Thursday, January 31, 2013

Reaching for Yield: A Simple Model

Miles Kimball poses an interesting question: How can we model "reaching for yield?" He poses this question in response to a claim by John Taylor that the Fed's zero interest-rate policy creates incentives for investors
"to take on questionable investments as they search for higher yields in an attempt to bolster their minuscule interest income." Kimball writes that
The often-repeated claim that low interest rates lead to speculation cries out for formal modeling. I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality.
"Modeled Behavior" blog has a complementary post today, also questioning how "reaching for yield" squares with economic theory. So here is my morning modeling exercise. It is a really simple, partial equilibrium model, but a model nonetheless. I'm not saying it's incredibly realistic, but I wanted to come up with the simplest model of "reaching for yield" I could think of. It has neither investor ignorance, nor irrationality, nor fraudulent schemes.




5 comments:

  1. In other words, insurance encourages people to take risks, aka moral hazard.

    I am a little bit confused. Suppose that the risk free rate was the same in both states. People will still be more likely to buy the risky asset in the bad state of the world, because insurance makes the risky asset look nicer when the bad state is more likely.

    Suppose that the probability of good and bad state is independent of the past, but that the risk free rate is lower in the bad state. Then won't people still be more likely to buy the risky asset when the risk free rate is low, just because the outside option (risk-free) is not as nice?

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  2. veryshuai, you are right, at least in this simple set-up the insurance scheme is critical to the decision to buy the risky asset in the bad state, not the Fed policy. So it looks like the low interest rate makes people "reach for yield," when really moral hazard makes them do so.

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  3. Ok, I thought that is what you were getting at. Thanks for the reply!

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  4. "I don’t see how such a model can work without some combination of investor ignorance and irrationality and fraudulent schemes preying on that ignorance and irrationality." Doesn't that pretty much describe the root causes of the GFC? It should be a standard caveat for pretty much any economic model, imho

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  5. Sorry for reviving this up. This is a very interesting post, I was just wondering if I can use this as a model if I am going to use my http://www.newreadyproperty.com/buy-a-property/ private property in Singapore

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Comments appreciated!