Thursday, September 20, 2012

QEEternity, The Bernanke Put

A contract guaranteeing an investor's right to sell a specified number of shares of a security at a set price (the strike price) by a set-date, thus binding another party to purchasing the security at the set price, is called a put option. Buying puts will protect an investor's position in the case of an unexpected decline in its share price. I.e., putting a floor under the price. Of course there ain't no free lunch. The buyer of the put must pay the would-be buyer of the stock a fee (called a premium) for his willingness to pay more than the stock is worth should the put-holder exercise his option (will do only if the stock falls below the strike price). And the closer the exercise price is to the actual price of the stock, the higher the premium.

In case you're wondering, that's essentially what they mean by "The Bernanke Put". Consensus has it that the Fed's willingness to print whatever amount of money for however long it takes to get this economy moving could bolster the stock market for Lord only knows how long - perhaps explaining the market's recent buoyancy. However, like a true put option, there's a cost. In the case of QE3Eternity, the obvious cost would be the pricing impact of ever-increasing the supply of money.

In my granola bar example, if you and 5 other desert-island-castaways bargain for the last granola bar in your possession, it's worth whatever amount of money your hungry friends have on them. If there's a dollar amongst them, assuming you're of a mind to sell, it's worth a dollar. If there's ten, it's worth ten. I.e., the supply of money growing faster than the production of goods = inflation.

The not-so-obvious cost would be the moral hazard of perpetually low borrowing rates. Here I'm thinking government borrowing. As you may have gathered from my recent rants, I find "politician" and "moral-hazard" to be synonymous. Washington can borrow money on the cheap, which could be huge in terms of reducing the deficit and the debt. However, alas, like the 2006 homeowner (now renter) who refinanced his mortgage and found himself with left-over cash flow and a home equity line of credit, our utterly-fearless leaders seem to have other things in mind.

Stay tuned...

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