EconSouth (Second Quarter 2001)

Research Notes & News highlights recently published research as well as other news from the Federal Reserve Bank of Atlanta. For complete text of summarized articles and publications, see the links below.

Making sense of the yield curve

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. But without the proper analytical tools, drawing inferences from the yield curve can be difficult.

In a recent article, Mark Fisher 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, Fisher 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 to make sense of the shape of the yield curve.

Economic Review
First Quarter 2001

Is why we use money important?

Money and its underlying function as a medium of exchange play a central role in determining the course of macroeconomic activity. But many of the models used to evaluate fundamental questions relating money and monetary policy to economic activity simply assume currency is valued. Such models 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. Victor Li’s recent 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. Li suggests that future research use quantitative analysis to explore not only how well these models explain the empirical facts regarding money and economic activity but also how well they might provide guidelines for the operation of monetary policy.

Economic Review
First Quarter 2001

Dollar Index

The dollar continued a slight decline in January 2001. In February, however, the dollar began to increase again and in March registered an overall increase versus the 15 major currencies tracked by the Atlanta Fed. The slight decline in January was the result of weaknesses against the European subindex. In February and March the dollar reversed this decline.

Note: For more detailed, monthly updates and historical data on the dollar index, see the Atlanta Fed’s World Wide Web site at

Analyzing the risks and rewards of selling volatility

The popular practice of selling market volatility through selling straddles, or a portfolio of options, exposes traders and investors to substantial risk, especially in equity markets. The returns can be very lucrative, but the probability of large losses far exceeds the probability of large gains. 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.

A recent article by Saikat Nandi and Daniel Waggoner 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.

While rebalancing the straddle to maintain minimal exposure to market direction 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.

Economic Review
First Quarter 2001

Social security reforms in Latin America face challenges

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.

In a recent article, Stephen J. Kay and Barbara E. Kritzer examine the broad range of pension reforms in Latin America and highlight 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 study concludes 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.

Economic Review
First Quarter 2001

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