Chicago economics delirium

26 November, 2017 at 10:48 | Posted in Economics | 1 Comment

I believe there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis. That hypothesis has been tested and, with very few exceptions, found consistent with the data in a wide variety of markets …

Michael Jensen

I am skeptical about the argument that the subprime mortgage problem will contaminate the whole mortgage market, that housing construction will come to a halt, and that the economy will slip into a recession. Every step in this chain is questionable and none has been quantified. If we have learned anything from the past 20 years it is that there is a lot of stability built into the real economy.

Robert Lucas

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  1. Covered Interest Parity has been persistently violated since 2008, in the $58 trillion currency swap markets. Covered Interest Parity is a prediction of the no-arbitrage assumption of neoclassical economics.

    In the Financial Engineering and Risk Management MOOC from Coursera, which I call “Quant 101”, fair pricing formulas are provided for bonds, futures, forwards, swaps, derivatives, etc. The formulas provide bounds on prices, explicitly based on the assumption of no arbitrage. Since that assumption is empirically violated in the very sizable currency swap markets, prices can’t be proved to be bound by the fair pricing formulas. The Efficient Market Hypothesis is thus challenged by the significant, persistent, observed violation of CIP in currency swap markets.

    In addition, the class cannot present a pricing formula for Mortgage-backed Securities; the prices are not analytical. In other words, valuations are arbitrary. MBS arbitrarily multiply the price value of the underlying mortgages, as traders collude to bid them up against each other, then spread panic in chatrooms if they take a short position. Matched-book dealers don’t care because they have hedges and insurance against devaluations. The insurance piece broke in 2008 but they have adjusted it.

    I suspect the next crisis will involve currency swaps. Because of the world dollar shortage, it seems countries are “printing” a lot of local currencies to swap into dollars at a higher rate than they could just borrow the dollars at. It may be fine, but bankers tend to go too fast in these new unregulated areas and forget something important. AIG before 2008 was issuing insurance on Residential MBS while holding RMBS as assets against which to pay out the insurance. When traders panicked and bid RMBS to $0, AIG couldn’t pay out on claims. But the Fed stepped in with the Maiden Lane programs to make a market in RMBS when no one else would, and loaned $180 billion to AIG so that Goldman Sachs got its insurance payouts on devaluing RMBS …

    Persistent significant examples of arbitrage in large markets such as the $58 trillion currency swap markets challenge the Efficient Market hypothesis. Swap market prices are unbounded by fair pricing formulas, which require no-arbitrage conditions. Furthermore, many prices such as those for RMBS are not analytical and are vulnerable to groupthink panics that arbitrarily lower prices just as groupthink exuberance and collusion arbitrarily raised prices. Conclusion: prices are arbitrary, unbounded by fair pricing formulas that result from the Efficient Market Hypothesis.


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