Under "normal" conditions, a 1/2% hike in the treasury yield would cause an upward move along all other spreads, pushing the junk bond yield from 10% to 10.5% (or thereabouts).
Bond prices (what they cost that day) move opposite to yields. Thus an increase of 1/2% in the Treasury and Junk/foreign bond yields takes the initial (par values of $100k each) and moves them to these new values:
Treasury Junk/foereign $86,717 (-13,283) $96,436 (-3,564) (x4)
Shorting. A trading house holds bonds in its portfolio and under normal conditions faces the risk of losses as well as gains. To help stabilize the overall portfolio value the house "shorts treasuries." This is where it borrows a treasury, immediately sells it, and promises to replace it at a later date. If the price of the treasury FALLS, the firm has borrowed and sold today at par (100,000) and buys back the same bond LATER at $86,717. It has thus realized a $13,282 gain on the Treasury bill. The same movement in interest rate generates a LOSS on the junk end of $3,564.
It emerges from this analysis--rounding roughly--that "shorting" 30 year treasuries provides "protection" against approximately $400,000 of losses from a change in interest rates in higher risk instruments. If, on the other hand, interest rates move DOWN, the INCREASE in the price of the junk bonds offsets the LOSS that occurs on the "short" position. Assuming a DECREASE in interest rates across the "spread" from treasuries to junk, of .5%, the situation would be:
Par: Treasury 100,000 Junk/for. 100,000 (x4) post DECREASE to 4.5%:
Treasury 115,395 Junk/for. 103,711 (x4)
The trading house with the "short position" in treasuries LOSES money (15,395) because it borrows, then sells, a par-value 100,000 treasury TODAY for $100,000 and has to pay $115,395 to buy the same instrument TOMORROW. But notice that $400,000 in junk bonds would move about the same way in the other direction. The trading house is "hedged" (protected) against "interest rate risk." This is "standard practice."
What is happening NOW:
The factor affecting bond values is NOT interest rate risk, but "liquidity risk" (whether someone can be induced to buy it, given perceived risk of repayment). Treasury bill interest rates are moving DOWN, so their prices are moving UP. Junk bonds, foreign debt instruments, etc., are moving to HIGHER interest rates and LOWER prices. So, if we define the "pre-crisis" situation as "par at $100,000"
par: treasury $100,000 Junk/for. $100,000 (x4)
we get (for example)
treasury $115,395 Junk/for. $96,436 (x4)
The hedged trading house has LOST money on its short treasury hedge and LOST money on the high risk assets the hedge was supposed to protect. Under "normal conditions" the loss of $15,000 (roughly) on the short position would be made up by an upward move of about $15,000 in the junk/foreign position. But now you are faced with a double whammy, a loss in the neighborhood of $30,000.
(This situation can be made far worse by margined trading e.g. futures contracts on fx or bonds, but that is not under immediate discussion here).
The trading house now has to RAISE money with assetst hat are DECREASED in value to cover its short position in Treasuries. It looks at the RISKIEST assets in its portfolio and SELLS THOSE FIRST. E.g., Asia/Russia, thence onward to Latin America. As a flood of bonds enters the markets, PRICES are driven down (and interest rates) are driven up. Foreign currency is similarly put under downward pressure.
Thus, in part, otherwise healthy economies are driven to pay sky high interest rates not through any fault or mismanagement of their own, but due to the bad hedging strategy of major international portfolio holders. If you are part of the (relatively small) commiunity of people familiar with what is going on, you will know that as interest rates are driven up and currency values down it is a good time to enter certain stock markets and short the stocks (see previous post). The fact that "you and yours" are liquidating is a good sign that money can be made by betting on the bad effects of that liquidation. This is especially true in relatively small stock markets (eg Asia, Latin America, etc.).
The above analysis excludes commissions and interest on the "short positions." Comment: Investors can change their assessment of "risk premium" on a financial security for a wide variety of reasons. Since even within a national economy "hysteria" can affect all classes of financial instruments, it is not at all certain that a Davidson-style pegged currency system would work. It would at best alleviate but not reduce one source of uncertainty in the system, but since the "currency peg" system would be "flexible" it is hard to see how it differs from gold style systems which also were "secure" but "flexible" in a crisis. The "crises" by their nature were determined by investors who had figured out the natural limits of "protection" afforded by the currency stability program(s) and were in a positin to make informed bets as to what would cause them to collapse.
-- Gregory P. Nowell Associate Professor Department of Political Science, Milne 100 State University of New York 135 Western Ave. Albany, New York 12222
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