Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Daily Archives: March 26, 2017

Why do economists ignore risk?

Cochrane writes on his Grumpy Economist blog:

Here’s how covered interest parity works. Think of two ways to invest money, risklessly, for a year. Option 1: buy a one-year CD (conceptually. If you are a bank, or large corporation you do this by a repurchase agreement). Option 2: Buy euros, buy a one-year European CD, and enter a forward contract by which you get dollars back for your euros one year from now, at a predetermined rate. Both are entirely risk free.

It is only an economist who today thinks of this trade as risk free. Before the global financial crisis many finance people would have thought so too, but not today. After the crisis, any serious finance professional would immediately think of the multiple risks in these trades:

  1. The US bank could default

  2. The European bank could default

  3. The forward contract counterparty could default

  4. There is euro redenomination risk. In that terrifying state of the world, depending on the nationality of the bank and the forward contract counterparty, one or both of these could be redenominated into some other currency – new francs, marks, liras or drachmas . Theoretically, you could end up being long new French francs (on the euro CD) and short new German marks (on the forward contract).

During the last decade, finance has moved on from simplistic notions of risk. I like to believe that in many top banks today, those who espouse Cochrane’s view of risk would be at risk of losing their job. Or at least they would be asked to enrol in a course on two curve (or multi curve) discounting. In today’s finance, there is return free risk, but no risk free return. Covered interest parity is today only an approximation that you may use for a back of the envelope calculation, but not for actually quoting a price. I wrote about this in a wonky blog post last year, and I have discussed two curve discounting in another wonky post half a dozen years ago.

The wonderful thing about finance is that it provides an opportunity to get rid of bad ideas by marking them to market. The problem comes when we distrust the market and start thinking of model errors as market inefficiencies. Cochrane writes about the violations of covered interest parity:

… this makes no sense at all. Banks are leaving pure arbitrage opportunities on the table, for years at a time. … But this is arbitrage! It’s an infinite Sharpe ratio!

Rather than accept that the covered interest parity model is wrong in a two curve world, Cochrane thinks that post crisis regulations are preventing the banks from doing this “arbitrage” and bringing the markets back to the old world. It is true that a Too Big to Fail (TBTF) can still do covered interest “arbitrage”. But what that tells us is that a TBTF bank can pocket the gains from the covered interest trade and palm off the risks to the tax payer. A TBTF bank can do the trade, because it is closer to being risk neutral (anybody can be risk neutral with other people’s money). Yes, the covered interest trade has a positive Sharpe ratio but not an infinite one, and perhaps not even a very large one. We need less TBTF banks doing low Sharpe ratio trades, keeping the gains and shoving the losses to the taxpayers.

And both economists and policy makers need to take risk more seriously than they do today.