bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

THE MONETARY AUTHORITIES AND FINANCIAL MARKETS 367
designed explicitly to allow agents to take positions regarding future events,
the range of potential market information has expanded dramatically. In
1995 and 1997, for example, Malz showed how information in options
prices might be used to indicate the probability of exchange rate realignments
in the ERM (Malz, 1995, 1997). Options are contracts which give
agents the right to buy or sell an asset at a given future date for a given price
(the ‘exercise’ or ‘strike’ price). ‘Call’ options are options to buy and will
be exercised if the market (or spot) price is above the strike. Thus the price
of a call option is telling us something about the market’s perception of the
probability that the spot price will be above the strike price. Since the lower
the strike price, the greater the probability that it will be exceeded at a given
future time, the price of the call varies inversely with the strike price. Clews,
Panigirtzoglou and Proudman (2000) show how an implied risk-neutral
probability density function (pdf) can be extracted from a short sterling call
option. A series of pdfs (from a series of calls) then tells us the probability
(as seen by the market) that the sterling three month interest rate will fall
within a particular range on a future date. These estimates then form the
basis of the famous fan charts in the Bank’s quarterly Inflation Report.
Given that the flow of benefits from virtually all financial assets lies in
the future and thus that current price must incorporate something of agents’
views of the future, scarcely any class of assets is immune from the search
for potentially useful information. So far, we have considered the possibility
of uncovering markets’ expectations of future interest rates (of different
kinds) and possibly of inflation. More ambitiously, it has been suggested in
recent years that financial markets might be made to yield information about
future developments in the real economy.
As with many fundamental insights into the working of financial markets,
Irving Fisher (1907) was amongst the first to point out that changes in
the spreads between the returns on different fixed income securities might
foreshadow changes in the macroeconomy. The idea was further explored
by Merton (1974), since when the growth in confidence in market wisdom
has led to a near-explosion of empirical studies. The basic idea draws on the
inverse relationship between risk and return. Thus, in any given economy,
government paper will have the lowest rate of return, followed by ‘AAA’
bonds issued by the corporate sector and so on up to the returns available on
‘junk’ or sub-investment grade bonds. The spreads represent compensation
for different degrees of risk and, provided the risk is correctly priced, must
function simultaneously as an index of the risk contained in each security.
It is a short step from here to assuming that changes in the spread are indicating
changes in the degree of risk. The principle is familiar, indeed cru-