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The Taylor Rule: Ignore Fraud Epidemics and Worship Markets

By       Message William K. Black, J.D., Ph.D.       (Page 2 of 5 pages) Become a premium member to see this article and all articles as one long page.     Permalink

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"[E]xtremely low interest rates led individual and institutional investors to search for yield and to engage in excessive risk taking, as Geert Bekaert of Columbia University and his colleagues showed in a study published by the European Central Bank in July."

Bekaert's study fails to comport with the scientific method because it too conflates correlation with causality.  Bekaert concedes that despite four prior econometric studies of the issue "no extant research establishes a firm empirical link between monetary policy and risk aversion in asset markets."  The conclusion reiterates:  "there is no empirical evidence on the links between risk aversion in financial markets and monetary policy."  Note that that the ECB authors are explaining that prior studies have not even demonstrated correlation.

At some points in the description of their study, Bekaert and his colleagues play it straight by describing a correlation and noting that some writers have asserted causality.

"The strong interaction between the VIX index, known as a "fear index" (Whaley (2000)), and monetary policy indicators may have important implications for a number of literatures. First, the recent crisis has rekindled the idea that loose monetary policy may lead to excessive risk-taking in financial markets."

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Within a three paragraphs, however, the authors abandon the scientific method and assert causality.  "A lax monetary policy decreases risk aversion in the stock market after about nine months.  This effect is persistent, lasting for more than two years."  Why would "lax monetary policy" (a term the authors do not expressly define) have such a large lag before it purportedly drove risk aversion?  Why would it cease to drive risk aversion after two years?  The authors offer no clues, which is remarkable given their claims of causality.  There is no logical or theoretical basis for their purported lag and persistence.  Under the "efficient markets" and "rational expectations" theories that are essential to the ECB authors' study the markets should immediately take into account all public information.  Indeed, under rational expectations theory, the markets should anticipate that Federal Reserve under Alan Greenspan would push down rates and incorporate the Fed's practice into current prices months, even years, before Greenspan lowered rates.  To the extent that the authors suggest any theory to explain the lags and persistence, the logical implications of their theory are that there should be no lag and the effect of "lax monetary policy" should be permanent.

Pages later, the authors implicitly admit that their study cannot establish causality because "the relationship between risk aversion and monetary policy may also reflect the joint response to an omitted variable"."  Yes, there are an enormous number of variable that could actually determine causality and it could be the interaction effects of many omitted variables that is most important in determining if there is any reliable "relationship" between risk aversion and monetary policy.  Because of these omitted variables Bekaert's study inherently cannot establish even reliable correlation between risk aversion and monetary policy because he did not control for these variables or their interaction.  Correlation cannot establish causation and controlling for some variables does not change that basic proposition of the scientific method.  I return to this point and provide specifics below.

But there are more basic problems with using the VIX index than conflating correlation with causation.  The ECB authors rely on a two-step process to purportedly derive their measure of risk aversion from the VIX index.  They state that the VIX index purports to be a measure of "the stock market option-based implied volatility."  The authors claim that they can derive separate measures of S&P 500 option investors' uncertainty and risk aversion by decomposing the VIX index.

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There are multiple, disabling problems with using the VIX index to measure the risk aversion of originators and purchasers of mortgages and mortgage derivatives.  First, no one knows whether the VIX index actually measures the implied volatility of the stock market (or, more precisely, the portion of the stock market that the VIX index purportedly relates to).   The VIX index was constructed on a theoretical basis with the theory arising from the efficient market hypothesis.  The theory is that if a portion of the stock market were efficient an investor could buy an option to invest in that would hedge the "implied volatility" in those stocks.  In order to operationalize this theory the creators of the VIX index had to specify how it would be calculated by making a series of choices about the date and nature of the stocks and precise options to use.  These calculations are approximations that would introduce errors even if the VIX were theoretically sound, particularly because the composition of the subset of stocks (the S&P 500) used to calculate the VIX and define the option used as the hedge changes over time as corporations fail or grow or shrink significantly.

It is highly unlikely that the theoretical basis for constructing the VIX index is sound.  Markets were grotesquely inefficient during the financial crisis -- the relevant time period.  The claim that derivatives had a consistent relationship to underlying assets such as the stock market also proved false during the crisis.

The result of these uncertainties is that we do not know whether the VIX index ever accurately represented the "implied volatility" of the stock market.  We do not know whether the VIX index's asserted relationship to the implied volatility of the stock market is consistent or varies.  There was never any way to prove whether the VIX index was accurate and represented a consistent relationship with stock market volatility.  The VIX is a faith-based index premised on a theory that proved false.

Second, there are strong reasons to fear that the so-called fear index is becoming an ever poorer measure of stock market implied volatility.

"Mike Pringle, global head of equity trading at [Citi], told Reuters that the VIX volatility index , is now as much a traded asset as it is a guide to investors seeking protection from losses.

The VIX reflects Standard & Poor's 500 .SPX options prices and, therefore, expectations of future market moves. The idea is that as people become fearful of losing their money, they are more willing to buy a put option as protection.

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At the moment, it remains at very low levels.

"A big mistake the market makes is looking at the VIX as an indicator of stock market risk. Why? Because it's an asset class and it's more traded for yield than protection,' Pringle said.

"The growth of structured products around VIX drove that move. In most cases, the VIX is sold to generate yield but during some stress periods, the weakness in the spot level triggers significant computer-generated technical buying from these products,' he said.

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William K Black , J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City. Bill Black has testified before the Senate Agricultural Committee on the regulation of financial derivatives and House (more...)

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