Options - The Pricing Ways Continued.......

Today let’s take a break from economic issues and get back to option pricing. In continuation with my last piece on option pricing (Link) , wherein we explored a much easier way to price options and what was even better was that it allowed for the flexibility to have non-normal probability distribution in pricing. Today I would like to write about how we can develop the concept further to include in the money and out of money options. Well if one understands the basic premise of my last article on this topic it’s fairly simple.

As I wrote before, basically if I buy an “At the money” call and put, the price that I should pay is the expected movement of the stock in that period. So in essence

C+P = E[S] – Eq 1

Now for any option that is “In the money” for the buyer to make any money and for the seller to loose money would be when the Stock crosses the Strike price of the option, so in essence what we really care about are the probabilities wherein the Stock Price crosses the Strike Price of the option.

So the price of the option would be:

C = (S-K) +E[ ∑_x=kⁿ p_x*S]

The above formula gives the flexibility to the reader to assume different probability distributions and use them in the option pricing.

Please Note that If I try to simplify the Black Scholes model i.e. take the assumption of Normal probability distribution I would be only be approximating the pricing, but nevertheless let me put it down anyways.

The call price (assuming interest rates as negligible) c = SN(d1) – KN(d2), the put formula is also accordingly KN(-d2) – SN(-d1),

c= SN(ln(S/K) + σ/2*√t) – KN(ln(S/K) - σ/2*√t), Since We are taking volatility for the entire duration of the option so I am going to replace σ*√t with σ .

Also I would express S in terms of K and σ as that’s what we are concerned about, i.e.

S = K+ K*σ*Ɵ

Putting these values into the Black Scholes formula and expanding the log portion using taylor equation the log portion would be reduced to Ɵ – Ɵ^2* σ/2

Finally adding both these terms and using the Normal expansion and exponential expansion by taylor series

N(x) =[∫_-∞⁰exp^^{- (x)^2}  + ∫₀ ^σ/2exp^^{- (x)^2}]/sqrt(2 π)

The first part is equal to 0.5, to integrate the second part of the expression let me expand it using the Taylor series. The Taylor series expansion of the exponential term is

e^x = 1 + x + x^2/2! + x^3/3! ……

Replacing x by Ɵ – Ɵ^2* σ/2+σ/2 and then integrating we get

N(Ɵ – Ɵ^2* σ/2+σ/2) = 0.5+ [₀ ^σ/2 ∑₀ⁿ (-1) ⁿ (Ɵ – Ɵ^2* σ/2+σ/2 )²ⁿ⁺¹/2ⁿn!(2n+1)] /sqrt(2 π)

As SD is small number (in decimals) we can ignore the higher power of σ,

Please note that if σ is high the whole notion of Normality falls apart and as does the Black Scholes model.

So expanding this expression and putting it in Eq 1 we get

C = (2* Ɵ - Ɵ^2* σ/2 + σ) * √(1/2π)  

Or more simply C = (2* Ɵ + σ) * √(1/2π)

Again this is simplying Black Scholes using mathematical tools what’s more important to understand is that the genesis of any option pricing i.e. using any probability distribution is this formula below:

C = (S-K) +E[ ∑_x=kⁿ p_x*S]

Till Next Time………….

Failure is the option

Writing after a long time indeed, got stuck in some daily chores and also reduced travel in the last couple of months gave me less time to think. Anyways here it goes now; also I did put up this article at Business Insider yesterday.

The high unemployment rate that has engulfed the major economies of the world is not just serious but also bewildering and these moments of pain and awe among the population is when governments try to intefere and curb the freedom of the society, the case in point being the new excess stimulus plan of Obama. After all wasn't capitalism supposed to allocate the resources efficiently then why is that we have 16% unemployment in US (U6), over 30% youth unemployment in Spain, Greece, Italy. I mean the problem of this world is fall output and so isn't it ironic that with so much unemployment around we are taking about this problem. A garbage reason that I always listen on television by many analysts and CEO's is that of lot of policy uncertainty which is leading to this bemusing irony. Well this may be playing a very small part in e scheme of things as I find it hard to believe that policy makers of a few decades back were far idealistic, efficient and superior than what the are now. The real reason for this catharsis is that the world we are living in is no longer free markets or the economic order is no longer capitalist but "crony capitalist"

Recessions, fall in stock prices and asset prices in general and failure of big and mighty are features of capitalism wherein it reorganises resources and efficiently allocates it to new sectors, people and industries which then take it forward thus creating jobs and continuing the boom. Unfortunately now even a 10-15% stock market fall is followed up by printing of money by the Central Bank of US, companies like GE and GM are saved under the garb of avoid huge job losses and of course the banks and the financial institutions (the less said of those the better) these institutions that add very little value in this society but for continuing the ponzi currency scheme. What's worse is that with every time they being saved under the farce too big to fail these banks have raked in too much of the economic resources.

What's required is not another failed government induced spending plan but instead the government getting out of the way of this economic reset, let the markets crash if ey have to and the companies and banks go bankrupt... There will be brief period of chaos followed by a new reinvigorated order as new capable people take over those deflated resources and as the capital froth from those assets move to new places thus creating opportunities from our young entrepreneurs and providing jobs to millions. Socialism and today's crony capitalism suffer from the same problem "misallocation of resources" the only difference is that while socialism gives less to the competent, crony capitalism gives almost everything to the incompetent but not letting them fail.


In the next article (sometime this month only) probably we shall talk about how this increase in government debt ends up doing no good but preserving the existing world order of ponzi banks and its monetary system.

The myth of Wage Increments

Today let’s take a break from the statistical and option pricing articles and discuss something very close to probably every reader of this blog “Salary Increments”, I had almost finished an article on the farce of the PEG ratios however I would post it at some later date.

I would like to believe that I am one the most ardent votary of free markets and contrary to what many people have wrongly built an impression I think that Karl Marx is one of the most original thinkers in the field of economics and whose views are actually not anti-capitalist rather he just exposes the fallacies of capitalism, mind you there is a huge difference between free markets and capitalism. Certainly what has been happening since 1971 after the collapse of the Bretton woods system is hardly free markets, on the contrary it’s the worst form of Communism. The reason I say that is because atleast the communists are open about their ideologies and hence atleast are true to what they say. Our so called proponents of free markets i.e. the respective governments have been imposing centrally planned economies since the last 40 years. However this type of system is even worse because unlike in communism where government controls price of capital and labour, here the government certainly controls the price of labour and transfers that wealth to the capitalists. Let me explain this in a bit more detail by taking the example of “Salary Increments”.

So how was your Salary increment this year, Oh!!! Sorry did it hurt… didn’t get any?? Or were you that unfortunate one who got the middle of the band 10-14%, or were you that star performer who managed that 20% raise!!! Sorry to all but let me break it to you……….. you all have lost out!!!

The labour like in most other countries is paid in currency (government’s proxy banks controlled). So in essence like any competition the labour force is competing for the x amount of cash that exists in this economy. Now let’s say that these banks true to their nature induce an extra 20% cash in the economy, so just to be at par with what you were the last year you should get atleast x*1.2 cash for your labour, this is the minimum amount that you should get and even if you get this you are still not being rewarded for you improvement in productivity that would have happened because of the experience that you gained at work and the knowledge and skills you added in the last one year.

Compared to last year and extra 24-25% of fresh money was created this year, thanks to the base money of RBI and add to that the printing presses of the banks that create money because of the fractional reserve system. Assuming that an extra 4% people joined the Indian workforce and adding that to the workforce even the star performer getting a 20% raise has lost out and who actually ends up at the winning side… that’s right “the capitalists”. Remember price rise is not inflation it is just a symptom of inflation. Inflation is always more money chasing fewer goods so the myth that if the raise is atleast equal to the rate of inflation and hence you are not worse of is nothing more than a false propaganda.

The raise should atleast be equal to the increase in the money supply in the economy net off the increase in labour supply and if we add to that the increase in your productivity because of improvement in skills and knowledge only then we would truly say that you have been justly compensated.

However this is rarely the case that the extra cash ends up with the capitalists who get compensated more than warranted and thus widening the gap between the capitalists and labour. Please don’t misunderstand that I am against them, I am just stating the case as is. The real culprit are the global governments that have monopolized the issuance of base money. If this whole system has to become just then like any other product the issuance of money should be liberalized i.e. anyone should be in a position to issue money and let the invisible hand decide whose money is sound. Remember “money is nothing but a promise” and I certainly never trust the governments.

Alright so this looks like a solution that would not come about before another decade when the whole system would collapse, till that time what to do. Ofcourse the first solution is to start your own business (not everyone’s cup of tea) so the next is going to be based upon the old saying “If you can’t beat them then join them” i.e. invest your money with the capitalists i.e. by buying stocks, third and even better print your own money.. is that possible? Sure it is; taking debt is equivalent to printing your own money, hence take debt and invest, and if you can ride the rabid this fiat money system would ensure that you are much better off, or fourth (the best in my opinion) is to invest in commodities and precious metals… since the entire system is doomed to collapse ultimately the biggest loosers then are going to be the holders of financial capital and the biggest gainers are going to be holder of real/tangible capital (commodity owners) and lastly if one can face the stomach crunches go for the “Random Chalice option” buy those wealth cups (please refer to the very first article of this blog). Surely we all are mature people and capable of taking our own decisions but when you are being cheated in your face it’s important to be cognizant about it and do something about it.

Till next time…………

Statistical Follies

In the previous article I showed how the price of an At the money option is nothing but .8* σ or in other words more generally the expected price movement of the stock. Now I would like to show how we can compute price of any option with much more flexibility i.e “Out of money” or “In the money” and then finally introduce interest rates. The idea behind this whole song and dance is not to attack any existing model etc. because anyways in my opinion they are nothing more than epitome of Platonicity but to provide with sufficient flexibility to price these derivatives under the real practical market conditions which are highly volatile more often than not.

But before that let’s first have a look at what is fundamentally wrong with the financial modeling. As always if the design of the whole building is flawed but the problem lies in the basics or the groundwork and that is what we are going to explore in this article. Again the following content would be a little technical but not a whole lot, since this article series are going to continue for sometime, I have decided to alternatively put out more pleasant read articles after each one these.

With the progression of time it seems and more and more aspects of our society are becoming centrally planned rather than aligned to efficiencies of the free markets.  With everything denoted and measured in government controlled currencies it’s a big sham to call global economies as free markets. Closing the heels is education and knowledge. What awards like Noble Prize etc. ensures is that rather than the forces of free market discovering what type of knowledge/research paper/theory is good for the world, this whole notion ends up in the hands of a few people. Can you believe it a “few good men” I am sure deciding what the coming generations are going to study and based upon that would eventually the future of this planet would get shaped.

Let me pick up the most cardinal concept in statistics – “standard deviation (SD)”. In my last article I showed how the value of an At the Money option is nothing but equal to its Mean Absolute Deviation (MD), we eventually replaced it by 0.8*SD to get it inline with the Black Scholes. Infact as I would show in this article using Mean Absolute Deviation is a far superior method of use in social sciences than SD. So the question:

Why on earth is SD in widespread fashion?

Answer: Happens when few people decide the fate of learning.

In the field of statistics a “statistic” is used for measurement if it has the smallest probable error as an estimate of the population parameter. If the population is perfectly normal then the standard deviation of their individual mean deviations is 14% higher than the standard deviations of their individual standard deviations. Please note the bold italicized word, that’s it… so basically SD is a perfect lab rat however in the field of real social sciences it’s an abject failure. The icing on the cake is that this useless musings are imparted to millions of naïve souls in schools and colleges since almost a century.

Himanshu Jain: “SD as a useless measure in the field of economic science”

Wrong Knowledge is tantamount to a Fukushima whereby even the coming generations pay a heavy price. With these noble thoughts let’s have a look at it’s disastrous consequences. Since I started with the option valuations and the Black Scholes hoax let’s take this topic for example.

Thinking intuitively the price of an option should have been equal to the expected value of the stock or in other words mean deviation. In perfectly normal world of lab rats we replaced it with .8*SD, however stock market returns are anything but normal. Ofcourse with Central Planning of Stock Market these days there can be an illusion of normality. My point if I carry on with MD as the measure of option (instead of replacing it with .8*SD) we find that:

C+P = E[S]  - Eq 1

Expanding E[S] we get:

S*∑_k=0ⁿ p_k*abs(S-x_k), Now if I assume that the distribution is leptokurtic (fat tailed – high kurtosis)

p_kl lim_s->0(probability of leptokurtic distribution close to mean) ≤  p_km lim_s->0(probability of mesokurtic distribution (no excess kurtosis) close to mean).

-          In other words the option prices of At the Money options should be slightly less than what is being computed by using standard volatility measure i.e. SD (σ)

Now-

p_kl lim_s->∞(probability of leptokurtic distribution far away from mean) >>  p_km lim_s->∞(probability of mesokurtic distribution (no excess kurtosis) far away from mean).

-          This implies that the prices of out of money options is far lower as estimated by using σ

For someone keeping a Platonic mindset let me put the proof below:

Since σ is calculated by squaring the movements of the deviations from mean, as the deviations increase σ basically explodes when compared to MD. To prove:

σ₁  = √[∑_k=0ⁿ a_k^2+S^2]/n, S>> a_k

MD₁ (d₁) = [∑_k=0ⁿ a_k + S]/n, S>> a_k

σ₂  = √[∑_k=0ⁿ⁺¹ a_k^2]/n

MD₂ (d₂) = [∑_k=0ⁿ⁺¹ a_k]/n

Since S>> a_k d₁ -d₂ ≈ S/n

And σ₁ - σ₂ ≈ S/√n , Since n is large in other words it shows that σ explodes parabolically when the deviations  are more meaningful and if SD explodes parabollicaly then think what would happen to kurtosis!!!

The implications of the use of the most fundamental concept of standard deviation in option pricing are enormous. It leads to a clear under pricing of Out of money options while making At the money options slightly expensive and it is this very pricing that we are going to explore soon………..

Black Scholes Conundrum Concised

I have never been enthused by this model after I left college. Not only large parts of this model’s derivation is taken from the seminal yet unnoticed paper of its time by Louis Bachelier but also the assumption of normality reduces it to be worth for the books of economic and financial history than otherwise.  What’s even worse is that this started a trend that tried to bring this subject of financial economics more apt as a social science into the realms of physical sciences. Anyways for those inclined to use this model or still revere it with some awe let me make your life simple. In one of my insomniac nights I worked upon this derivation, I would cut the entire crap used in the derivation of Black Scholes band bring out the same model in a very simple form. So here we go.

PS: The content would be a little technical but can be easily understood with a few minutes of patience as the mathematics is pretty simple (as was the aim of this whole exercise)

Basically if I buy a call and a put, the price that I should pay is the expected movement of the stock in that period. So in essence

C+P = E[S]  - Eq 1

After time t, where t is the maturity of the option. Now in the realm of Black Scholes the distribution of the returns from the stock is Normal. So instead of using the expected return E[S] I have to be using the Standard deviation or √E[S^²] and the relationship between √E[S^²] and E[S]in the world of Normality is pretty simple:

E[S]/ √E[S^²] = √(2/π) – Eq 2

We can also represent √E[S^²]  by σ so in essence Eq 2 now becomes

E[S] = √(2/π) * σ

Hence Eq 1 now becomes

(C+P)/S =  √(2/π) * σ

For At the money options (the starting point from where deviations are computed can be taken as 0) and assuming interest rates as negligible C≈P. Hence

2C/S = √(2/π) * σ or C/S = √(1/2π) * σ

That’s it……….. the price of the option is the standard deviation of the underlying asset divided by the square root of 2π

Now let me get to this equation by reducing the Black Scholes model. Later some other day I shall give you the proof by using geometric interpretation.

The call price (assuming interest rates as negligible) c = SN(d1) – KN(d2), the put formula is also accordingly KN(-d2) – SN(-d1), We are taking the case of At the money option as it is convenient to show. So for At the money option.

c= SN(σ/2*√t) – KN(-σ/2*√t), Since We are taking volatility for the entire duration of the option so I am going to replace σ*√t with σ and K by S (as the option is At the money). Hence

c= SN(σ/2) – SN(-σ/2), N(-σ/2) = 1- N(σ/2),

c= S(2 N(σ/2) -1), Similary p = S(2 N(σ/2) -1), Hence

c+p = 2S(2 N(σ/2) -1), as c=p Hence,

c/S = (2 N(σ/2) -1) – Eq 1, Now

N(σ/2) =[∫_-∞⁰exp^^{- (σ/2)^2}  + ∫₀ ^σ/2exp^^{- (σ/2)^2}]/sqrt(2 π)

The first part is equal to 0.5, to integrate the second part of the expression let me expand it using the Taylor series. The Taylor series expansion of the exponential term is

e^x = 1 + x + x^2/2! + x^3/3! ……

replacing x by σ/2 and then integrating we get

N(σ/2) = 0.5+ [₀ ^σ/2 ∑₀ⁿ (-1) ⁿ σ²ⁿ⁺¹/2ⁿn!(2n+1)] /sqrt(2 π)

As SD is small number (in decimals) we can ignore the higher power of σ,

Please note that if σ is high the whole notion of Normality falls apart and as does the Black Scholes model.

So expanding this expression and putting it in Eq 1 we get

c/S = [σ]/ sqrt(2 π) as we got it earlier without this whole and dance.

This expression is for At the Money options at negligible interest rates. We can do it for out of money/in the money options as well and introducing a little bit of interest rates also. So in anycase, next time if you feel bound to calculate volatility or option price using the assumptions of Normality for At the money options your formula is

C/S = √(1/2π) * σ

I wasn’t able to write anything last month so the next one would hopefully follow soon…….

Can't Buy Food... Eat IPADs

Some three centuries ago the French state was in complete disarray, the government ran up huge deficits because of the wars with England and soon this transpired in the form of unabated inflation. It’s people unawares (like most common people are) and reeling under the severe bout of inflation went to their king and complained that they can’t eat bread as it has become too expensive before the king could speak his beautiful wife asked her pupil “To instead Eat Cake”, soon the obliviousness of the French royal family culminated to their demise in the then French Revolution.

History often repeats itself but the irony is that most of us can’t see it as we are it’s participants. It’s like if two trains are running on the same track in the opposite direction they are definitely going to crash into each other however the passengers inside the train would never get to know no matter how many times in the past they have seen it happening from outside. Something interesting happened about 2 weeks back. In one of the seminars the NY Fed President was asked about the Fed’s total obliviousness to inflation when instead the Food and energy inflation was the highest ever recorded since 1974!!!, to this the Great NY Fed President replied that overall inflation was still moderate (their freaking core inflation) and so while the Food inflation maybe high but there are something like “IPAD” that are getting cheaper!!! This statement by the NY Fed President (who is either like most economists completely oblivious to the real world or totally hand in gloves with his crony bankers) is a harbinger of the things to come (just to note that this month his totally manipulated core inflation was also the highest recorded in 2.5 years). While the queen of France could be excused for her comments these are supposedly learned men. If this trend continue the battle lines in Middle East and southern Europe would spread elsewhere, add the last night protests in London to the list. Let me point out that this trend is not just peculiar to Central Bankers in US but everywhere.

The response to the catastrophic disaster in Japan by its Central Bank was to the same predictable action of printing money. The Japanese Central Bank printed some 700 billion dollars!!! In just one week just so that it’s stock market does not crash. The result of this tsunami of money printing was that the Japanese stock market may have fallen overall by just about 6-7% in the last week but the price of rice which last time I checked was what was really needed by those people affected by quake rose by 12% (in a week) and to the best of my knowledge people can’t eat stocks, so great job BOJ.

What many people don’t understand is that the stock market going up is not always a good thing; it is the reason why it goes up and that is more important. During the last 2 years the markets across the world have gone up mainly because of one single reason (Money printing). To explain my point let me pick another lesson from history, that of the famous Weimar Republic. After the end of war in 1918, Germany had a huge task ahead… not only did it need to rebuild but also to pay the obnoxious price of war imposed upon it. Soon it found its hands full and resorted to the old money printing trick. The result on the asset price was as follows:

-          The nominal value of the stock market increased by 89 times in the 8 years following the war (looks good then read further)

-          The value of gold increased by 1600 times!!!

-          It soon took an entire wheelbarrow to buy 2 eggs

-          The people had to be paid their wages twice a day

More importantly with the large population living in tatters and only handful of bankers who were cognizant of this process were able to save their wealth by investing in hard assets thus created a serious communal rift in the society and thus paving the way for Hitler.

I am so glad that the BOJ saved the stock market and saved a few of their friends, while the majority of its people are going to soon feel the impact of higher rice and other commodity price for years. Just wonder why they couldn’t understand that because of the destruction in the quake that since the supply of goods has reduced so should the credit and yes assets have to deflate because of that. The realty is that the governments across the planet are so extended that they have no way but to generate inflation to get out of this mess. Unlike the private sector the government is not a profit generating entity but a welfare entity (supposedly) and so when it runs large deficits the only way it can repay is by increasing taxes… however the reason the taxes are so problematic with the masses is because it leads to transfer of wealth from one person to another and so the government devised another way out of it… debt, by selling its debt the government was able to create the mirage that it was not necessarily a transfer of wealth as my money taken from me would be ultimately returned back to me in the future. However how would the government return this money back, well there could have been just two possible ways either raise the taxes in the future or take more debt and run a ponzi scheme (this is what many developed countries tried for a while) and when this ponzi scheme is about to run its course then what should it do.. well then it came with that brilliant idea of currency. In my last article I explained how currency is nothing but the government liability of the shortest duration. The only difference between currency and other forms of government liability of the shortest duration. The only difference between currency and other forms of government debt is the fact that based upon the currency depends the overall private debt  generated by the fractional reserve system (check the previous article) so contrary to today’s logic in times of slowdown the currency supply should contract because the supply of goods have reduced. The irony is that currency which is essentially government liability and is controlled by just few non-elected representatives across the planet forms one side of almost each transaction and also the modern unit of accounting in economics and this a system that we describe as free markets!!! I wonder how different it is from a politburo of Soviet communists deciding the nations 5 year plan.

It’s very important the people understand that what they are earning every month by putting in their time and hardwork is essentially government debt that the Central Banks can print as much as they wish with the flick of a finger and distribute it to their crony bankers. Think about it this way that you have spend hours of your personal time and studied hard and passed the exam, at the time of the convocation the Director of the college announces that passing the exam was not necessary and everyone would get the degrees simply because his son failed in that exam.  So it’s important do away with the “cash” as soon as you have it and invest it in hard assets and especially not to deposit much of it in banks and thus not allowing them to play with under the fractional reserve system .

Often there is this propaganda that commodities don’t yield any cash flow and so are not good investments, while I agree to this hypothesis in normal times but these times are hardly normal… please not the key word in their argument “cash flow”…. While fixed income and equities would yield some cashflow 1 year down the road, however what good would be that cash if it’s value has significantly eroded because of the inflation generated by money printing. Don’t fall for these arguments, in an environment like this hard assets are the ones that would outperform because when the money is provided to a corporate he buys those hard assets first operates upon it in the second stage and sells it in the third stage so by the time he gets the “cash flow” to the shareholders in the third stage that money has significantly lost its purchasing power.

There are only 2 ways to deal with this situation, either do what people in Middle East and parts of Europe are doing or play the cards smartly that are dealt to you by the Central Banks and it’s pretty simple buy commodities (mainly bullion and agri) and hedge it by shorting equity (let me be clear even though equities would go up because of the money printing the pace at which the commodities would appreciate would far outweigh that of the equities. The hedge is important because we would have intermittent collapse of liquidity like the one we had in 2008 and this hedge would keep you in the game………

PS: With China increasing the prices of its rare earth metals soon Mr. Dudley (President of NY Fed) would find his IPADs also getting expensive not sure what would he eat for some food for thought.

Incas Curse and the Deal with the Devil

US GDP no. came in a couple of weeks back, apparently the reported nominal GDP growth rate was 3.5% and the real GDP growth rate was 3.2% so in essence according to this data the inflation figure was just 0.3%!!! and I always thought that statistical chicanery is the monopoly of communist and dictatorial regimes. Infact sovereign slanders and lies are becoming fashionable these days, a clear trend in how big a soup these governments are, what’s more it is applicable to all categories of governments be it the oldest or biggest democracy in US and India or communism in China and as we are seeing it now under the dictatorial regimes of Middle East. Anyways probably this is not the right forum for sovereign government bashing so I will limit myself to the economic thought. In one of my last articles I alluded to the fact that a nations currency is linked to its productivity and with the certainty of the demise of the fiat currencies investing in Gold and Silver might be prudent but one should keep in mind that if the value of Gold and Silver goes up one is not creating wealth but rather preserving wealth (no doubt it is also important) but this point should always be kept in mind. To explain it further let me take you some 500 years back to the Incas civilization, back then the Inca society was based on toil and innovation. Their legends of gold and silver deposits attracted the Spanish invaders, the Incas were swiftly defeated and what we saw was one of the biggest plunders of history. The Incas used to consider gold and silver extracted from their mountains as metal of God and instead of circulating it in their economy, they used to store it in their temples dedicated to God. They found little use for them in their society beyond a point infact on the contrary excess of this metal was considered as a bad omen for their society. So to their astonishment they found it quite curious as to why the Spaniards were after this metal. In any case after the plunder, the Spanish sailors sailed back from their golden voyage with the hope that with this loot the Spanish Splendor would reign supreme for generations to come. Well that was the hope.. Instead the Spanish empire and economy saw a decline that pushed the once great power in Europe to the second rung.

So what really happened, why didn’t all this gold took the Spanish nation far ahead of everyone or were the Incas really right in their thinking that excess of this metal could lead a society to ruination. Well believe it or not they were!!! The Spaniards were indeed stuck by the “Incas Curse”. Hey but hold on wasn’t this article about economics and currency and certainly not about ghost stories. Indeed it is about economics because the “Incas curse” was nothing but “Inflation!!!”.  It doesn’t matter on what the currency of a nation is issued… Paper or Gold if we increase its supply and the quantity of goods produced remain the same it would lead to inflation. So since gold had practically very little in producing anything tangible, it merely acted as an increase in currency supply.

With this context in my mind let me move the topic of QE 2 and some of the misconceptions that I hear around me.

Well not just general public but even many of the fund managers have this misconception that QE 2 is fresh money printing. Well in layman terms maybe yes but the answer is not really!!! As I explained in my earlier articles money is nothing more than the liability of the government with the shortest duration (let’s for simplicity assume one day although it is a variable and can go to as low as 0)

So Money like government debt is a liability and since it is not backed by anything both are the same. So let me define money again: Money is a government debt of shortest Duration and hence the most liquid. Currently with 2 trillion dollars of base money and about 13 trillion dollar of conventional US Federal Debt the net Federal liability is about 15 trillion dollars. What the Federal Reserve is doing is tweaking this distribution or what I would say is performing a maturity swap wherein it replaces the relatively longer term liability (5-10 year debt) with shorter term liability (US dollars). My point is that unlike what most people including some seasoned fund managers feel QE 2 unless made permanent is not leading to the creation of new money and in a fiat monetary system that the world is in cash and government debt are replaceable. Infact this last point is very critical to keep in mind.

So that brings me to the next question, if QE 2 is not really leading to the creation of new money then is it really inflationary. Well in the short term it is definitely inflationary however in the long run all bets are off. Let me explain, since the duration of cash is low (assume it to be 1 day) it makes sense to put that money into an asset where its value is preserved and so the existing treasuries, stocks, commodities and other debt instruments are ideal for this purpose. So as the long dated liabilities are replaced with cash, some other asset classes definitely get a kick owing to the shorter duration of cash if it is perceived that the cash would loose its value in the future. So the next point is where would this cash go. Well it should into 2 avenues 1) A place where its purchasing value is preserved 2) Where there is value, growth but more importantly momentum. Hence longer dated treasuries may loose value and commodities would gain value along with some equities. So yes temporarily this is inflationary but lets look at it a little longer.

Lets say that the Fed buys bonds of 100 billion worth of face value at 5% coupon payments 1 year down. So at the end of 1 year the buyer of that bond (assuming he bought at par) would receive 105 billion dollars.  However if the inflation expectations become high then the value of the bond falls far below the face value (let’s say 95) so in essence by buying it today the Fed is pumping in 95 billion dollars today whereas it could have pumped 105 billion dollars had it done it 1 year into the future. So the world is essentially short of 10 billion dollars one year into the future.

This is a dangerous game to play as its tantamount to saying that since God can’t help me let me have a Deal with the Devil. It can work only in two situations:

1)    If there is an existing demand for short term liquidity for productive spending which is clearly not the case

2)    It has been evaluated that if the equity market goes up by x percent then the consumer spending increases by 3.5 of x percent. So let’s say that if the equity markets go up by 60 percent then the consumer spending due to the wealth effect would increase by 2.1 percent and since consumer is 70% of US GDP it increases by about 1.5% and this increase in consumer spending could then kick start the investment cycle in the country. 

Well all I would say is that the price of failure could be very high for getting such a small kick from the economy. Because if it doesn’t work out then as I pointed above that the world could actually get into a deflationary tailspin where asset prices across the board start to collapse.

However going by the actions of the Central Bankers wherein they are ready to put a floor every time S&P falls by 10% it may so happen that they might start buying assets themselves!!! thus bringing another twist to the tale and finally bringing the reality of inflation. The reason I call it a deal with the Devil is because if it doesn’t work out (and the chances are that it would not) then we could see a collapse in asset prices across the board as the future liquidity dries up and if to stop this collapse from happening the Central Bankers make the effects of QE2 permanent by putting back the proceeds of federal debt into the market and buying other assets then this “Deal with the Devil” could end up invoking the “Incas curse” and that could unleash the same deadly magic on this world as it did some 500 years back on the Spanish Empire……..