The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Friday, July 27, 2007

Derivatives, Leverage, and the Case of the Vanishing Bond Market Vigilantes

A recent article in The Economist -- Vanishing vigilantes: Why the markets may be undermining central banks (July 19, 2007) -- points out that the so-called bond market "vigilantes" that used to punish central banks for being soft on inflation have gone awol. Bond yields have been low even for countries that have incurred large current account deficits.

One of the reasons offered by the article for this phenomena is that financial derivatives have allowed traders to take on greater leverage. This leverage has increased the prices of bonds (or assets linked to them) and that, conversely, means lower yields. This phenomena, along with the carry trade (where traders borrow in low-yielding currencies and invest in higher yielding ones), may have contributed to the case of the vanishing vigilantes.

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