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Economic Review

Economic Review
C O N T E N T S
First Quarter 2001/Volume 86, Number 1

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.

These files are in PDF format, which requires Adobe Acrobat Software (links off-site)

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
Acting Editor

NANCY PEVEY
Managing Editor

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

LYNNE ANSERVITZ
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, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713 (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

Forces That Shape the Yield Curve
Mark Fisher

The yield curve shows how the yield on a government bond depends on the bond’s maturity. Monetary policymakers and observers pay special attention to the shape of the yield curve as an indicator of the economic impact of current and future monetary policy. Without the proper analytical tools, however, drawing inferences from the yield curve can be difficult. This article uses high-school algebra to introduce those tools in a rigorous but accessible way.

The author develops the basic ideas about the yield curve using an analogy. Next, he discusses bond pricing in a world of perfect certainty, where no-arbitrage conditions are first worked out algebraically. The element of uncertainty is then added via a single flip of a coin, and the no-arbitrage conditions for bond prices are worked out for this scenario as well. These no-arbitrage conditions are shown to imply the existence of a risk premium that depends on the price of risk and the amount of risk. Finally, the article demonstrates how to translate the no-arbitrage condition for bond prices into a no-arbitrage condition for yields.

The author concludes that convexity—the nonlinear relation between bond yields and bond prices—leads to surprising and even counterintuitive results in yield-curve analysis. A firm grasp of the no-arbitrage conditions is therefore necessary in order to make sense of the shape of the yield curve.


Is Why We Use Money Important?
Victor E. Li

Money and its underlying function as a medium of exchange play a central role in determining the course of macroeconomic activity. However, many of the models used to evaluate fundamental questions relating money and monetary policy to economic activity simply assume currency is valued and overlook the important properties of money that influence the way it is used and how its supply affects the economy.

Search and matching models of money identify the characteristic assumptions for motivating the use of money in carrying out transactions by explicitly capturing the trade frictions that cause money, rather than some form of barter, to be used. This article summarizes some of the recent literature on search models of money and their successful application to issues such as currency substitution and the impact of money’s quantity and growth rate on inflation and economic activity.

This promising class of models, the author concludes, does indeed shed light on these topics and has an enormous potential to address an even broader range of issues. To date, the results of most of these applications have been qualitative. In future work, a quantitative analysis would explore not only how well these models explain the empirical facts regarding money and economic activity but might also provide guidelines for the operation of monetary policy.


The Risks and Rewards of Selling Volatility
Saikat Nandi and Daniel Waggoner

The popular practice of selling market volatility through selling straddles exposes traders and investors to substantial risk, especially in equity markets. The returns can be very lucrative, but the probability of large negative returns far exceeds the probability of large positive returns. In fact, selling straddles has resulted in substantial losses at banks and hedge funds such as the former Barings PLC and Long Term Capital Management.

This article outlines the risks and rewards associated with selling volatility by first examining the statistical properties of the returns generated by selling straddles on the Standard and Poor’s 500 index. The authors demonstrate that the usual practice of selling volatility by comparing the observed implied volatility with the volatility expected to prevail could be flawed. This flaw could arise if the underlying asset has a positive risk premium and the returns of the underlying asset are negatively correlated with changes in volatility. Thus, basing the decision to sell a straddle on a comparison of seemingly irrational high implied volatilities with much lower expected volatility could itself be an irrational choice.

Does it help to rebalance the straddle to maintain minimal exposure to market direction? While such rebalancing is theoretically feasible, the authors find that this process exposes the trader to model risk and does not eliminate the skewness of returns from selling volatility.


Social Security in Latin America: Recent Reforms and Challenges
Stephen J. Kay and Barbara E. Kritzer

Over the last decade Latin American countries have served as the world’s laboratory for pension systems based upon individual retirement savings accounts. In the 1990s several countries in the region followed Chile’s lead in setting up individual accounts, and since that time countries throughout the world have looked to the region for lessons.

This article summarizes the broad range of pension reforms in Latin America and highlights some of the most noteworthy and unique features of each country’s reforms. Some countries have adopted defined-contribution individual accounts as a replacement for state-run pension systems; other countries have embraced mixed systems or have made individual accounts optional and supplementary. The authors also examine some of the most serious policy challenges faced by governments implementing the new systems. Policymakers are seeking to reduce administrative costs, limit evasion, incorporate new categories of workers into the system, and improve competition in the pension fund industry.

The authors conclude that pension reforms are continuously subject to revision and that reform itself can be an incremental process. Latin America’s social security systems are likely to continue to attract international attention from policymakers as governments worldwide confront the challenges of pension reform.