Incite -- (v) 1: give an incentive; 2: provoke or stir up; "incite a riot"; 3: urge on; cause to act
Wednesday, June 09, 2004

A Point So Often Missed: The Presence of an Administered Rate
Written by: Speculator

The Fed Funds Rate (the one that Beck discussed earlier) is perhaps one of the most curious facets of the global financial machine. It is a rate that is almost exclusively symbolic, strictly in the sense that it is a rare day when it is actually assessed.

Note: the FFR is the rate that the Fed will charge to a commercial bank for overnight funds should said bank fail to meet depositary margin requirements. Most often, if a bank falls into such a shortcoming (which is rare in and of itself), it will request relief from banks that it has standing relationships with. The Fed is positioned (in a function called "The Fed Window") should all of these relationships fail. In the commercial banking world, you DO NOT want to show up to the Fed Window.

However, it caries with it such power and influence, that it is considered by some to be omnipotent. To be sure, it is the base rate that 99.9% of all global rates are subsequently priced from; it is the universal ingredient in the global debt derivative cocktail.

But the most noteworthy aspect of the FFR is that it is an administered rate. This is in direct contrast to the way rates are normally generated - via market forces. An administered rate, by its very definition, is fabricated, and in this case, relatively static. In a world governed by aggregate reactions (re-pricings) to stochastic processes, a stagnant and artificial base is almost alien.

So, what's the problem? Well, there are scores of schools on risk, but let's distill them to two: one school envisions a relative rate of aggregate risk (on any scale - local, national, global) and the other believes in an absolute rate, one that is defined currently by its history. It is the first school's invitation of an applied rate that supplies the second school with questions.

The most commonly used rate to begin measurements of all sorts of financial risk is what is known as the Risk Free Rate (RFR). What the RFR intends to capture is the sum of the Real Rate of Risk (which is the debate from the preceding paragraph) and Inflation. The real rate of risk is an implied figure, which is backed out from the RFR and rate of inflation.

The most common proxy for RFR in the domestic spectrum (and incorrectly in the international) is the yield on the current, on-the-run, 10-year US Treasury Bill, which currently yields 4.81%.

Now, the chief driver of the RFR is the FFR, in essence the RFR is a derivative of the FFR. This essentially makes the RFR a quasi-administered rate. This is when things get scary. The RFR is used in numerous applications to determine, among other things, how much it is going to cost a business to finance its operations. (This is determined through a ubiquitously applied model of finance, the Capital Asset Pricing Model, which uses the RFR as one of its three inputs) So, allowing the assumption that inclusion of a quasi-admin rate yields further quasi-admin rates (granted, as more ingredients are added, the influence of the original administered rate is diluted), the cost of capital determined through the CAPM model is a quasi-administered rate.

Now, if you are a member of the first school of thought on risk, this is not bothersome to you; all rates are relative to one another and risk is properly priced.

If, on the other hand, you believe in some arbitrary real rate of risk that has been absolute, yet dynamic, throughout all time, then the administered nature of the FFR should cause concern. An illustration:

On the first trading day following 9/11, the Fed immediately cut the FFR by 50 basis points (bps). The 10-Year yield subsequently fell, over the next few trading sessions, by 90% of the Feds move. (This inconsistency in rate movements causes the Yield Curve to either flatten or amplify) What this did was cause financing costs across the globe to fall for almost all parties (there are some yield curves for certain pools of high risk that fully absorb movements in the short end via amplification or dampening of the curve). For the period of time from 9/14/01 to January of this year, the 10-year yield was at 50+ - year lows, indicating multi-decade lows for proxy measurements of risk.

If you happen to believe in the second school of thought, this is rather oxymoronic. During a time of arguably unparalleled geopolitical risks, our proxies for measuring financial risks were at multi-decade lows. This is the core of the problem with an administered rate for those that subscribe to the second school of thought.

Soon, I'll post about the hazards surrounding the artificial nature of the FFR.

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John Beck

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