Central Bank Credit Risk and a New Risk-Free Benchmark

NEW YORK ( TheStreet) -- The concept of risk-free rate (meaning that it's free of credit risk) is one of the most fundamental pillars of modern finance theory.

It is used to derive the pricing of all derivatives, even if that's done with shaky, oversimplified assumptions.

The risk-free rate had been assumed to be the relevant sovereign yields, in most cases those of the U.S., before the 2008 financial crisis. But the continuing crises have called into question the notion that major sovereigns are free of credit risk.

Furthermore, the central bank interventions of the past several years have destroyed the pricing framework. Central banks have not only distorted the market by coming in as significant, profit-insensitive players, but also by manipulating outright the shape of the yield curve (e.g., Operation Twist).

As another example, the Federal Reserve's QE3 has pushed 30-year agency bond yields below those of comparable Treasuries, as shown by T. Rowe Price.

Surely this has left derivatives quants, risk managers and traders cringing in pain around the world.

The impact of this central bank distortion is much greater and wider than the average investor realizes. It is on the same scale as the Libor scandal, but I suspect that it is underappreciated outside the financial world.

When the risk-free benchmark is in question, so are all derivatives prices, risk valuation and related hedging. You don't know how to judge prices, you don't know whether an arbitrage opportunity is actually a trap and you don't know how much risk you have taken on. Even if you are confident in your guesstimate, you don't know how to hedge it or whether the hedge will work as expected.

I suspect the "London Whale" episode is related to this risk distortion in many ways. The combination of rising sovereign credit risk and distortion of all principle reference curves has rendered quantitative finance irrelevant; it would not have existed today if not for the sheer lack of motivation to get rid of useless departments at major banks. It is as if we are back to the stock option days before Black-Scholes.

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 ( gramercy.com).

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.

Bitcoin is perfect, since the supply is rigidly defined by mathematics. Unfortunately we are still a long way from accepting bitcoins as a common reference. Until then, a new gold standard could be established as the common reference, the true credit-risk-free asset against which all currency credit risk is determined and the corresponding true credit-risk-free rate is calculated.

Gold generates no intrinsic return, as rightfully pointed out by gold antagonists; but herein lies its most important qualification as the common credit-risk-free benchmark. I doubt we will ever return to the old gold-standard. But the new gold standard could take root in this framework.

At the time of publication, Bo Peng was long gold.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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