# An asymmetric bet on interest rates

[ finance ]

In a classic scene of No Country For Old Men, Javier Bardem’s character ominously asks a shopkeeper: “what’s the most you ever lost on a coin toss?”. The shopkeeper says that he doesn’t know – this is probably quite a reasonable response given that for a fair coin, one has little reason to make a bet since your expected value (EV) is zero. Yet retail investors seem to make coin-toss bets all the time: they conclude that based on their analysis, a certain stock is a buy (i.e it has positive expected value). But they often forget to account for model risk – the risk that their analysis itself is faulty.

There is plenty of research to show that in actual fact, the buy/sell decisions of (retail) investors may as well be coin flips. Steve Cohen, the legendary hedge-fund manager, points out that his best portfolio managers get the direction of stock movement right only 56% of the time. However, the key to their success is the asymmetric payoff (technically speaking, the skew). Namely, when they are right, they ride the stock up to significant gains, but when they are wrong they are quick to cut losses. Let’s assume that whenever they are right, the stock goes up 30%, but if the stock is going down they will cut their losses at 5%. The EV is then calculated as follows:

Hence despite the “low accuracy”, the expected return on a single trade is an admirable 17%. We can use EV calculations to understand the profitability of all kinds of trading setups – some funds choose to make bets that have a less than 5% chance of being right, but will return 100x if they are. Other players, particularly market makers and option sellers, choose to make fractions of cents on every trade, but often have significant tail risk. In this post, I want to present an idea I had at the start of summer for an asymmetric bet on US interest rates.

## Outline of the pitch

It was July 2019: the height of the trade war, Brexit uncertainties alive as ever, people wondering if the decade-long bull market was going to come to an end (having forgotten about December 2018) – all eyes were on the Federal Reserve and it seemed that every day financial news sources had a different analysis of what would happen to interest rates. I was reading the Financial Times when a statement popped up that really excited me:

the market is pricing in an 100% probability of a rate cut of 25bps or more

This statement provides an interesting opportunity to make a positive EV bet because of the asymmetry it presents. I fundamentally do not believe that zero probability events exist, apart from in maths textbooks. For example, thanks to quantum theory, there is a nonzero probability that a tennis ball thrown at the wall will travel through it due to quantum tunnelling. Humans (and markets) are incredibly unpredictable, hence it made no sense to me that markets can be certain about anything.

My proposal was to make a hawkish bet (i.e betting that interest rates will either stay the same or go up). Because the market thinks that there is a 100% chance of a cut, if the rates are indeed cut, then I wouldn’t pay much for being wrong. However, on the off chance I’m right, my payoff could be huge.

In the rest of the post, we will discuss how to actually bet on interest rates, how the market-implied probability of a rate cut is calculated, and a post-mortem of my pitch.

## The Federal Reserve and interest rates

Banks in the US are legally required to keep some cash in the Federal Reserve. Amounts in excess of this minimum reserve can be lent as an unsecured loan to other market participants; the interest rate on these loans is the Federal funds rate.

These loans are negotiated by the borrowers and lenders (who are usually financial institutions). Why, then, do people always talk about the Fed hiking/cutting rates? The answer is that although the Federal Open Market Committee (FOMC) doesn’t set interest rates, it does set a “target rate”. This is more than just words, because the Fed can conduct open-market actions to help move the overnight rate towards its target – this typically consists of either buying or selling government bonds. For example, when the Fed buys government bonds, there is more money in the system so people will pay less to borrow money (i.e interest rates go down).

## Fed funds futures

A forward contract is an agreement between a buyer and a seller to transact in a particular quantity of some item, at a specified date and price in the future. For example, a soybean farmer might want to lock-in a sale price for their soy beans before the harvest and might thus agree to sell 5,000 bushels exactly 6 months from now (May 2020), at a price of 8.85 per bushel. Come May 2020, the farmer delivers the soybeans to the buyer and is paid $\$8.85 \times 5000 = \$44,250$.

## Conclusion

Unsurprisingly, the Fed decided to cut rates by 25bps, citing weak global growth and trade tensions. However, I don’t think this pitch was incorrect. The point is not that I thought rates would be held steady, but that I was willing to assign this outcome a higher probability than the market was.

I ended up pitching this idea, together with three other students, to a panel of managing directors at J.P. Morgan as part of an industry insight event. They were sceptical initially, but were quite intrigued once I had made it sufficiently clear that this was really a play on market expectations rather than interest rates directly. On a side note, I ended up receiving a summer internship offer at JPM for trading, so perhaps there was another dimension to this asymmetric bet…

If there’s anything you should take away from this post, it is this: I am certainly not claiming to know more than economists about what the Fed is going to do. What I am saying is that whenever the market is so sure that something is going to happen (or never going to happen!), there could be an opportunity for an asymmetric return distribution.