Further Thoughts on Interest Rates and Inflation

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

It seems the one thing the ermerged from the discussion on the
relationship of interest rate to inflation is that clear defintions of
economic condition are necessary to fully understand or describe such
relationship.

Althought it is not a derivative instrument unless its is structured as a
swap, interest is derivative whose value is derived from the amount of the
principal and the interest rate.  The interest rate determines the amount
of interest to be paid over time on a principal sum.  In a debt free
economy, the interest rate is irrelevant because with zero principal, the
interest payment is also zero, regardless of the interest rate.  In a
saturated debt market, as in Japan now, the interest rate is also
relatively irrelevant because all existing loans are mostly likely fully
hedged and new loans are not being written for lack of demand.  The zero
interest rate in Japan has little impact on the economy because qualified
borrowers cannot be found even at negative rate. In other words,
outstanding bad loans have already absorbed all availble collateral and
then some.

Thus it follows that the impact of interest rate on the inflation rate is
a function of the size of the aggregate debt in an economy in relation to
the market value of the collateral.  Aggregated demand for new debt which
is a function of surplus collateral.  Yet collateral is a function of
market value.  There in lies the detonator for implosion of a debt economy
in a bear market.

What is a bear market?  Price is not doubt the interection of supply and
demand, provided supply and demand are defined broardly without excluding
externalites.  In an open market, technical analysts will tell you that
when an item is put up for sale, the price is not set by the seller or the
buyer. Price is the result of open bids, adjusted according to the degree
of market friction.  What produces a bear market is the absence of bids,
the seller in a non-monopoly then lowers the asking price for fear that
another seller may catch the sale. Potential buyers hold back in hope for
a more desperate seller.  Thus a bear market emerges.

A bull market is created by reverse dynamics.  Buyers pay asking price or
offer above asking price for fear of losing the deal.  Sellers hold back
for better offers.  If the upward price pressure is greater than interest
cost, potetnial sellers will borrow against the asset rather than sell.
This tends to increase the market value of the asset, qualifying it for
additional loans, which in turn pushes prices up further.

This spiral could go on forever if it were not for the little problem of
interest payment.  Loans are not allowed to postpone interest payment.
When that happens it is called a default, the worst word in the credit
business.  Thus loans rely not just on collaterals, but also on the cash
flow that the collateral of another asset can generate for servicing the
loan by paying interest periodically.  This little convention prevent the
existence of perpetual bubbles.  There will come a point when the cash
flow capacity of an asset will fail to support the interest payments on an
ballooning loan perfectly secured by the asset's rising market value.

When that happens, the borrower must sell and the upward price pressure
peaks and start reversing itsself as price downward pressure.  The nature
of the credit system is such that the downward slide is much more forceful
and speedy than the upward climb.  The rapid downward slide is called a
burst of the bubble or a debt collapse.

Now, history has shown that two related developments could under normal
conditions prevent or soften a debt collapse.  They are: 1) sufficient
increase of the money supply by the Fed and 2) inflation which is
generally the result of an increased money supply in an no growth or
negative growth situation.

Now money supply is generally defined as 1) currency in circulation  and
2) deposits in savings and checking accounts. Item 1) is non-interest
bearing. Too much money in relation to the output of goods tend to push
interest rates down and push prices and inflation up.  Inflationary growth
in turn requires more money to sustain growth.  Too little money tends to
push interest rate up, lower prices and output and causes unemployment and
idle plant capacity, which in turn further reduces real demand for money.

There was a time when the money is in deposits with commercial and saving
banks is roughly equal to loans outstanding in the economy.  The Fed,
through cost of funds (interest), partial reserves and capital
requirements, could control the money supply.  The Fed still attempts to
manage the money supply by setting bank reserves and the discount rate
where banks can borrow to meet their reserves needs, as well as Open
Market Operations to achieve ff rate targets by trading government
securities to inject or drain money in the system.  The Fed also
participates in the Repo market to keep the repo rate in line with the ff
rate.  Repos allow banks to skirt the reserves requirment when expanding
their loan portfolios. Banks often do not even own the government
securities thye use to execute repos, the proceed of which yield banks
such interest rate spread from bank loans that the cost of borrowing the
government securities are more than covered.  With deregulation, all of M1
money except cash has become  interest bearing.  And with ATM and credit
card use, the amount of cah needed in the economy has shrunk dramatically.
Everyone is opperating with just in time cash management.  M2 is overnight
repos, overnight Eurodollars, savings accounts under $100K and money
market mutual fund shares.  M3 is M2 plus time deposits over $100K, term
repos. and L (Long term liquid funds) is M3 plus T bills, savings bonds,
commercial papers, bankers acceptances and eurodollar holding of S
residents (nonbank).

With the growth of securitization, banks pass off  their loan portfolios
to investors in the credit market.  In this process, banks act as reverse
intermediaries from their tradition wholesale to retail role, and become
retail marketeer to feed a wholesale credit market.  This credit market is
totally outside the control and juridiction of the Fed.

Tax deductability of interest such as home mortgages, interest on margin
accounts, interest on loans for mergers and acquisitions affects the
impact of interest on inflation.

Risk arbitrage is a risky play to profit from the simultaneous purchase of
stock in a company being acquired and sale of stock in its proposed
acquirer.  It is also known as takeover arbitrage, a play that profits by
cashing in on the expected rise in the price of the target's shares and
drop in the price of the acquirer's price.  The risk is if the takeover
falls through for any number of reasons, the arbitrageur may be left with
huge losses.  Risk arbitrage differs from riskless arbitrage which entails
locking in ot profiting from differences in the prices of two sucurities
or commodities trading on different exchanges.  Risk arbitrage is done
through credit, using the current market value of the shares as
collateral.

Risk averseness is not just an attitude, it is a calculatable premium.
Given the same return with different risk alternatives, a rational
investor will seek the security offering least risk, or coversely, the
higer the risk, the higher the demanded return. In the credit market,
instruments are all priced preicsely and with uniform standards to reflect
risk averseness  Risk-based capital ratio is a minimum ration of estimated
total capital to estimated risk-weighted assets, required by FIRREA
(Financial Institution Reform and Recovery Act).
The bench mark for risk-free return is the 3-month Treasury bill.  The
CAPM (capital asset pricing model ) used in modern Portfolio Theory has
the premise that the return on a security is equal to the risk free return
plus a risk premium.

The ideal of a transaction is to be riskless.  A riskless transaction
guarantees a profit to the trader that initiates it.  An arbitrageur may
lock in a profit by trading on the difference in prices for the same
security or commodity in different markets.  For instance, if gold is
selling for $300 at NY and $298 in London briefly due to market
inefficiency, a trader who acts with electronic speed may buy a contract
in London while simultaneously selling a contract in NY, yielding a
risklees profit.  Riskless transaction is also a concept used in
evaluating whether dealer markups and markdowns on OTC (over the counter)
transactions with customers are reasonable or excessive.  NASDAQ uses the
5% rule, meaning markups  (when customer buys) and markdowns (when
customer sells) should not exceed 5%.

Uncertinty is not measurable, but risk is a measurable possibility of
losing or not gaining value. The most common ricks in business are
inflation risk; interest rate risk; exchange rate risk.  These risks are
interlinked by complex relationships. Other business risks are inventory
risk, liquidity risk, actuarial risk, political risk, credit risk
(repayment), risk of principal and underwriting and guarrantor risks.
Risk-adjusted discount rate in portfoio theory and capital budget analysis
is the rate necessary to determine the present value of an uncertain or
risky  stream of income.  In the New Economy, this discount have been
thrown out the window and replaced by fantastic premiums.

It is useful to remember that interest is not the cost of money at an
annual rate, but the cost of using money (debt). The cost of availability
of money is a standby fee.  Money not used is interest free.
Interest rate risk exist when changes in interest rate will asdversely
affect the value of an investor's securities portfolio.  For example,
holders of long term bonds or utility stocks assume a significant interest
rate risk because the value of those bonds or utility stocks will fall if
interest rates rise. Interest rate risks can be hedged by buying interest
rate futures or interest rate options contracts.  It is useful to
understand that futures and option contracts are not market prediction,
but market implication that are calculable prcisely.  Interest sensitive
stocks are those of firms whose earnings change when interest rates
change, such as a bank or utility.

Interest is the cost of debt and debt is part of the money supply and in
modern finance, the biggest part.  Not all debts are interest bearing and
some debts carries negative interest either nominally or de facto due to
inflation.  The acceptibility of the cost of debt is generally meaured
against the opportunity cost of not taking on debt.

Interest rate swaps and currency swaps have seen explosive growth in the
last two decades.  Interest swaps are used to reduce risk by synthetically
matching the duration of assets and liabilities of financial institutions
as interest rates got higher and more volatile.  In currency swaps, two
parties sell each other a currency with a commitment to re-exchange the
principal amount at the maturity of the deal.  Originally done to get
around exchange control, now currency swaps are widely used to tap new
capital markets, in effect to borrow funds irrespective of whether the
borrower requires funds within that market, but for use in other markets.
The World Bank has been an active participant in currency swaps with US
corporations.
An interest rate swap is an arrangement whereby counterparties enter into
an agreement to exchange periodic interest payments based on a specified
notional principal amount. Swaptions give either the payer or receiver the
right but not the obligation to enter into an interest rate at a preset
rate within a specific period, or the reveiver to right to receive fixed
payments.  Often, the swaps are further hedged with other instruments.

Debts can be taken in a number of currencies, even financiall instruments
and company shares.
A weak dollar policy is one that forces or allows the dollar to fall in
value against foreign currencies.  That means holders of dollars and
dollar assets will get fewer units of another currency in exchange for
their dollars.  A weak dollar favor US exports because it enhances the
purchasing power of holders of foreigners currencies who may or may not be
foreigners.  The conventional factors behind a weak dollar are: loose US
monetary policy, deteriorating confidence in the US government,  trade
and/or budget deficits, relative low interst rate on dollar denominated
debt and/or returns on dollar assets, both dividends and market
capialization value.

Structured finance exerts fundament impact on the relationship between
interest rate and inflation rate.
The key instrument in structured finance is the derivative, which is a
contract whose value is based on the performance of an underlying
financial asset, index or other investment.  For examples, a structured
note issued by a corporate may pay interest to note holders based on the
rise and fall of oil prices.  This gives the investor the opportunity to
earn interest and profit from the change in price of a commodity at the
same time.  In this case, it is obvious that maket price of a commodity
drives interest rate and not the reverse.

Other derivatives are complex debt instruments.  It can be a medium term
note, in which the issuer enters into one or more swap arrangments to
change the cash flows it is required to make. A simple form utilizing
interest rate swaps might be a three-year floating rate note paying LIBOR
plus a premium semiannually.  The issuer arranges a swap transaction
whereby it agrees to pay a fixed semiannual rate for three years in
exchange for the LIBOR.  Since the floating rate payments (cash flows)
offset each other, the issuer has synthetically created a fixed-rate
note.  The risk of interst rate fluctuation is passed on to the counter
parties of both ends of the swap.  Thus interst rate risk is exchanged for
counterparty risk which theoretically is less (but not necessarily).

Structured settlements are agreements to pay a designated party a specific
sum of money in periodic payments over an extended period, sometimes for a
life time without definitive end, instead of a lump sum.  The risk on the
uncertain aggregate payout amount is assumed by the srtructure.

An ordinary option is a derivative whose value changes in relation to the
performance of the underlying stock.  Black/Scholes made indepensable
contribution to the growth of the option market by providing a
mathematical calculation for precise pricing of a option, changing it from
myterious prediction to rational implication.  A more complex example of
an option would be a futures contract, where the option value varies with
the value of the futures contract which in turn varies with the value of
an underlying commodity or security.  Derivatives on the performance of
assets, interest rates currency exchange rates, and various domestic and
foreign indexes are common.  A key characteristic of derivatives is its
ability to exploit leverage which when used knowledgably, can enhance
returns for investors, and be useful in hedging portfolios.  In the
1980's, abuses in program trading became notorious and in the 1990's, when
the protective strategy of portfolio insurance was distorted to mask
systemic risk, leading to huge losses for hedge funds, mutual funds,
municipalities, corporatiobns, money center banks and financial
institutions and investment banking houses.  These astronomical losses
resulted from unexpected movements in interest rates, caused by central
bank fiats and exchange rate turmults, adversely affecting the value of
derivatives when unwound.

Bear markets are prolonged periods of falling prices.  Theories aside, a
bear market in stocks is usually brought on by the anticipation of
declining economic activity and a bear market in bonds is caused by rising
interest rates.  But there is also a market convention that a bear market
in equity pushes a bull market in bonds, caused by a flight to qulity and
safety.  Thus the relationships between bond prices and equity prices are
often indeterminate and complex.

A bear spread is a strategy in the options market designed to take
advantage of a fall in the price of a security or commodity.  A bear
spread execution buys a combination of calls and puts on the same security
at different strike prices in order to profit as the security's price
falls.  An alternative execution buys a put of short maturity and a put of
long maturity in oder to profit from the differences between the two puts
as prices fall.

A bear trap situation confronts short sellers when a bear markets reverses
itself and turns bullish. Anticipating further decline, the bears continue
to sell and then are forces to buy at higher prices to cover at expiration
date, especially on triple witching Fridays, third Friday in March, June,
September, and December.

A bear raid attempts to manipulate the price of a stock by selling large
numbers of shares shot to pocket the difference between the initial price
and the new, lower price after the maneuver.  Bear raids are illegal under
SEC rules which stipulate that every short sale be executed on an upstick
(the last price higher than the price before it) or a zero plus tick (the
last price was unchanged but higher than the last preceeding different
price).  There are however enforcement problems of this rule due to the
commplexity and speed of transactions and that foreign markets that trade
US shares have different rules.

Bull spreads can be executed in three varieties: Vertical spread:
simultaneous purchase and sale of the same class at different strike
prices but with the same expiration date; calendar spread: same price but
different expiration date; diagonal spread: combination of vertical and
calendar spreads.  An investor who believes a stock will rise, even if
only moderately, can buy a 30 call for 1+1/2 and sells a 35 call for 1/2;
bith options are "out of the money". The net cost of the spread, or the
difference between the premium, is $1.  If the stock rises to 35 just
prior to expiration, the 35 call becomes worthless and the 30 call  is
worth $5 with an investment of $1.  If the price goes down, the investor
loses $1.

BEARS is acronym for Bonds Enabling Annual Retirement Savings.  They are
the flip side of CUBS (Calls Underwritten by Swanbrook)  Bears holders
receive the face value of bonds uderlying call options but excercised by
CUBS holders. If the calls are exercised, BEARS holders receive the
aggregate of the exercise prices.

Defeasance in corporate finance is a technique whereby a corporation
discharges old, lower rate debt without repaying it prior to maturity.
The corporation uses newly purchased securities with a lower face value
but paying higher interest or having a higher market value. The objective
is a cleaner, more debt free balanced sheet and increased earnings in the
amount by which the face amount of the old debt exceed the cost of the new
securities. The first time defeasance was used was in 1982 when Exxon
bought and put in an irrevocable trust $312 million of US government
securities yielding 14% to provide for the repayment of principal and
interest on $515 million of old debt paying 5.8 - 6.7% and maturing in
2009.  Exxon removed the defeased debt from its balance sheet and added
$131 million after tax earnings to that quarter.  In that case, high
interst rates actually yileded a profit for a company with low rate old
debts.  Defeasance is now routinely used by every corporation, confusing
the impact of interest  rates on short term profit.

Collateralized Bond Obligations (CBO) are investment grade bonds backed by
a pool of junk bonds.  CBOs differ from CMOs (Collateralized Mortgage
Obligations) in that CBOs represent different degrees of credit quality
rather than different maturities.

CBO underwriters package a large and diversified pool of high risk, high
yield junk bonds, which is then separated into tiers. A top tier represnts
the higher quality collateral and pays the lowest interest rate; a middle
tier is backed by riskier bonds and pays a higher rate; the bottom tier
represents the lowest credit quality and instead of receiving a fixed
interest rate receives the residual interest payments - money that is left
over after the higher tiers have been paid.  Then there is the Z tier
which is blow all three upper tiers. CBOs, like CMOs, are substantially
overcollateralized and this fact, plus the diversification of the pool
backing them, earns them investment grade bond ratings. Holders of third
tier CBOs stand to earn high yields if the default rate in the collateral
pool falls, or lose money when the default rate rises, as is currently.
CBOs provide a way for big holders of junk bonds to reduce their portfolio
and for securities firms to tap new sources of buyers in the junk bond
market.

CMOs separate their mortgage pools into different maturity classes called
tranches by applying income (payments and prepayments of principal and
interest). Tranches pay different rates of interest and can mature in a
few months or 20 years.  CMOs are usually backed by government guaranteed
or other top grade mortgages with AAA ratings.  If mortgage rates drop
sharply, causing a flood of refinancing, prepayment rates will soar and
CMO tranches will be repaid before their expected maturity.

Convertable bonds are off balance sheet obligations that give its holder
the previllege but not the obligation to exchange for securities of the
issuing company at some future date under prescribed conditions, usually
when market share value reaches a crtain point.  Also convertible bonds
require the issuer to repay some or all of the obligation if the share
value of the issuer fall below a specified level.
Bond mutual funds are designed to produce current income for shareholders.
Bond funds also produce capital gain or loss when interest rates
fluctuate.  Unlike the bonds they hold, these funds never mature.

Bond swap simultaneously sells one bond and purchase another, with the
motive to swap longer maturity to produce a profit; or to swap improved
yield for higher risk, or lower yield for higher quality, or to create tax
deductable loss through the sale while purchasing a substitute bond to
preserve the investment.

It is obvious that derivatives inject elasticity if not outright
distortion in the relationship between interest rate and inflation rate.
And since the notional value of the derivative market is many times the
market value of the credit and equity markets, this distortion now
dominates markets behavior.   This is one of the reasons why the
traditional business cycle has been lengthened.  It is not because of
Grreenspan's magic touch.  But the business sycle has not disappeared,
merely extended at a cost. The cost is a much more violent and sudden
release of built-up pressures when counterparty risks move against the
sytem.

Henry C.K. Liu