Layman's Guide to the Bond Market

Another correspondent chimes in:

Could you explain this in simple English? I don't have any training in economics, but I want to understand. For example, why is it that the interest rate and the price move in opposite directions? I thought the interest rate was the price.

Excellent idea! The first thing to understand is what exactly a bond is. A bond is just a debt. If I am selling bonds, what I'm really doing is borrowing money. What I am selling is the promise to pay a certain amount of money at a set date in the future, and I am selling that for a price less than the amount I will pay at the future date. 

So, say I want to borrow some money for one year. I offer a $1000 bond for sale at, say, $990. If you want to lend me this money, you agree to give me $990 now, and I agree to give you $1000 in one year. This difference, $10, is what determines the interest rate, in this case, 10/990 = .01 = 1% (good deal for me!). This is the price I must pay to borrow this money. What is it that determines this interest rate, that is, what determines the difference between what I get now and what I have to pay in a year? For simplicity, we'll just say that it's mostly based on what you, the lender, or the buyer of my bond, think of my likelihood of paying you back, and the difference between what the money is worth to you today versus what it is worth to you in one year (the "time value of money").

The other way to look at a bond is from the buyer's perspective. As we've already said, the person buying a bond is really lending money to the person selling the bond. As we saw above, the interest rate is the price the bond seller (money borrower) must pay in order to borrow the money. From the perspective of the bond buyer (money lender), the interest rate is the "rate of return" on the money loaned. Think of it this way: you've found yourself with an extra $990. What do you want to do with it? You could put it in a checking account, where in one year you will still have $990, no more, no less. You could buy something that you think will go up in value, like stock, or a commodity like gold or oil. If you do that, you're hoping that you'll be able to sell it in the future (say one year) for more than you bought it for. On the other hand, you could also lose money if  whatever you buy goes down in value. So on the one hand (checking account) you have virtually no risk of losing your money, but absoluely no chance of growing the money. On the other hand (stock, commodity) you have the chance to make a lot of money, but also the chance of losing a lot (as much as all of it, if the company you buy stock in, for example, goes bust). A bond is a sort-of middle-of-the-road between those two extremes. You will earn more than a checking account, but less than best-case stock or gold purchases. The risk is less than that of stocks or commodities, because you will get back what the bond says you will get back, unless the company goes bust. (With a stock, it could lose value if the company is struggling, but still in business.) 

So this is pretty straightforward, right? I want to borrow some money, and you have some lying around, so we agree a price and we're both happy, right? Not so fast! From my perspective, not much can happen  from here. I will pay you in one year. But this is not the end of the story for you. You've lent me your extra funds for one year, mainly because you didn't expect to need them. But now, six months into our agreement, suddenly you need your money! D'oh! What are you going to do? I don't have to pay you back, and in the world of high finance, I'm not going to do anything I don't have to. That gives you only one real option: find another person that you can sell my debt to. Maybe in our little miniature model of high finance, there is a third person. Call him Hans. Hans also has some extra cash, but he doesn't want to tie it up for a whole year, so he's been keeping it in a checking account earning nothing. Now you come along with an offer to Hans: buy this bond with only six months left before the payoff. You need your money back now, and Hans gets a productive place to put his money for six months.

Since you gave me $990 in exchange for me giving you $1000 in one year, you tell Hans that, since it's now six months into that year, that you'll sell him my bond for $995. This way you get the same interest rate that you were expecting, except for only half the year, and Hans gets the same interest rate for the other half-year. You and Hans make your deal, and now Hans holds my bond. This matters not a whit to me, because I wasn't going to try and hunt you down to pay you back in a year; you would've come to me, my bond in hand, and asked for your money back. Now, instead of you, Hans will come to me at the end of the year and get the $1000.

Now let's add one complication. What would happen if, when you and Hans were negotiating to sell my bond, Hans'd had other options? What if a fourth person, call her Martha, had been also offering to sell a six-month bond of her own? She only wants to borrow $1000 for six months. She's offering her bond for sale for only $992. Remember that you are trying to sell my bond for $995. What luck do you expect to have selling my (virtually) identical bond for more money? You're going to have to sell my bond for $992 if you want any hope of selling it. Remember that we said that the price that a bond sells for when it it "new," that is, when it is sold by its original borrower, determines the interest rate. The $1000 bond I sold you for $990 had an interest rate of 1%. So what is the interest rate on Martha's bond? (1000-992)/992 = 0.8%, but since this bond is only for six months instead of a year, the effective interest rate is twice that, or 1.6%. So what has happened here is that the prevailing interest rate has gone up from 1%, when I sold you my bond, to 1.6%, when Martha is offering to sell her bond. What has this done to my bond (your asset)? It has decreased its value. You can't sell it for the $995 that you'd want to in order to get the rate of return that you'd anticipated. You have to sell it for $992, which means that you only earned 0.4%. Now, if you hold your bond until its "maturity," that is, until the time that I agreed to pay you back, you would get the money we agreed to, unless I went bankrupt. But once you start buying and selling "used" bonds, that is, bonds whose original buyers wish to sell them, you face the same risk you face with assets like stocks and gold.

This is how the selling price of ("used") bonds moves in the opposite direction as the current interest rate. I hope this helps. If I've just made a pig's breakfast of the whole thing, let me know below.


(*Note: Math is simplified for explanatory purposes. Real interest rate calculations are slightly more involved.)

Chavez and Markets

Early prediction for the rest of the week: world commodity markets will go totally haywire while traders figure out the new lay of the land. Oil, obviously, but since various futures are relatively good substitutes, and futures impact spot prices*, all commodities will likely be screwy for a bit.


*This is a point of contention, I know, but I am asserting it, and, on this, I am not alone.

The Treasuries Market and the Federal Reserve

A correspondent writes:

I started to read this article, The Fed Is Starting To Prepare For A Future PR Nightmare, and I have to admit I do not understand it. Here I am ready to be awarded a Masters degree in economics. Yet I have not learned enough about money, banking, government fiscal policy, and central banking, to understand the points being made in this article.

Basically, the Federal Reserve earns revenue each year on its assets (mainly bond holdings). After its operating expenses are deducted, the profits are remitted to the Treasury. This has the effect of refunding much of the interest payments that the Fed receives from Treasury.

The price of a 'used' bond (as opposed to a newly-issued bond) moves inversely with the interest rate of near substitutes (mainly those newly-issued bonds). That is, if the interest rate on new Treasury bonds falls (due, say, to increased demand), the market value of existing Treasuries will rise, because they pay a higher rate of interest than the new bonds. (Side note: the demand for bonds can be alternately seen as the supply of loanable funds. If we graph the bond market, the market value of the bonds is the price, and the demanders are lenders. If we graph the loanable funds market, the interest rate is the price, and the suppliers are the lenders. The same information is conveyed by each approach; the difference is merely in presentation.)

The BI article is concerned with an opposite situation. If the demand for Treasuries falls, the interest rate will rise, driving down the market value for existing bonds, such as those on the Fed's balance sheet.

What the article left out was the fact that a fall in the demand for Treasuries means that there must be a corresponding rise in the demand for an equivalent safe asset, and such a beast has not been seen in the wild for some time. The reason so many lenders flock to Treasuries in the first place is that there doesn't at this time exist an similarly safe liquid asset. This is why lenders are happy with such exceedingly low returns.

(Of course the interest rate on Treasuries could rise because supply has fallen, but most political and economic observers would welcome that novel and exciting development.)


(Perhaps some further thoughts to follow...)


UPDATE: I've posted a layman's explanation of how the bond market works, and why prices and interest rates move in opposite directions, here.

Mamas, Don't Let Your Babies Grow Up To Be Goldbugs

I spent some time this evening flipping through John Allison's The Financial Crisis And The Free Market Cure, his unconventional and contrarian take on the 2008 financial crisis. (That's an hour of my life I'll never get back.) It's not that I expected to agree with his views; I just didn't expect the book to read as if it were written by a child. Sample sentence: "We built too many houses, too large houses [sic], and houses in the wrong places." The general tone is that of a tantrum; Mr Allison rails against his imagined oppressors, and expects his audience to empathize with his tragic role as a lone voice of reason whose triumphs will be yours if you just listen but you won't because how could you when you've been brainwashed by Paul Samuelson! and Bernanke who's DEBASING the CURRENCY! and SOCIALISM! [trails off...]

There is one lesson in this book: the danger of bad economics. I'd expect Mr Allison to concur, except that the lesson is not in the book; Mr Allison himself is the lesson.

Quote of the Day - Colbert

“If this is going to be a Christian nation that doesn't help the poor, either we have to pretend that Jesus was just as selfish as we are, or we've got to acknowledge that He commanded us to love the poor and serve the needy without condition and then admit that we just don't want to do it.” -Stephen Colbert

Why are we still debating democracy? Or, How I learned to Stop Worrying and Love Dictatorship

Alex Tabarrok:

We usually think of democracy as a way of aggregating diverse preferences but we can also imagine that we share similar preferences and that what we disagree about is the best way to achieve those preferences. From this perspective, democracy can be thought of as a tool for information aggregation. Using simple probability theory, Condorcet showed in 1785 that even when each individual voter has only a slightly better than chance probability of choosing the bettier [sic] of two options the probability that majority rule chooses the better outcome quickly goes to 1 as the number of voters increases (the wisdom of the crowds). 

A number of writers at Crooked Timber have been discussing Knight and Johnson’s The Priority of Democracy, one strand of which involves such an cognitive defense of democracy. Cosma Shalizi, for example, writes: 

Democratic debate is a tool for cognition, for harnessing the dispersed knowledge of the citizens and their diversity of perspectives and insights. 

But does an cognitive defense of democracy lead to universal suffrage? Or does it suggest what Melissa Schwartzberg calls “epistocracy”, rule by the educated? (See also Henry Farrell’s comments). The wisdom of the crowds breaks down when the crowd’s errors are systematically biased rather than random. As Peter Boettke notes, Bryan Caplan makes a strong case in The Myth of the Rational Voter that better educated voters are less systematically biased than the average voter and more likely to agree with experts on questions of fact. 

When voters are not equally competent some remarkable mathematical results show that the best cognitive democracy is not universal suffrage and one-person, one-vote but a specific form of weighted voting. 

Begin with a simple example. Suppose there is one correct decision and there are three voters each trying to reach the correct decision with competence levels of {.55, .55, .55}, where the competence levels are just the probabilities that each voter chooses the correct decision. The best a dictator could do in choosing the correct decision is .55 but if use majority rule the probability of reaching the correct decision is 0.57475, higher than that of any individual voter. (We reach the correct decision if all three voters reach the correct decision which has prob .55^3 or if two voters reach the correct decision and one does not, as this can happen in three ways the probability of the latter is 3*.55*.55*(1-.55) for a grand total of .57475.) Moreover, if we were to increase the number of voters to 100, the probability of majority rule reaching the correct decision goes to 84%–far above that of any dictator, this is the essence of Condorcet’s theorem. 

Now let’s assume that the voters have competences of {.55,.60,.70}. Majority rule, using the same reasoning as before, gets us a democratic competence level of .673, not bad but notice that this is less than the competence level of the highest competence individual. The ideal voting system in this case would weight voter three enough so that she determines the outcome, thus giving democracy a competence level of .7. 

More generally, if the voter competences levels are {p1,p2,p3} then the cognitively most efficient voting scheme gives each voter a weight of Log[pi/(1-pi)]–the result is remarkable for a being such a simple formula of the voter’s own competence level (note that the individual’s weighting is not a function of the competency levels of the other voters.) The result was shown first in this context by Nitzan and Paroush, Nobel-prize winner Lloyd Shapely and Bernard Grofman also made important contributions and see Grofman, Owen, Feld for some related results.) 

Democracies make many decisions which are information based (Does Iraq have weapons of mass destruction? Will an invasion make the US safer? Do phthalates cause significant health risks?). Note also that we might also use this method for many committee decisions. Which scientific approach is deserving of greater funding? Which marketing plan should we adopt? Is surgery the best option? and in these decisions weighting votes by a measure of competence, which can be estimated from past decisions, may lead to significant improvements in outcomes. 

Voters have diverse preferences not just competences but we could combine cognitive and preference aggregation theories of democracy by using high competence voters from different demographics categories to estimate what people would think about issues if only they were better informed. In this way we can distinguish differences due to knowledge from those due to preferences and we could upweight the competent while maintaining demographic balance thus creating a cognitive democracy based on enlightened preferences. [emphasis added throughout]

This is reminiscent of Ron Paul's criticism of black voters, that they must not be intelligent because they vote for 'liberty' so rarely. Perhaps Mr Tabarrok measures 'competence' similarly. (On a technical note, I do find the math interesting, elegant, and irrelevant.)

The obvious question raised by the heterogeneous-competence example (which seeks to weigh votes by 'competence') is, "If we can determine 'competence,' why not find the person with the highest competence and elect him dictator?" Then we will always have the 'correct' outcome, or at least we will never have to worry about the incompetents dragging down the likelihood of a 'correct' outcome.

If you reformulate the model, and assume that 'correct' and 'incorrect' decisions are simply preference A and preference B (no value judgement), then the voter that was closest to 'correct' in Mr Tabarrok's model (who ought to be voted king, as we've already learned) is simply the person who wants preference A the most, and since he is running things now, that is what we shall get. Funny how nicely that works out, isn't it? Mr Tabarrok's intellectual forebears certainly thought so.

Why, oh why, does the liberty cult hate democracy so?

"Questions that are rarely asked"

"VTProf," via Tyler Cowen:

Another consistency question: can you simultaneously believe that minimum wages have small disemployment effects (implying inelastic demand for labor) and that higher immigration has small negative wage effects (implying elastic demand for labor). Sign me up for relatively elastic demand for labor (in the long run) – that’s why I support immigration and am skeptical about min wage!

This assumes that the demand for immigrant labor and the demand for minimum wage labor are one and the same, which is not necessarily the case.

Some questions are rarely asked because they aren't good questions. Others, because they aren't relevant to the discussion. Still others, well...

Stand Back

Inspired, or course, by this.

Gavin Wright and the Racial Wage Gap

Gavin Wright:

By the 1930s, labor markets in the South had come to display a distinct “racial wage gap,” supported by systems of vertical workplace segregation.  Not only were job categories classified by race, but black wage rates typically peaked about where white pay grades began.  These structures persisted through World War II and the 1950s, showing few signs of softening even in the presence of rapid urbanization and industrial employment growth. [emphasis added]

This gets exactly to the laissez-faire notion that discrimination is unsustainable in business, from either a customer- or an employee-relations perspective. The reasoning is usually expressed in this manner:

"If a firm discriminates, they will fail to maximize business and/or fail to hire the best workers, which will lead to their downfall. Therefore, anti-discrimination laws are unnecessary."

Of course, the missing word is "eventually." Over a long enough time span, the above reasoning is probably true, but history has shown that such social institutions can endure for generations.

On a macro level, such institutions retard the growth of the efficiency of labor, which, in the long-run, is the sole determinant of overall economic growth. Indeed, Wright argues in the book that the Civil Rights Movement benefited white and black alike.


from here.

more.

yet more.

via.

Demand Side Economics

Conscience Warrior has a new reader in the person of Alan Harvey, chief cook and bottlewasher over at Demand Side Economics. He very generously mentioned us in the most recent episode of his podcast. While I don't subscribe to every last detail of his views, I think we are in broad agreement on the way in which the world works, and as to what the best solutions are to the problems we face.

He published Demand Side: The Book last year, which compiles the ideas of some of the great minds of economics past and present into a sort of field guide to modern markets and the macroeconomy.

Mr Harvey also maintains the excellent forecasting site re: Macro Baseline.

Things Ain't Always As They Seem...

Politician and professor Michael Munger wants to “build a bridge between philosophers and economists.” To do so, he's coined a term, "euvoluntary exhange," which means a "truly voluntary" exchange, as opposed to an exchange which is voluntary only in the sense that no individual is coercing any other. Professor Munger's formulation allows that coercion can be circumstantial rather than personal, in that one party to a transaction is so disadvantaged by circumstance that his choice is not truly (eu-) voluntary.

This might be a useful distinction, and perhaps the impetus for an interesting discussion, if bridge-building were truly Professor Munger's goal.


Mike Munger, 4 February 2013:

This is a trick to draw my friends on the left into a discussion of voluntary choice. Euvoluntary choice is a warm and fuzzy idea that we can all agree on, but what I'm really arguing is that nearly all choices are welfare-enhancing regardless of whether they are euvoluntary or not.

Michael Munger's papers on euvoluntary exchange.

Title Inflation, German Edition

Nicholas Kulish and Chris Cottrell:

The university revoked the doctorate of the minister, professor Annette Schavan, on Tuesday, and on Saturday she was forced to resign her Cabinet post. It was the second time a minister had quit the government of Chancellor Angela Merkel for plagiarism in less than two years.
...
But many people attribute the underlying deceptions to an abiding lust and respect for academic accolades, including the use of Prof. before Dr. and occasionally Dr. Dr. for those with two doctoral degrees, which Rieble called “title arousal.” [emphasis added]

More here.


I'm not entirely sure what I can add here, except that, somewhere, Sir Bernard Woolley is smiling.