This Day On The Street
Continue to site right-arrow
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
Cramer's Action Alerts PLUS - See his portfolio and get alerts BEFORE every trade. Learn more NOW!

Central Bank Credit Risk and a New Risk-Free Benchmark

The market needs to abandon the dysfunctional old framework and find its footing with a valid credit-risk-free benchmark. The central bank factor needs to be factored out.

With existing interest rates and credit markets out of question, foreign exchange seems to be the only possibility. And here lies the clarifying thought: Inflation risk is currency credit risk, or more specifically, the central bank's credit risk.

Currency credit risk may be a new concept in finance theory, but it makes perfect sense. When a currency loses 50% of its value through inflation, that is a default, on the central bank's part, with a 50% present-value recovery.

In other words, in a normal inflationary environment that modern central banks consider healthy, central bank default by definition a certainty; the only question is recovery. It's a different type of default from the familiar, traditional ones: it's not a binary event, but rather a continuous process with varying recovery over time.

For example, assuming the Fed achieves its new inflation target of 3%, in 10 years a dollar is worth 74 cents today, or 74% recovery; in 30 years, it's a 41% recovery.

To put these numbers in perspective, the average U.S. corporate senior secured bond recovery (all ratings) from 1987-2008 is 64%, as shown by Moody's by way of (

In the old interest rate and credit markets, the difference between the nominal interest rate and the real one is the inflation. Since the meaning of "interest rate" has become ambiguous, we are forced to transform this into the realm of FX forward rate: The difference between the nominal FX forward rate and the real one is the relative inflation expectation between the two currencies in question.

The inflation expectation curve and the FX forward curve are both observable, at least for major currencies. Calculating the true credit-risk-free curve becomes a simple exercise in subtraction. The interest rate parity is not broken by this transformation. Instead, it's cast under a new, clearer interpretation: Currency credit risk can and should be quantified explicitly.

There is one problem remaining, however. FX rates are all relative; thus the credit-risk-free curves derived this way are also relative. An obvious choice for the common reference asset is gold, although it's not perfect since the supply is not exactly constant.

2 of 3

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Try it NOW
Only $9.95
Try it NOW
14-Days Free
Try it NOW

Check Out Our Best Services for Investors

Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Options Profits

Our options trading pros provide over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • Actionable options commentary and news
  • Real-time trading community
Try it NOW
Try it NOW
Try it NOW
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
GLD $115.33 -0.12%
AAPL $128.72 -0.49%
FB $80.18 0.73%
GOOG $573.87 0.04%
TSLA $199.56 0.00%


DOW 18,065.78 -137.59 -0.76%
S&P 500 2,095.95 -11.83 -0.56%
NASDAQ 4,962.92 -16.9810 -0.34%

Partners Compare Online Brokers

Free Reports

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs