Economics and similar, for the sleep-deprived

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Update: Oh yeah!

Friday, September 20, 2002

Get yer money for nuthin' and your risks for free1

Friday afternoon thorts ... as I've mentioned before, absolutely central to finance theory is the concept of the "risk free rate of return". This makes an appearance in Classical economics as "the price of waiting", "the intertemporal rate of substitution", the "rate of time-preference", etc. It's an absolutely indispensable analytical tool for any economics which deals with the concepts of time and uncertainty (or to put it another way; it's hardly used in mainstream economic thought at all).

In so far as mainstream Neoclassical economics gets to grips with time at all, it deals with it by assuming that (since markets are efficient), the rate of time-preference, or the premium one is willing to pay to have "Bread Today" rather than "Bread Monday", is taken to be equal to the rate of return on a risk-free asset. After all, since markets are efficient, the rate of return on a risk-free asset has to be the price of something, and since it can't be the reward to risk-taking, it has to be the reward to pure waiting, right?

Well ... maybe. In actual fact, I have big philosophical problems with the concept of "pure waiting". It seems more or less incoherent to use the normal economic tool of ceteris paribus in this context. If you hold everything else the same except that you allow time to change, then you're saying that nothing changes, but time passes. But is time without change really a sound concept? How could we tell it had passed? But that's not what I'm on about right now.

For the time being, let's accept that "the reward to pure waiting is the rate of return on a risk free asset". What is a risk free asset? Name one. Sorry, MBA students, you just gave the answer "ten year government bonds", you are the weakest link, goodbye. As I've noted before, it's perfectly easy to lose your shirt trading ten year government bonds; they fluctuate quite a lot. They give you a more or less risk free return in nominal terms and over a ten year horizon, but those two provisos include a whole load of items which we don't want to count as part of the pure reward of waiting. Probably best to make a list first of potential investments which can't possibly be risk free:

  • Any investment in physical capital (return depends on the rate of profit, which is variable)
  • Any investment promising a fixed return in nominal terms (doesn't guarantee the level of consumption you can afford with the returns)
  • Any tangible item not directly consumable (what you can buy with it will depend on relative prices, which are variable) -- this includes gold and land.

The most promising candidate left would be index-linked government securities, which promise that, on some future date, you will be able to buy the basket of goods represented by the CPI index, in a quantity which grows at the yield on the index-linked security. But this brings us face to face with the problem indicated above; as a matter of empirical fact, you can get carried out trading TIPS. A ten year bond will let you postpone your consumption for ten years, but your money is locked up in the meantime, and all sorts of things might change over the next ten years. You could get a bit more clever and buy TIPS strips, effectively "locking in" today's entire forward curve of expected inflation, but you're still not really protecting yourself in this way; you're closer than anything else on this list to locking in a guaranteed stream of consumption goods, but that's not the same as postponing your consumption in a risk-free way. It doesn't get you round the fact that in carrying out any such financial transaction, you're exchanging certain consumption for claims on deliveries in the future, during which time anything could happen. Or to put it more bluntly, when I swap an apple today for an apple tomorrow, I'm always at least taking the risk that I might be run over by a bus this afternoon, in which case I'll never get to eat that apple. An asset can't be risk-free in the sense one would need for its return to be the "price of postponing consumption" if it's illiquid.

So what are we left with? Well, basically, that staple of the investment portfolios of millenarians and loonies, canned food. You can guarantee consumption at a future date by storing canned food (by the way, a quick tip to "child-free" whiners; this is the only way in which you can fund your retirement in a way which doesn't make your moaning about having to pay taxes for the education of "other people's children" utterly hypocritical), and you can open the cans and eat it any time you like. But what's the rated of return on canned food? Probably negative if you consider that the quality of what you end up eating is lower than if you'd spent the same cash on fresh food today.

So, I'm turning this one over to the collective wisdom of my readers. Do please feel free to post schemes for securing risk-free exchange of today's consumption for consumption at some future date, which deliver a positive implied rate of return, and I'll report back in a couple of weeks (on the other hand, as a sort of Dadaist joke on the theme of this comment, maybe I won't). The best I can do so far is buying an apple tree which is already bearing fruit, but I can't help thinking this is some sort of cheat .....

1As is apparently customary in what I refuse to refer to as the "blogosphere", I would like to point out that the titular phrase was conceived of entirely by me, in a single act of creativity with no input from any outside source ever. It is also copyright me for ever, as are its component words, which nobody can now use for any purpose at all.
1 comments this item posted by the management 9/20/2002 06:26:00 AM

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