Certain policy actions require a high level of precision to be successful. In a recent paper, we find that using margins on derivative trades as a macroprudential tool would require such precision. Such a policy could force derivative users to hold more liquid assets. This would help them to meet larger margin calls and avoid fire-selling their derivatives, which could affect other market participants by moving prices. We find that perfect calibration of such a policy would completely eliminate this fire-sale externality and achieve the best possible outcome, while simple rules are almost as effective. However, calibration errors in any rule could amplify fire-sales and leave the financial system worse off than if there had been no policy at all.
In 1995, Fischer Black, an economist whose ground-breaking work in financial theory helped revolutionise options trading, confidently stated that “the nominal short rate cannot be negative.” Twenty years later this assumption looks questionable: one quarter of world GDP now comes from countries with negative central bank policy rates. Practitioners have been forced to update their models accordingly, in many cases introducing greater complexity. But this shift is not just academic. Models allowing for a wider distribution of future rates require market participants to hedge against greater uncertainty. We argue that this hedging contributed to the volatility in global rates in early 2015, but that derivatives can also play an important role in facilitating monetary policy transmission at negative rates.
Financial market prices provide information about market participants’ Bank Rate expectations. But central expectations can be measured in different ways. Mean expectations, derived from forward interest rates, represent the average of the range of possible outcomes, weighted by their perceived probabilities. On the other hand, modal expectations, which can be estimated from interest rate options, represent the perceived single most likely outcome. Currently, these market-implied mean and modal expectations for the path of Bank Rate over the coming few years differ starkly, with the mode lying well below the mean. In this post we argue that this divergence primarily reflects the proximity of the effective lower bound to nominal interest rates.