## Thursday, August 03, 2006

### Flying blind

While futures and forwards are merely priced by arbitrage, options trading is fascinating in that it throws up new information in the form of the implied volatility, which is the market's view about future volatility. This is something which is not visible before we have options trading but is visible after options trading commences.

In addition to revealing what private agents believe, it is also an excellent free forecasting tool. By now, there is a rich literature which tells us that such market-based measures are forward looking, and are very good forecasters.

In several other situations, financial markets are shaping up as new sources of forward-looking information for the statistical system: this includes market-based measures of inflation expectations, market-based measures of the probability distribution of the decisions of the US Fed in the next two meetings, etc.

Traditionally, it is felt that the Indian license-permit raj in finance induces real costs by virtue of supressing information about the yield curve and the exchange rate. In an article in Business Standard today, I argue that our approach of financial repression induces costs which go beyond the lack of a trusted yield curve and the lack of a trusted exchange rate. The host of information sources which are based on derivatives markets are also lost when policy makers block the development of financial markets. These information sources play a marvellous role in the decision making of private agents and of public policy in mature market economies, but we don't have them in India.

I worry about the illusion of control that goes along with flying blind. In the present situation, we don't observe a market exchange rate or a market yield curve, we don't observe market-based estimates of future inflation and inflation volatility, we don't observe market-based estimates of future currency volatility, and so on. I think that in a developing country, where the economists and the econometric models are weak, the benefits from having market-based forecasts is even stronger than is the case in industrial countries. (Of course, this goes over and beyond the minor matter of not having a decent measure of inflation).

Update: Jayanth Varma has a nice post on the delicious exchange-traded binary option on the Fed Funds rate that's gaining momentum at CBOT.

Coincidentally, today's Business Standard also carried a debate between Bibek Debroy and myself on the subject of capital account convertibility.

1. Along with the information about future expectations that one can gauge from observing such measures (implied vols,yield on iflation indexed bonds etc.), I think there is also a crying need for a revamped and sophisticated statistical data collection system...The nature and breadth of the data releases in an economy like the US is simply fascinating..Retail sales, production numbers, wage releases, reasonably accurate employment numbers, spending on credit cards, home sales, rentals, etc etc..And the great thing is that such data releases are timely, accurate and regular. As a result, market participants have , over a period of time, constructed explanations of the impact of data releases and eagerly look forward to them..
In contrast, the Indian statistical system looks very crude and incomplete...Andy Mukherjee also had a piece on the "fudging" of export data from time to time(available at bllomberg.com), so there is also a question of credibility..I am not sure if the World Bank/IMF/Rating agencies judge the quality of such economic data released by countries, but the question mark over quality remains...
But even after thus, there is the problem of the huge unorganized sector of the economy that can never be captured in any data collection exercise..Some people estimate that the unorganized sector is as big as the organized one in terms of output of goods and services! Is there any sensible way to capture whats happening in this sector??

2. do you think the implied vols in the indian equity market forecasts the future volatility

3. Does the Nifty option implied vol make much sense? I don't know. There isn't yet a paper on it (to the best of my knowledge).

One big problem is that NSE does not release the intra-day time-series of timestamped market-by-price (the top 5/10 prices and associated quantities). This makes it difficult to get time-aligned midpoint quotes on the spot and on the derivatives, using which accurate calculations can be made. The first paper on this page talks a bit about measurement problems. As of yet, the data resources required to solve these measurement problems aren't in place.

Please note: Comments are moderated. Only civilised conversation is permitted on this blog. Criticism is perfectly okay; uncivilised language is not. We delete any comment which is spam, has personal attacks against anyone, or uses foul language. We delete any comment which does not contribute to the intellectual discussion about the blog article in question.

LaTeX mathematics works. This means that if you want to say $10 you have to say \$10.