Fed Funds‑Everything Else is a Derivative
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Date: 04-18-2005
Start Time:
6:00pm
End Time: 7:30pm
Speaker: Stan Jonas, FIMAT
Location: 412 Shapiro CEPSR, Davis Auditorium
ABSTRACT
In last few years there has been a dramatic "financial experiment" taking place. On the one side the market's have unbeknownst to most, except of course those directly involved, have developed an entirely new trading vehicle-essentially Arrow-Debreu state variables.
These FED FUNDS futures and options are essentially
bet's on the prime driver of all financial market, the path of the Central Bank
policy variable in the future. At the same time and not coincidentally, in an
almost Hegelian "Master-Slave" dialectic, the Central Bank (and here we mean all
Central Banks, but explicitly the Federal Reserve Bank and the Bank of England),
have incorporated these derivatives as their major mechanism of communicating
with the marketplace, and deriving what the expectations they're attempting to
impact are.
The existence of actual trading in Arrow-Debreu's has
transformed almost all interest derivative trading. As an example, FIMAT's the
largest trader in the dominant Eurodollar futures options market place, perhaps
the most liquid options marketplace extant. We have not quoted or used a
traditional "Greek" in either trading or quoting in almost 2 years.
1. The existence of Digitals on the FED has enabled us to see that Three- Month Eurodollars (Term rates) are nothing more than a basket of digitals.
2. Recognizing Eurodollars (libors) as digitals has revolutionized the Options and Swap marketplace.
3. Traditional "mumbo-jumbo" about skews, vol surfaces, have now become relegated to those that do not trade.
4. With the Central Bank, now essentially targeting Arrow-Debreu policy variable, that the market can and does evaluate, Central Bank management of expectations has become almost transparent.
5. Policy clarity has predictably, changed the entire pricing matrix of options.
Ø We will examine the FED FUND's futures.
Ø
Options on FED FUNDS futures (an option on a digital)
Ø Show the mapping
between those and Eurodollar futures
Ø And finally complete the mapping to
the complete yield curve.
Ø And in passing examine whether concepts like
"risk premium" and "risk neutrality" have any operational content in a fully
arbitrage able [Complete Arrow Debreu] marketplace.
Oh yes, we'll show how in the midst of the most liquid marketplaces, there still exist not just arbitrage structures, but what we call HYPER ARBITRAGE structures where not only is the no downside and the possibility of a gain, but where one actually get's paid to make money in every state of the world.