) are important tools the Federal Reserve uses in implementing monetary policy. By undertaking such transactions with primary dealers, the Fed can temporarily increase or decrease the quantity of reserves in the banking system. The focus of this article is the repo market, especially the role the market plays in the financing and hedging activities of primary dealers. The author explains the close relation between the price premium that newly auctioned, or on-the-run, Treasury securities command and the special repo rates on those securities. The author?s analysis demonstrates that the rents that can be earned from special repo rates are capitalized into the price of the underlying bond so as to keep the equilibrium rate of return unchanged.

The discussion begins with a description of repos and reverses, the difference between on-the-run and older securities, and the ways dealers use repos to finance and hedge. The article then examines the difference between general and specific collateral, defines the repo spread and dividend, presents a framework for determining the equilibrium repo spread, and describes the average pattern of overnight repo spreads over the auction cycle. Finally, the article discusses convergence trades and repo squeezes. Two appendixes provide detailed analysis.


The Behavior of Federal Funds Futures Prices over the Monetary Policy Cycle
Jeff Moore and Richard Austin

The federal funds futures market enables market participants to both hedge interest rate risk and speculate on interest rate movements. Prices of federal funds futures also reveal market participants? expectations about changes in Federal Open Market Committee (FOMC) policy. This information allows monetary policymakers to assess the degree to which asset prices already reflect potential policy moves and these prices? likely reaction to policy changes that deviate from market expectations.

This article examines the relationship between U.S. monetary policy changes and futures market participants? ability to forecast these changes. Previous research has shown the federal funds futures market to be a relatively good forecaster of changes in the fed funds rate on average. But these studies treated futures market data as a single sample and failed to take into account the significant changes in forecast error behavior over different periods of the monetary policy cycle.

The authors find that futures market forecast error mean and variance differ substantially over various stages of the monetary policy cycle, with overall performance improving considerably in the latter half of the 1990s before deteriorating sharply through 2000 and 2001. The data also reveal both substantial overshooting and undershooting by futures prices around turning points in the path of the funds rate. Finally, the evidence suggests that increased disclosures of information by the FOMC during the past decade have played only a minor role in improving futures market participants' forecasting performance.