# A Yield of 3.1%, from Victor Niederhoffer

A yield of 3.1 % on the 30 year gov bonds corresponds to what kind of mortgage rate? And what kind of impact on housing?

## Michael Cohn writes:

I am not near terminals, but I would guess that the 30 year rate is set by the marketing department over the appropriate tsy, but every mortgage analysis I see that includes the TBA product uses 2-10 year swaps and treasuries to hedge the production. The option adjusted simulations give mtg durations way far below the stated maturity. Of course this duration extends as rates generally rise–the dreaded Negative convexity….

If the 10 year rate is 2% and the 30 year rate is 3.1%, then the average 10 year rate starting in 10 years must be (93 - 20) /20 = 3.6%. Looks like a bust in housing somewhere the far side of the world of 10 years.

I'm wondering whether this can even be arbitraged away. It's always surprising to me how commodity deliveries are NOT, despite very obvious math, only a month or two, or a year forward.

I'm floored by the chair's ability (or eagerness) to predict any economic development 10 years hence. We've been on unprecedented path ever since ZIRP ensued. Both the political and economic moves should be viewed as completely unpredictable, if not random, that far out.

Is the perpetual commodities gap down to commercials being a 600lb gorilla? Particularly sovereign-backed commercials? They will smash open a small arb by being price insensitive, thus making the basis too painful to hold as it widens? Or rather, the basis is too uninteresting to hold if you do it in a size that will leave you safe upon arrival of gorillas?

Is the Chair's maths based on a risk-neutral expectation? ie., the current superlong end of the curve is a good estimate of the future long end of the curve? Which often does not work out that way? [I was trying to figure the formula you are using at the end - which one is it?]

Some of the back and forth over past days has had me thinking about science vs. mumbo. Science matters. But if at least one has a grounding in science, does that justify occasional "mumbo"? ie., We can allow the Chair his gut?

Kasparov knew his science cold: his brilliance was knowing when that grounding told him something in his gut, out of his range of proof, and to act upon it: Quoth Gary:

"Oh it [intuiton] does exist! It's the most valuable quality of a human being in my view. […] You have to learn how to trust your intuition. My view is we severely undermine the importance of intuition, because intuition involves taking too much risk. Whether we like it or not we live in a risk averse culture and intuitive decisions very often cannot be explained in the terms that should be required by corporate culture or by other family members. By adding this core of intuition to the decision making process, we can dramatically improve the results."

Or does Taleb apply, and we should all get back into bed, beneath the covers, as anything more impressive achieved during the day is luck?

# A Logic Riddle (Heads You Lose, Tails You Lose), from Rocky Humbert

Real interest rates are back near their recent record lows (5 year TIP= negative 1.2%; 10 Year TIP= negative 0.15%); and gold's recent behavior is once again consistent with these facts. Riddle me this, Batman:

If I buy a 5-year TIP at a negative 1.2% real yield, and hold it to maturity, that means I am certain to lose 1.2% of purchasing power over the next five years. BUT: Were I instead to short a 5-year TIP at a negative 1.2% yield, and hold the short to maturity, does that mean I am certain to make 1.2% of purchasing power over the next five years? And, how can BOTH of these statements be false?

Private riddle for The Chair:

What do Galton, Batman, and Robin have in common?

The Riddler's False Notion:

Robin: Holy molars! Am I ever glad I take good care of my teeth!

Batman: True. You owe your life to dental hygiene.

## Sushil Kedia writes:

Logic Riddle is a misnomer for what is truly a contradiction. The presentation has a contradiction. In life, in markets there are no contradictions. Allow me to quote Ayn Rand from the Atlas Shrugged, "If there is a contradiction, check your premise".

Rocky, your logic is based on inflation remaining what it is right now the same also during the maturity and at the point of maturity of the 5 year TIPS! Market is not pricing that! Market is pricing inflation will come down! That's all. Check the premise, there are no contradictions.

Purchasing Power is a good term to help create this contradiction. Purchasing power will be Cash in your hand on day of maturity Divided by (1+inflation)^5 if I take the Annualized realized inflation readings. Realized Inflation readings five years from now will be known only then.

## Rocky Humbert responds:

Dear MisterMeanor:

2. That means it's possible to have not only a negative REAL YIELD but it's also possible to have a negative NOMINAL RETURN! (So much for the risk-less treasury market.

4. Your statement "Market is pricing inflation will come down! That's all. Check the premise, there are no contradictions" is 100% UPSIDE DOWN. There is little justification for locking in a negative 1.2% compounded real yield UNLESS you have no alternative investment that does better. You need an inflation assumption of RISING INFLATION not falling inflation due to the way these seasoned bonds behave.

I reckon, back of the envelope, north of 3.8% compounded CPI…. is required to have these TIPS beat the bullet 5 year … and even then you still lose 1.2% of purchasing power (compounded) per year. If you want to bet on disinflation/deflation, you would short these bonds at 105 with an inflation factor of 226/220 with abandon, and buy 5 year bullet bonds to term.

Batman just ended. The Flintstones are on now.

## Charles Pennington writes:

That's a very nice riddle.

These bonds trade dearly I think because there aren't many other competing foolproof CPI inflation hedges.

Obviously if you short the bonds AND hold the short sale proceeds in cash, you are at risk of losing money. You short \$1 million in bonds and hold the \$1 million proceeds in cash. The bonds could go up in nominal terms by a factor of ten to \$10 million. Meanwhile your short sale proceeds sit there in cash, still just \$1 million, and when you cover, you lose \$9 million. That's a loss in any terms.

Of course, if you could use your short sale proceeds to buy something that tracks the CPI without the built-in "negative carry" that the TIPS have, then you'd have a perfect arbitrage. But such a thing doesn't exist.

(Does it?)

A 1 year bond is four three month bonds.

A three month bond is a treasury bill financeable for cash as legally defined by the government at the rate set by the federal reserve.

If ex ante you knew that rate, let's say it would be zero for the next year, then if the one year note traded at 1 percent, there would be risk free arbitrage in buying the note (because the note is defined as acceptable collateral to get cash without exception at the overnight rate, it is perpetually fungible).

But all of this is true because arbitrage needs a unit that you're left with at the end, say for example cash, to make the calc.

I will not solve the last part of your riddle yet Rocky.

Let me ask, can the fair value of cash, the unit of account in arbitrage, which is merely the desire to lend known resources today for unknown future wants x years from now, change?

I don't want to lend at these rates.

I'd rather just have the money in the bank.

But if you know the money in the bank is guaranteed to earn zero shouldn't you buy the bonds and finance them at zero?

And if you know that the nominal bond is priced on the arbitrage condition above, and you believe that inflation will be three percent,t hen if you short the bond and earn the overnight rate risk free, and buy the tip and pay the over night rate risk free,and you hold these positions to maturity, since they are both fungible for cash, then you are guaranteed to earn the difference between future CPI and the ex ante break-even, which is an unknown variable free to take any value.

If you had an opinion on the future rate of inflation you could express that view only because of the other variable being priced to remove arb.And the riddle you speak of which seems to be, why would you commit ex ante to a negative real return can be answered by saying arbitrage of the other instruments demands that only the break-even and not the real rate is solved for by the buyers and sellers in the tips market.

Then What is the real rate set by? That is a very tricky question. The answer is in the above, but not obviously.

## Duncan Coker writes:

I believe selling the 5 year Tip and buying the 5 year bond would do better than 1.2% (anti negative real rate) and would actually capture the inflation rate of around 2%. Empirically if you convert them to zero coupon for calculations then sell the 5 year tip around 105, buy the 5 year bond at 95, this makes for a compounded return of around 2%, 10 profit, holding to maturing. But then again there is a reason I don't trade bonds much.

I think of tips only in term of the real yield. It would take a very unusual set of circumstances to get me excited about investing in a situation where I can earn a negative real return. These bonds, if I recall all have CPI floors built into them so persistent deflation while sapping a bond of its built in inflation accretion can't turn the redemption figure below par. Each bond has a different sensitivity to the built up inflation component depending upon when issued. This is because the bond pays the same real coupon and the principal balance is adjusted by prior CPI (riding on a train so can't look up)

Certainly these bonds are one of the only high quality ways to hedge inflation. There are a number of global ways to do this but France, etc. Have bigger issues.

So what can happen when you short one of these. I wonder for those who can obtain info what the cost to borrow for the short is here. Obviously the overnight reinvestment is not a plus here.

Seems like I should expect to earn the real yield in this case which is a depreciation toward par but what is my short cost?

## Tyler McClellan responds:

I set up my example clearly.

The reason the thirty year bond cannot be arbitraged to short term rates is very simple. There is no way to credibly make the claim that short term rates will be X for thirty years. There is no institution that can impose the stick. I put very little weight on all the other things. Its the fact that short terms rates could be radically different in the future that generates the volatility not the other way around. Long bonds are very convex and thus this is a major reason they should have a lower yield, offsetting the term premium.

Your examples about LTCM and MF Global are meaningless. Their assets were never fungible at 100 percent leverage for the overnight rate. The Fed conducts monetary policy by making cash and bonds of certain maturities exchangeable for each other at certain overnight rates. To compare this to MF global where the bonds are explicitly not instantaneously fungible with cash (euros) is very odd.

Your example about RV strategies in fixed income is a good counterpoint to the limits of arbitrage. I agree that a one year rate 29 years forward is not subject to the same laws of arbitrage as other instruments. This is for a simple reason. The one year rate 29 years forward is not something that is dynamically set in the market by participants trading until equilibrium. It is an artifice of other things that are traded in this manner and thus it "falls out" of other asset prices.

In general arbitrage is the mechanism by which the sum of views in the market derive their equilibrium condition. You have to have a variable that reflects some view for arbitrage to do heavy lifting. I cannot arbitrage a one day interest rate 17.75 years forward for the simple fact that there are no views on that variable and thus it is merely an artifice that arises from the ecology of the market.

As for mingling "real and nominal". You do not understand your own analysis. The market already believes that we will have about 2% inflation and is nonetheless holding cash at 0%. So the accepting of negative real returns ex ante exists in many markets as a necessary fall out of accepting other variable. To say that this comes from the TIPS market is strange. All the tips market does is allow people to have differing views on the future rate of inflation. Everything else is determined by much more liquid (and therefore likely to be subject to arbitrage pricing) markets.

You will get negative real returns (your vaunted guaranteed decline in real wealth (a phrase that I dont understand)) ex ante in either the nominal or the TIPS market. If you reread what you wrote, you will understand this has nothing to do with TIPS.

As for your last question. You already understand the answer rocky. You get more than PAR day one for being short the TIP.

If you

1) take all those proceeds and reinvest them at the fed fund rate at the future path

2) and if inflation is equal to the breakeven-rate

3) then you will lose the real value of the capital lent to you at exactly the same rate that the market says the real value of the capital lent to you must go down ex ante.

Put another way,

If

1) you must earn the nominal return priced in the market,
2) experience the inflation rate priced into the market,
3) and deposit your funds at the monopoly price set by the FED,

then you are indifferent between the two outcomes and are guaranteed to earn the same negative return. Which is of course why there is a market. All of which i wrote a long time ago as a explanation for why it might make sense to be short tips but if an only if you could tell me why based on your estimate of the above three variables. Any speculation on the real rate is meaningless, it is not a variable one can have a view on outside of the above (if and this is a key assumption, cash money from the fed reserve is the unit of account you wish to sum all the steps across. Its very possible the real term structure of other commodities is different)

## Rocky Humbert responds:

I will address your many points more specifically when I have some time. But I will make a very simple observation (which you ignored)….which has to do with the interactions between inflation and tax policy and the zero interest rate boundary problem.

Let's assume a simple Taylor rule and that the fed sets overnight funds at inflation+100 basis points. Let's further assume a marginal tax rate of 30%.

Case I) Let's assume that inflation is running at 5%. Then fed funds is 6%. Then my after-tax nominal return = 0.7x 6% = 4.2% and my after-tax real return is negative 0.8%.

Case II) Let's assume that inflation is 2%. Then fed funds is 3%…and my after-tax nominal return = 0.7×3%= 2.1% and my after-tax real return is positive 0.1%.

Case III) Let's assume that inflation is NEGATIVE 2%. Then fed funds is 0% … and my after-tax nominal return = 0%, but my after-tax real return is positive 2%.

This is a clear example where real after tax returns behave in counter-intuitive ways…. and so the apparent negative return on TIPS might have less to do with inflation expectations per se, and more to do with the tax effects…. (or more succinctly, an investor in Case III above would be willing to buy a tip that has a negative 2% real yield and would be indifferent to case II, where the same TIP has a +100 real yield.) Just a thought

## Tyler McClellan writes:

Very true. I once worked with Paul McCulley on the tax implications of same. As you never posed that as a question I didn't address it.

I agree with your points and thing it is a modest contributor the the current equilibrium pricing.

## Philip J. McDonnell writes:

I think one point that has not really been made in this discussion is that TIPS are paid back at the greater of inflation adjusted value or par. This means that they have an implied deflation protector built in.

It is like a deflation put which has intrinsic value in and of itself. In many ways we are in a deflationary environment caused by the great credit bubble unwinding throughout the world economy.

I just scanned the riddle discussion. It seems to me that the reason you can't make money shorting TIPS is like the obviously idiotic action of shorting dollars in dollars. Let's say you decide to short a million dollars, and sell it to someone for a million. That's what shorting is, and yet you are in exactly the same situation as you once were.

If TIPs are losing purchasing power against a basket of commodities, but dollars are losing it faster, if you short TIPS you get something that loses purchasing power even faster than TIPS, hence no gain. If you could find a way to get paid for your shorted TIPS with a basket of commodities, and there is high inflation, you can buy them back with fewer commodities, so you make a profit.

# The Observer Effect, from Jeff Watson

June 21, 2011 | 6 Comments

I was reading about the famous double slit experiment and then thinking about the Heisenberg uncertainty principle, the math, and the observer effect. I wonder what types(if any) of market implications could be attributed to the observer effect.

## Ken Drees writes:

Interesting. I was contemplating this more than a few weeks ago too, but let it drop. It made me think of Schrodinger's Cat:

Schrödinger's cat is a thought experiment, usually described as a paradox, that Austrian physicist Erwin Schrödinger devised in 1935. It illustrates what he saw as the problem of the Copenhagen interpretation of quantum mechanics applied to everyday objects. The thought experiment presents a cat that might be alive or dead, depending on an earlier random event. In the course of developing this experiment, he coined the term Verschränkung (entanglement).

I was considering how a trade is alive and real only when one puts it on or opens the box and everything else is meaningless– the counting, the theory, the expected outcome– all meaningless unless you commit and then make it real and apart of consciousness, reality, an entity.

Schrodinger's kitten's also interesting as a thought experiment across space and time. What I recently learned about the uncertainty principle was that there is a different way to think about it. I always thought about it in terms of how the observer may be creating the uncertainty in measuring both mass and acceleration with the instruments. What I now understand is because of quantum uncertainty these particles actually don't really know exactly where they precisely are at a given point in time beyond a prob distribution so if they don't know where they are I certainly can't help them as much as I would likes to be able to do so…

2 closing related issues:

There's the insidious cursor and key watcher viruses.

Another related aspect is the inadvisable practice of putting your cursor over the execute button onscreen and having it execute without having touched the mouse, or accidentally touching the mouse or keyboard at the wrong time triggering the trade. Been there, done that.

There is also the issue of order field depth, which is a form of "disclosed" watching, and other order related manipulation issues perhaps posing, perhaps honest bid, perhaps flow bashing or bandwidth hogging, flashing. Lack surely can speak to many of these techniques he sees in individual stocks.

If risk is defined as what is not known in the future that if it happens would hurt you, than imagination of what could happen causes you to avoid and prevent that perception.

Done to extremes this creates new risks from the over abundance of care and lack of focus on any other risks even to the point of altering the minds ability to cope. Think interest rate duration management and the creation of the tranches in the securitization process and modeling of those securities. Done in mass this creates bubbles, hysteria, or pop-stars. ( I believe this is the "Lady Gaga" "Apple" link. It is not mysticism but the creation of popular mystic.)

Much of psychology is the study of how unrealistic risk perception creates a difficult life and alters their reality for the fearful and anxious. Why should the markets be immune?

Lady Gaga is to Apple as Amy Winehouse is to Rimm.

# SGX, by James Sogi

Heard that Singapore Exchange will get rid of its infernal lunch hour break.

As someone who very much enjoyed my old 11-1 TSE break later revised during my tenure to 1.5 hours I regret the lost of civility. Started work at 7am. Exercised during the break. Would work perhaps to 7-7:30pm and home at 8 fully exercised and sated with the work experience.

## Jeff Watson writes:

In the old days, I might have said that I would enjoy what basically is two opens and closes in a day, especially from a floor perspective. That being said, I'm sure that Mr' Sogi is relieved as there's not the opportunities today that were present in the opens and closes 20 years ago.

# Gamed ETFs, from Alan Corwin

I have been intrigued by recent discussions of ETFs by List members, in particular the UNG and UNL ETFs. Not long before this discussion, there was a discussion indicating that UNG got gamed every time that it needed to roll over the futures that provided the underlying asset for the ETF. Finally, there was a mention by Rocky that UNG had lost 78% of its value since inception while the nominal underlying asset had lost 37%.

Is the relatively greater loss in the value of the ETF a product of this gaming? If not, what alternative theories have been posed?

Other ETFs dealing in commodity futures where there are expenses associated with taking delivery would seem to also be subject to similar manipulation. Have the values of these ETFs experienced similar erosion? Isn't any such commodity ETF bound to erode away given enough time?

Finally, it seemed that today most ETFs were down significantly more than their underlying components. Did any news come out that would appear to be distinctly unfriendly to ETFs in general?

## Gary Rogan writes:

This ubiquitous article explains enough about the storage costs and their effect on performance. I came across an additional explanation that the predictable patterns of buying and selling on certain days depress/inflate the prices enough in the wrong direction for the holder to matter as well.

I think it is useful to separate the concepts of 'gamed' and 'carry cost due to contango'. Having contango in the related futures market induces a roll cost every time the fund rolls forward into a new month. That would seem to be an unavoidable structural flaw in many of these funds that will eventually lead to their demise. But the gaming aspect is somewhat different. Specifically I mean that gaming is due to the actions of other market participants who front run the roll periods making it more expensive for the fund to perform its roll operations. That activity simply adds to the roll costs that already exist from contango.

Should I be thinking any differently about the deferred option contracts on these products such as VXX (Barclays Volatility Futures ETF or for that matter the UNG discussed here? How do I think about the changing nature of the basket with respect to these term options that are outside of the existing futures basket for the current composition of the ETF and at their own delivery subject to a new basket? I am convincing myself that I need to learn about basket options influenced by the passage of time.

The VXX currently has some similar roll phenomenons — however, because it is not a physical commodity, it is not bounded by the same physical supply/demand characteristics of things like natgas, crude, wheat, etc. Rather, volatility is a second-order derivative with no physical delivery — and so the roll can swing wildly and remain in a positive carry condition for very extended periods of time. For example, during the 2008/2009 period, VXX experienced the exact opposite condition — and the rolls were very profitable (because short-term volatility was higher than long-term volatillity expectations).

I want to be clear on an important point: If a speculator is bullish on natgas and believes that prices will rise sharply (in a relatively short time frame), then the UNG is a perfectly reasonable vehicle to express this bet. Natgas periodically doubles and triples in a short period of time. However, if you want a long-term exposure to the nat gas market, then this is a horrible vehicle.

Similarly, having a longterm short of the VXX to pick up the rolls is somewhat analagous to selling far out of the money puts on the S&P. You'll make money most of the time. But you will also occasionally wake up and have a dismal mark-to-market and perhaps give back more than you've ever made. Some may argue that this risk can be managed — but that's as much art as science.

# A Daughter’s Good Fortune, from Victor Niederhoffer

One of my daughters is not very experienced at handling money, so my wife suggested that she buy some stocks to put her foot in the water. She chose company names she knew and liked like Netflix and Martha Stewart and American Apparel. "A young person's portfolio," her broker said. On average they are up 25% in the last two months.

In looking at her portfolio, I made a Baconian mistake. I said Martha Stewart is losing money on every sale and the sales are down. Don't buy it. It couldn't be good. My wife said, "She has to learn. Let her do it it." That one's up 40% or so. I am reminded of the time Collab and I were in our first six months of writing. Five of my daughters or siblings came to me over a weekend with requests to start or fund an Internet company. As I said at the time, "if so many people are coming to me, down on my luck and fortune, why imagine what the supply and backlog must be among the real players. It's about to burst." One has similar thoughts about my daughter's good fortune.

## Sushil Kedia adds his two cents:

My two cents:

1) In the beginning we always call them lucky only. Too little data to conclude yet. Commonsense becomes more and more uncommon as each of us goes onto accumulate experience and other tools. Let her have her way. Let her find her own victories and lessons.

2) When my daughter would begin trading in some years, I would go short or long against her positions on a paper trading system I will maintain quietly and separately. Once her positions are closed by her, I would share my paper-trading risk management system with her to see where the deviations are. I would let her learn from my mistakes and wins against her rhythm, without pulling her away from her own.

## Michael Cohn shares:

"The Junk Rally & Quants: guru Matt Rothman says both quant and fundamental metrics continue to struggle in the 'junk' rally as Valuation remains 'largely irrelevant'. His models continue to show that stocks with variables such as the high short interest, weak b/s, highest beta, continue to significantly outperform. So how long can the junk rally go? The current low quality rally started March '09 is among the longest such rally on record, but, the underperformance of 'Quality' stocks is still only now a 'moderate' (9%) versus (10-18%) u/p of similar periods since the 1950s."

This seems to be a widespread issue according to Barclays.

Always jump on beginner's luck if you can.

# The Goldman Roll, from David Aronson

April 14, 2010 | 1 Comment

I am wondering if anyone out there is familiar with a trading opportunity called by some, the Goldman Roll. As it has been explained to me, there is a large numbers of long-only commodity funds. As a given contract that they hold long, say oil is coming due to expire they need to sell that one and then roll into a long position in a further out contract. This creates a very definite trend in the spread that can be exploited. Sell the near one short and buy the next one out. As the roll transactions are executed the Far minus the Near spread has a very predictable and smooth rise. It is claimed that this phenomenon has not be widely recognized and thus remains in existence thus far. Any comments out there on this claim would be appreciated.

Dr. Aronson is author of Evidence-Based Technical Analysis, Wiley, 2006

Goldman Roll? More like market roll!

This has been around as long as futures have existed and is nothing sinister. However, as some here were actually around when modern exch. traded futures began, I shall defer to them.

You can maybe get some clue as to roll direction by looking at open interest depending on the contract, but it's not always a good guide. Worth bearing in mind that people hold offsetting positions and much also depends on commercials vs specs etc.Also, if it were that easy to make money, it wouldn't exist…

## Michael Cohn writes:

There is index money invested in commodity Indices and a plethora of ETFs. For example, USO or UNG. These commodity ETFs hold futures and there is a need to roll the contracts in a somewhat predictable way although there is now more flexibility as to day. This long exposure always has to sell the near and buy the far contracts. It is fairly easy to see the amounts involved…

## David Aronson replies:

Yes, I am on the lookout for all of these creatures. But kidding aside for the moment, are you saying that the claim that such an opportunity exists is on par with sightings of Big Foot? i.e., it's nonsense?

## Russ Herrold writes:

It is a safe statement that there are and will always be 'unknowable unknowns' out there in the woods, and that the 'Absence of evidence is not evidence of absence' (but rather sometimes, just a statement that we cannot prove a hypothesis with our current tests and tools)

If I had a Bigfoot in my basement that laid gold bars, I would never reveal that secret, and take great pains to keep that 'trade secret'.

If I had engineered a winning strategy, I would certainly consider sowing disinformation and negative results and disinformation, to lead people seeking to reverse engineer my results, down into blind allies.

I think as a careful investigator, all we can say is: We do not know of a public proof that such exist.

By co-incidence, I am wearing a tee shirt today of a Unicorn, feasting on roast leprechaun, and as she takes knife and fork to her meal, the magic rainbows are let out.

The idea of taking advantage of a robotic function (mindless ETF doing its monthly maintenance) makes sense; once you notice the ripoff, wouldn't a hunter now wait for the fox?

## Tom Printon writes:

I used to fill the GS roll in the coffee pit. Locals typically positioned themselves one to two days ahead of GS. When and if profitable was usually good for few tics, but one had to have size on to be worth while. Off the floor trader's vig would be difficult to overcome.

This reminds of "The Night Of The Long Knives" also called Operation Hummingbird. It is interesting how the market was "prepared" for this event that occurs after an impressive up leg. We will see if the event will be able to trigger more volatility. It will say a lot about this market.

# Buffett’s Puts, from George Zachar

March 2, 2009 | 8 Comments

I recently did a very crude estimate of the value of Warren Buffett's puts betting that the price of the S&P would be above, relative to their price at trade entry. Conservatively, they're roughly up 3.5-fold, using Bloomberg analytics.

## Phil McDonnell writes:

A similar back of the envelope estimate shows that his short puts are up by at least 1.5 fold using current volatility estimates.  Given the rise in volatility the puts are more likely up something like 4 fold.  Thus the write-off should be something like \$5.5B * 1.5 = \$8.5B (at a minimum).

In a Yahoo article yesterday it was reported that Buffet received \$8B for the puts he sold.  So on the higher end the exposure might be \$8B * 4 = \$32B.  In any event the current write off clearly seems to be understated.

The Oracle espouses such virtues as clean accounting and a preference for mark to market accounting.  And yet, the companies he owns are not marked to market for the most part because they are not publicly traded.  Thus they continue to be carried on the books at a valuation determined by the Oracle.  If we use the S&P as a reference, the market value of the typical company has fallen by something like 50%.  BRK carries something like \$250B in operating assets (excluding cash).  Thus it is reasonable to estimate that if his portfolio of companies was marked to market that it has declined by about \$125B in current market value.  If this loss was taken today it would more than wipe out the \$120B of equity that the company claims.

There are other hidden gems on the balance sheet.  For example one wonders what \$4B in deferred long term asset charges are.  The \$34B in Goodwill basically represents what the Oracle over paid to buy his companies.  In the current environment one wonders if any of that is left.  The \$17B in deferred liabilities remains another mystery.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

The sale of puts was hardly free — just look at Berkshire's stock performance. However, what makes this strategy tenable for Berkshire was that he does not have to post margin, unlike 99.97 percent of counterparties on this trade.  This is the major advantage that allows him to play long term nominal drift and benefit from survivorship bias.  Had anyone else sold those puts they already would have been downgraded by rating agencies.

# Still Trying To Do Better Than Fed Weeks, from Michael Cohn

In 2003 I extensively analyzed the movement of markets during weeks with scheduled Fed events. I have yet to find robust enhancements to that work, but I continue my reading and research, although my day job occasionally intervenes. I am finishing a book on CDO Investments by Fabozzie et. al., and Robust Statistics, by Maronna, Martin, and Yohai, published by Wiley, just arrived from Amazon, along with Neoclassical Finance, by Stephen Ross, the latest installment of The Princeton University Series of Lectures. I previously enjoyed Bill Sharp's book in this series. It neatly explained utility functions, and deals with issues the author had with his world famous models. I also recommend The Volatility Surface, by Jim Gatheral.

# Drift and the Long Bond, by Victor Niederhoffer

I recently reviewed a paper which drew my attention to the long term rise of the US Treasury long bond future (continuously adjusted with all contract shifts), showing a price rise from 78-20 to 114-06 from 1977 to present. The question we are batting around the office is whether there is any economic reason for there to be a long term upward drift in prices. Such a drift would be related to the normally rising structure of the yield curve, with long term yields higher than short term. The upward shape is supposed to occur because of increased price variability of the long term bond vs. short term and liquidity preference; the desire to have your money sooner rather than later because your risk on holding the investment until it expires is greater. Liquidity would also seem to relate to the ability to trade the issue at tight spreads. Any educated comments on the subject would be welcomed.

Prof. Charles Pennington replies:

I assert that Treasury futures will have a long term upward drift if and only if long term bonds outperform short term in total return, over the long term.

Suppose that a bond maturing in 30 years is trading at price 100, and let’s assume that long term yield are 10% and short term yields are 2%.

Consider a futures contract on 30-year bonds that settles in one year, and suppose that this contract is trading at price P.

We could construct a risk-free portfolio consisting of a long position in treasury bonds and a short position in the treasury bond futures contract. This should earn the short term risk-free rate (and let me assume that 1 year is close enough to being “short term”).

Let’s also suppose that after one year, the price of the 30-year Treasury, which will also be the settlement price of our futures contract, has risen by \$1 to a value of 101.

The final value of our portfolio, which cost 100 initially, is:

101 + 10 + (Pi-101)

(The “10″ is the dividend, and “Pi-101″ is the gain or loss on the short sale.)

This final value should be equal to 102, since we should earn the risk-free return. From that, we can solve Pi and get 92.

So in this example, the total return of a Treasury bond was 11% (10% dividend and 1% capital gain). The total return that we would have had by going long the futures contract would have been (101-92)=9, or 9% of the notional value. That’s equal to the total return that we would have had from holding the bond minus 2%, the short term rate.

In other words, the return from the futures contract is “as if” we had borrowed at the short term rate and bought the long term bond.

If that strategy makes money over the long term, then the continuous futures contract will show a long term upward drift. The Siegel book indicates that that strategy was about breakeven from 1802 through about 1980 and then did quite well since then.

Paul DeRosa Responds:

It is true that the bond future trades at a discount to its delivery value equal to the positive carry on the cash bond. If that carry is negative, the future will trade at a premium. There are hundreds if not thousands of traders who spend their days bent over desks enforcing that condition. It doesn’t necessarily imply the price of the futures contract will drift upward over time. They drift upward only within each quarter. So in the example you give, the contract will start each quarter at a discount of 2% to its maturity value. If the level of market interest rates were to stay at 10%, the next contract also would start the quarter at a 2% discount, but it would have the same maturity value as its predecessor. I would add one caveat, which sounds like a technicality but who overlooking as been the cause of tens if not hundreds of millions of dollars in trading losses during the past 30 years. The 2% discount I alluded to can be reliably captured only by owning the contract and being short the so called “deliverable” bond. At any point in time, several different bonds can satisfy the delivery conditions against the contract, only one of which is cheapest to deliver. Being long the contract and short the wrong bond can lead to any one of several outcomes.

George Zachar replies:

Yes. The accretion of the forward months should be identical to the positive carry one would receive by owning the underlying bond outright and financing it at the overnight/repo rate. You can make the money by carrying the “cash” or buying the forward, but the dollar amounts should be the same. This is carry and not drift/true price appreciation.

There is very slight positive carry on bond futures now:

USZ6 Dec06 110-18
USH7 Mar07 110-17
USM7 Jun07 110-16

The two-year future shows the impact of negative financing/curve inversion, where holding the instrument costs money (as your asset yields less than its cost to carry).

TUZ6 Dec06 101-28 3/4
TUH7 Mar07 102-02 s

The carry/deliverables/basis on these contracts is perhaps the most “crowded” trade on the planet.

“In the day”, one could make money in the forward mortgage market, when lenders would sell their production forward at a discount to carry. Those glorious days are long gone.

Carry hogs, er, traders have been known to “ride the Japanese curve” with enough leverage to make your eyes tear.

JBZ6 Dec06 133.56
JBH7 Mar07 132.83

They’d buy the forward Japanese bond, and pocket the carry, enduring the interest rate, yield curve and currency risks along the way.

The takeaway here is that one must be aware of all this when looking at fixed income debt futures prices. To evaluate long term interest rates cleanly, it is best to look at yields of relevant “constant maturity” indices.

Earlier posters observed that very long-term secular trends of dampened reported inflation and declining risk premia since the financial shocks of the Volcker era account for the observed trend toward lower yields and higher bond prices. I wholeheartedly second that analysis.

Stocks, famously, have unlimited long-term upside. Fixed income has the “zero bound” on rates, and central banks who have shown themselves willing to ensure that Deflation is rarely seen. Therefore, with an assurance that there’ll always be a little inflation, debt instruments are effectively capped out when their yields reach the low single digits.

Michael Cohn responds:

I would recommend everyone find a way to get “Rolling Down the Yield Curve” by Martin Leibowitz, circa early 1980s. Few articles as clear about how bonds work. I stopped trading basis myself in 1989 when four JGB basis-traders for what was then Mitsubishi Bank took me out to lunch one day in Japan.

Very little can go wrong when you are long the cheapest to deliver and short the future. Depending upon the set-up it was also a way to play changes in yield curve shape but now there are so many instrument, such as swaps, to play it an explicitly.

Jon Corzine made his name at Goldman by trading the delivery options and the dead period after the US bond contract stopped trading each delivery cycle. The legendary trader Mark Winkleman at Goldman made his name buy buying the bond basis and funding it cheaper. He had it to himself and our friends at Salomon. The old days were relatively easy.

You need to have a firm grasp of reverse repo rates for the deliverable bonds, and yield curve volatilities, to play from short side where you are short the bond and long the future. I recall the programs at my firm for modeling the change in deliverables to be extensive, as I use to play the bund basis, but with no apparent skill as I did not control the collateral, as could a German insurance company.

Dr. Alex Castaldo responds:

The question that started this thread was: is there an upward drift in fixed income markets like there is in equities?

The article by Vesilind claimed that this is so, and this drift arises from the fact that the yield curve is (on average) upward sloping due to the “liquidity preference hypothesis” and/or the “preferred habitat hypothesis”. In other words the “expectation hypothesis” of interest rates does not hold and there is a non-zero “term premium” embedded in interest rates.

Certainly there have been plenty of academic articles in recent years saying the expectation hypothesis does not hold. But I am more interested in the practical money-making potential here.

A simple strategy to capture the drift, that works well according to Vesilind, is to be long the “fourth nearmost eurodollar future”. I decided to test an even simpler strategy: each September buy the eurodollar future with one year to expiration and hold it until expiration.

You can think of it as a test of the good old “Keynesian normal backwardation hypothesis”: is the price of the future one year before expiration biased low compared to the expectation of what the settlement price will be.

Here is the data:

Contract       Date      Price      ExpDate  Price    Chg

EDU6 06 9/19/2005 95.690 9/18/2006 94.610 -1.080
EDU5 05 9/13/2004 97.045 9/19/2005 96.080 -0.965
EDU4 04 9/15/2003 98.165 9/13/2004 98.120 -0.045
EDU3 03 9/16/2002 97.535 9/15/2003 98.860 1.325
EDU2 02 9/17/2001 96.425 9/16/2002 98.180 1.755
EDU1 01 9/18/2000 93.470 9/17/2001 96.890 3.420
EDU0 00 9/13/1999 93.755 9/18/2000 93.340 -0.415
EDU9 99 9/14/1998 95.040 9/13/1999 94.490 -0.55
EDU8 98 9/15/1997 93.825 9/14/1998 94.500 0.675
EDU7 97 9/16/1996 93.700 9/15/1997 94.281 0.5812
EDU6 96 9/18/1995 94.260 9/16/1996 94.440 0.18
EDU5 95 9/19/1994 93.180 9/18/1995 94.190 1.01
EDU4 94 9/13/1993 96.070 9/19/1994 94.940 -1.13
EDU3 93 9/14/1992 96.140 9/13/1993 96.810 0.67
EDU2 92 9/16/1991 93.550 9/14/1992 96.870 3.32
EDU1 91 9/17/1990 91.670 9/16/1991 94.500 2.83

Avg 0.724

T Stat 1.940

At first the results look impressive: there is a 72.4bp per year gain, with a t-statistic near 2. However, much of the result is driven by the first two years (1991 and 1992) when interest rates were dropping rapidly. Without these two years the gain is only 39 basis points with a t-statistic of 1.15.

As mentioned by others, it is difficult to distinguish the term premium from the general interest rate decline after 1990.

The Vesilind paper is an excellent and reasonably accessible overview of mechanistic currency trading systems that execute carry trades based on yield differentials, and volatility (implied riskiness).

The authors find, retrospectively, that during a period of irregularly declining rates and risk premia (1993-2006), rotating capital between currency pairs offering high yield spreads at times of high perceived risk earned worthwhile alpha.

The carry/risk aversion trade is a standard formula for speculating in currencies, and the authors “kept it simple”, making evaluation of their strategy relatively easy.

The study’s charts neatly show the performance of different strategies as the cycles change.

I must, however, disagree with the chair that currency pairs trading per se can be said to showcase “drift”. The time period involved was particularly favorable to yield chasers, and the regular shifting of positions from one set of underlyings to another strikes me as antithetical to the notion of passive drift.

That said, I believe there is a different speculative lesson to be drawn from this study, and that is the seeking of relative value within the confines of a large, complex set of related instruments.

Relative value among currency pairs based on yield/return vs. vol/risk strikes me as analagous to relative value within the stock market between sectors and individual stocks. There’s no shortage of relaive value measures with which to “count” fundamental and performance dispersion in stocks. Ditto risk/vol.

The paper at hand provides a nice introductory framework for setting up relative value/risk matrices.