What is an inflation risk premium?

I was reading a fascinating article from the Dallas Fed on the changing nature of long term rate movements (globalization Effect on Interest Rates) but am confused by the authors decomposition of the inflationary component of bond rates into an expected and risk component. Rather than emailing someone who might be able to explain it to me, I hope that a reader will comment and educate me.


If I understand things correctly, the risk-free real rate component is the market wide return required to make a risk-neutral agent indifferent between taking money today versus some time in the future. The real rate risk premium is the spread between the riskless rate and the risky rate appropriate for the entity doing the payments. Then the inflationary expectation component takes these real rates and makes them nominal by adding in the markets expected rate of inflation between today and some time in the future. This then leaves the 'inflation risk premium' -- What is this?

It clearly can't be an analog of the risk spread as inflation expectations are the same regardless of who wrote the bond. The text in the box says:

This part of R compensates lenders for the risk that inflation will be higher than expected, in which case the principal and interest returned will have less purchasing power than anticipated.

That makes no sense to me. If, at the time of pricing, there is expected to be some volatility in future inflation then this will be taken into account when calculating the expected inflation component, using risk-neutral probabilities, right? If so, then

\lamba_\pi

will be zero.

What am I missing?

Update: Duh!

Impending Doom

The econo-blog-o-sphere is quite certain that we aren't in for a soft landing when it comes to the current housing price bubble. The fine folks over at Autodogmatic put not too fine a point with:

If you don't agree with me, try this little quiz: (1) Do you believe the mortgage interest rate risk in the next few years is to the (A) upside or (B) downside? (2) Do you believe median incomes are trending, in real terms, (A) up, or (B) down.

If you answered "A, B", you can give yourself a pat on the back for honesty. But you've also just implied that the housing bubble ain't comin' back any time soon.

If you answered anything else, your views are either incoherent or totally disconnected from reality.

I thought I'd ask the loan officers what they think. Well, I didn't do this, but the fed was clearly able to get a coherent sentence or two from the fine men and women at the front lines of our credit crisis. So, I thought I'd put together a little chart to highlight one small point, namely that loan officers want to relax credit standards when housing prices drop. Now if we are to believe that housing prices are falling due to A & B above, then I don't quite see how that environment is conducive to relaxed lending standards.

The Wisdom of Needles

About 6 years ago (aka, long before the days of RSS), I set up an email account on my server to gather various news feeds with the aim of correlating news against market data. I also scraped a few pertinent sites and threw together some latent semantic analysis code to correlate against real time stock quotes. While my code stopped running about 6 months ago when I moved from Solaris to Linux and never bothered recompiling, I continue to amass the news feeds. And what have I learnt from this exercise: That markets are a great predictor of news. Not the other way around.

We now find ourselves in the blog-o-sphere[1] and this idea is being revisited:

Edward Hadas over at breakingviews.com (another paywall, but really good analysis site founded by Hugo Dixon) likens it to using the ‘wisdom of crowds’ to trade. I’m sorry Edward but actually I think you’ve got this one wrong. ‘Wisdom of crowd’ - mining would be things like Marketocracy and SocialPicks. Monitor110 in my opinion is all about finding the needle in the haystack; finding the individual voice or nugget that escapes crowd amplification. Finding the kernel before it becomes a snowball. Where I do agree with him however is the paradox of diminishing returns: the more people find the needle the more difficult it will be to monetise. Or paraphrasing Dash - ‘if everybody is special, it really just means that nobody is…’

Do I think there is anything in Marketocracy? Sure! If/when these ideas take off they will evolve to efficient markets that are almost as good as using real markets to predict the future. Which, to paraphrase Barry Ritholtz, is only really good for trend following. And despite our best wishes, looking at historical market data provides us with damn near nothing informative about the future.

One could argue that the problem with my attempt to correlate news with market activity is that I wasn't looking for the needles in the haystack, and in fact my haystack was being generated and distributed by journalists and PR staffers well after the event. I agree that this is a problem, but I do not see mining the blog-o-sphere as a profitable long term strategy. One just has to look at the pump'n'dump schemes that fill my inbox or the lead-gen junk that fills SERPs. When a voice no longer needs to be amplified by agreement, ala in prediction markets, it is very easy for a lone voice to manipulate others.

Prediction markets are so hot right now, but I get the feeling that people are missing out on some basic economics in terms of understand what is a prediction market and what isn't. If you can buy something now, hold it for the future (possibly a some cost) then prediction markets don't really have a reason to exist. Compare the situation with stocks verus weather derivatives. Anyone can buy a stock today and can hold it. Or they can use options to replicate that strategy. At an arguably lower cost they can even use the nascent single stock futures market to do this. This replication strategy is available to anyone. If the market has an informed view about the future evolution of returns then this will be reflected in the spot price because such replication strategies exist and there will be no arbitrage between spot and future prices. This argument holds for all commodities that can be stored.

Hence any prediction market for this class of commodities is irrelevant. Existing market mechanisms provide an environment where future predictions are embedded within the current spot price.

No one can fill their pockets with summer cooling days. I can not keep a cloud in my lounge room and unleash it on Florida during orange picking season. The weather today does not particularly informative of the weather 3 months from now and as such prediction markets are valuable for future events or things that can't be stored as there is no way to replicate strategies on the spot markets to embed information in current prices.

Yesterday my friend Jon dropped by the office and we talked about his research project as he starts his thesis under Robert Engle. One of the ideas we discussed was what I see as the three causes of information asymmetry in markets:

1. Timing: I know something before you do
   
2. Accuracy: I know something about something, but I'm not sure what
   
3. Interpretation: I know that X will happen which I think means Y, whereas you think it means Z
   

Of course, information is latent in financial microstructure. We can't readily see it or measure it, even after the fact. But lets assume that blog-o-mining has solved this. I still see nothing that gives any agent a distinct advantage in the war for information asymmetry.







--
[1] For some reason whenever I hear 'blogosphere', I think Biosphere

jdigittl on BASH

Its late at night and the brain isn't feeling as sharp as it was 10 hours ago so the only thing left to do before stepping away from the computer is to check out bloglines. John Battelle links to a site that calculates the worth of my blog. My blog is worth $6k. Neat. Totally wrong, but neat.

Actually, its not neat. Silly numbers piss me off. I left marketing analytics world because people didn't pay attention to ROI metrics in 2000 like they paid attention to numbers with dollar signs in front of them.

Things have changed somewhat and now the entire world of lead gen and direct marketing live and die by campaign metrics.

But that's not the point of this post.

After toying with the calculator (aka sticking in jdigittl.blogspot.com and then leaving), I searched for jdigittl on technorati. This was the first time I did a blog-o-sphere ego search. I find only 2 links to my name -- one of which is a direct quote of a direct quote of mine that appears on bash.org (an IRC funny-quotes site).

I'm not going to link to the blog that quotes this, because whilst it is in German, it looks like a spam blog designed to get organic mortgage traffic. And in all their wisdom, the algorithms behind the site chose that quote to garner $$$ traffic.

At this point, I'd love to rant about the comparative uselessness of algorithms that 'price' things that are neither bought nor sold, but the blog-$-meter says that the spam mortgage blog is worth $0.00.

Its worth something to someone.

postscript
Ok. I just revisited the German site. They are not a mortgage spam site (as far as I can tell), but rather than editing my post I'll let my point stand. I do this for two main reasons:

1. That was a pretty cool segue, wasn't it?
   
2. Blogger causes Firefox to run really really slow on my Linux box
   

But rather than falling prey to the sin of silly numbers, let me reinforce my point with this blog. The same blog-$-meter gives also says that it is worth $0.00. This strikes me as odd given that I found this spam site linked directly from the Google organic search results. I guess that only counts as 1 link using the 'Tristian Louis' method. Actually, it counts as 0 links, because Google isn't a blog.

Now, I'll be the first person in line to state that valuation is hard. People way smarter than me may even agree with me on this point. But picking one measure, and extrapolating from that can be quite dangerous.

Let me suggest four criteria for choosing a good measure for valuation:

1. Measurable - Can you actually measure this for the thing you are trying to value?
   
2. Testable - Can you measure it for enough other things that have been valued by some 'market'?
   
3. Accurate - If you use your measure(s) to come up with a valuation, does it make accurate predictions?
   
4. Sane - Even if it is accurate, does it make sense? I.e., can you rationalize why it may actually work for observations outside of your sample.
   

Clearly the blog-o-bling meter falls foul of a few of these.


post-post script
*giggle* Blogger's spell check doesn't know the words 'Google' or 'Blog'.

CBOT

A few months ago I was given the opportunity to present my thoughts on the intersection of lead generation and financial markets at the Chicago Board of Trade. As readers of this blog are aware, I am convinced that there are numerous signals indicating the desire for more advanced financial instruments to services the needs of lead generators and buyers. However, my experiences at Root (and previously at Traffion) continually remind me that adjusting market behavior is far more difficult than the economics textbooks would suggest. So while I was optimistic that change would occur, I was uncertain as to the timing. Today I am very pleased to welcome the formal public announcement of an alliance between the CBOT and Root Markets. [Press Release]

My recent work has focused on pricing nascent, and as yet untradable, swaps. Today's announcement heralds the coming days when similar contracts will be readily traded.

If anyone out there is interested in buying or selling leads at a fixed price I am happy to say that Root is open for business!