The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
jSpnpmic
/Review
March/April 1995
Volume 80, Number 2
Federal Reserve
Bank of Atlanta
i),mut[p
AUG
FRB RESEARCH LIBRARY
In This Issue:
Private Sector Responses to the Panic of 1907:
A Comparison of New York and Chicago
£/sing Eurodollar Futures Options:
Gauging the Market's View of
Interest Rate Movements
FYI—Examining Small Business Lending in
Bank Antitrust Analysis
¿895
bonomie
Review
March/April 1995, Volume 80, Number 2
j ^ e p n p m i c
j^éview
of Atlanta
President
Robert P. Forreslal
S e n i o r Vice President a n d
Director of R e s e a r c h
Sheila L. T s c h i n k e l
Research Department
B. Frank King, Vice President and Associate Director of Research
William Curt Hunter, Vice President, Basic Research and Financial
Mary Susan Rosenbaum, Vice President, Macropolicy
Thomas J. Cunningham, Research Officer, Regional
Eric M. Leeper, Research Officer, Macropolicy
William Roberds, Research Officer, Macropolicy
Larry D. Wall, Research Officer, Financial
Public A f f a i r s
Bobbie H. McCrackin, Vice President
Joycelyn Trigg Woolfolk, Editor
Lynn H. Foley, Managing Editor
Carole L. Starkey, Graphics
Ellen Arth, Circulation
The Economic Review of the Federal Reserve Bank of Atlanta presents analysis of economic
and financial topics relevant to Federal Reserve policy. In a format accessible to the nonspecialist, the publication reflects the work of the Research Department. It is edited, designed, produced, and distributed through the Public Affairs Department.
Views expressed in the Economic Review are not necessarily those of this Bank or of the Federal Reserve System.
Material may be reprinted or abstracted if the Review and author are credited. Please provide the
Bank's Public Affairs Department with a copy of any publication containing reprinted material.
Free subscriptions and limited additional copies are available from the Public Affairs Department, Federal Reserve Bank of Atlanta, 104 Marietta Street, N.W., Atlanta, Georgia 30303-2713
(404/521-8020). Change-of-address notices and subscription cancellations should be sent directly to the Public Affairs Department. Please include the current mailing label as well as any new
information. ISSN 0732-1813
(Contents
Federal Reserve Bank of Atlanta Economic Review
March/April 1995, Volume 80, Number 2
Private Sector Responses
to the Panic of 1907:
A Comparison of New York
and Chicago
Ellis W. Tallman a n d
J o n R. Moen
J () t / s i n g Eurodollar Futures
Options: Gauging the
Market's View of Interest
Rate Movements
Peter A. A b k e n
The trend toward greater provision of payments services by
nonbank providers raises a question for regulators: What if these
nonbank institutions suffer unfavorable balances or experience a
run? The authors of this article look to the Panic of 1907 as an
example of how private market participants, in the absence of
government institutions, react to a crisis in their industry. They
suggest that New York's and Chicago's contrasting experiences
during the panic may provide useful lessons for both regulators
and market participants.
The article compares responses to the panic by bank intermediaries in the two cities through clearinghouses. The apparent isolation
of trusts from the New York Clearinghouse left the clearinghouse
with inadequate knowledge of their condition and hindered prompt
action. In Chicago, the clearinghouse had timely information on
most intermediaries in the city, including the trusts, and therefore
was positioned to react quickly.
The distinct nature of the Panic of 1907 and the differences between private market regulation through clearinghouses and the
current framework of public regulation limit recommendations for
today's financial world. Nonetheless, the historical experience
provides a precedent for the development and growth of payments
services offered by nonbank providers, which should not be ignored as key players in the payments system. The key lesson from
history is that such ignorance can be expensive.
Investors and analysts frequently use financial market prices in
their attempts to divine market expectations—a difficult exercise because of the myriad influences on financial market prices. This article focuses on shifts in market outlook regarding the direction of
interest rate movements since 1988 as well as market reaction to
specific events influencing interest rate changes in the short run—
namely, Federal Reserve monetary policy and its periodic Federal
Open Market Committee meetings.
The discussion examines the Eurodollar futures options traded at
the Chicago Mercantile Exchange and explains how to infer the implied skewness of interest rates—a measure that gauges the direction
and magnitude of their movements—from these options. In particular, this article shows how the skewness of the distribution of a
short-term interest rate, LIBOR, can be inferred from market prices.
The basic conclusion of this article is that a marked shift in market outlook on interest rate movements occurred in late 1992. The
analysis finds that during 1993 and 1994, skewness was manifest
by a premium in the prices of Eurodollar futures puts, which offer
protection against rising interest rates, compared with those of Eurodollar futures calls. The findings also indicate, though, that the Eurodollar futures options prices are too "noisy" to detect changes
in the markets' view of future short-term interest rate movements
following FOMC meetings.
FYI—Examining
Small
Business Lending in Bank
Antitrust Analysis
W. Scott Frame
The U.S. banking industry has entered an unprecedented period
of consolidation and reorganization. This bank merger wave has
sparked public policy debate about the desirability of such combinations, particularly in regard to evaluating antitrust considerations.
More than thirty years ago, legal precedent established the relevant antitrust product market for banking as the "cluster of banking
products and services." Many are questioning whether a move away
from this aggregate approach toward a more traditional productbased antitrust analysis would better reflect today's market realities,
in which the presence of numerous nonbank competitors competing
over wider geographic areas often reduces concentration concerns. At
the same time, the market for small business loans has particularly interested both bank regulators and the Justice Department because of
the lack of nonbank competitors and the local nature of these loans.
The author of this article provides an overview of recent developments in banking antitrust analysis, particularly in the area of small
business lending. In discussing the potential costs and benefits to disaggregating the product market for purposes of antitrust analysis, he
concludes that while doing so is theoretically appealing, disaggregating the product market for banking (and examining small business
lending) suffers from several measurement problems resulting from a
lack of reliable data.
J^-ivate Sector Responses
to the Panic of 1907:
A Comparison of
New York and Chicago
r
Tollman is an economist in
the macropolicy section of the
Atlanta Fed's research department. Moen is an assistant
professor in the department of
economics and finance at the
University of Mississippi.
Moen thanks the University
of Mississippi , Office of Research, for a summer research
grant supporting this project.
The reference department staff
of the Joseph
Regenstein
Library at the University of
Chicago provided
valuable
help in locating
information
on Chicago trust companies.
Federal
Reserve Bank of Atlanta
Ellis W. Tallman and Jon R. Moen
he recently proposed (and aborted) merger between software giant Microsoft and Intuit, the producer of the leading personal
financial s o f t w a r e for personal c o m p u t e r s , d e m o n s t r a t e d the
potential for growth among nonbank providers of payment services. In this case, neither of the parties is in the payments system, of course, but the recent growth in payments services provided through
nonbank entities and the tremendous potential for the use of technologies
like the Internet for such services points toward greater participation in the
payments system by nonbank providers of payment services. For regulators,
this trend raises questions: What if nonbank providers of such services suffer unfavorable balances or experience a run? How should they be treated?
N e w York's and Chicago's contrasting experiences during the Panic of 1907
may provide useful lessons concerning this issue for both regulators and
market participants.
During the National Banking Era (1863-1914), several episodes of recurrent financial crises plagued the United States well after most other developed banking systems had eliminated them. By this time m o s t European
countries had central banks that could provide reserves during a crisis, but in
the United States bankers and depositors still had to rely mainly on the private sector to meet unusual demands for cash. Without a central bank to
function as a lender of last resort, the U.S. banking system during panics
turned to private market organizations known as clearinghouses to protect the
system from a total shutdown. 1
The Panic of 1907, the last and most severe of the National Banking Era
panics in the United States, provides an example of h o w private market participants, in the absence of government institutions, react to a crisis in their
Economic Review 9
industry. In previous research, the authors highlighted
h o w the Panic of 1907 centered on N e w York City
trust companies (Ellis W. Tallman and Jon R. Moen
1990; Moen and Tallman 1992). These trusts, a kind
of intermediary not designed as a bank but performing
bank services, saw dramatic growth in deposits at the
turn of the century mainly as an avenue for circumventing legislative restrictions on national banks.
This article compares private market responses to
the Panic of 1907 by bank intermediaries in N e w York
and C h i c a g o through the institution of the clearinghouse. The different responses to the panic center on
the relationship between national banks and trust companies and the relationship between the private cleari n g h o u s e s and trust c o m p a n i e s . T h e fact that N e w
York trust companies were not m e m b e r s of the N e w
York Clearinghouse, whereas the larger Chicago trusts
were members of the Chicago Clearinghouse, greatly
influenced h o w the private sector in each city was able
to cope with the panic. In Chicago, the clearinghouse
had timely information on the condition of most intermediaries in the city, including the trusts, and therefore was able to react quickly to any potential threats
to the payments mechanism. The circumstance in N e w
York was notably different. The apparent isolation of
trusts from the N e w York Clearinghouse left the clearinghouse with inadequate knowledge of their condition
and hindered prompt action when panic withdrawals
first struck those intermediaries. 2
The lesson this historical instance offers is that it is
unwise to ignore the implications of modern-day financial distress at n o n b a n k i n t e r m e d i a r i e s o f f e r i n g
payments services. Although the distinct nature of the
Panic of 1907 and the d i f f e r e n c e s b e t w e e n private
market regulation of clearinghouses and the current
framework of public regulation limit any further inference about recommended responses in today's financial world, there is a clue in examining the historical
episode for the questions it raises and for the debate
and research it m a y generate about the potential responses of public authorities to impending changes in
the financial system.
Structures and Institutions in
New York and Chicago
T h e Rise of Trusts. The system of unit banking
and the stratification of national banks produced several financial centers in the United States, with N e w
York and C h i c a g o being the m o s t important. 3 Even
2
Economic
Review
though national banks in both cities had been operating as central reserve banks under the guidelines set
down by the National Banking Acts (1863, 1864), and
their financial intermediaries operated under similar
legal constraints and regulations, the panic unfolded
quite differently in each city. 4 In N e w York dramatic
runs hit the trust companies, forcing several to close.
In Chicago suspension of convertibility of deposits into cash was not as extensive as in New York, and the
c o n t r a c t i o n in d e p o s i t s was m u c h less s e v e r e . N o
trusts were forced to suspend in Chicago. In N e w York
J.P. Morgan was central in directing the actions of the
commercial bankers and a rather reluctant clearinghouse association. The Chicago clearinghouse and its
m e m b e r banks appear to have been key in coordinating the response to the panic.
A s it does today, N e w York City obviously played a
more central role in the United States financial system
than Chicago did. In 1907 the total assets of all New
York City national banks were m o r e than five times
the size of all Chicago national bank assets—$1.8 billion versus $340 million (Moen and Tallman 1992,
612; F. Cyril James 1938, 688). Nevertheless, similarities between the two financial markets justify a comp a r i s o n . F o r e x a m p l e , the l a r g e s t b a n k s and trust
companies in Chicago had a volume of assets comparable to that of the largest N e w York banks and trusts. 5
Both cities also saw the rapid rise of a relatively unregulated intermediary, the trust company, around the
turn of the century (George E. Barnett 1907, 234-35;
Moen and Tallman 1992, 612). In Chicago the pace of
growth equaled that in N e w York (James 1938, 690;
Moen and Tallman 1994, 20). Notably, between 1896
and 1906 trust company assets and liabilities in both
cities g r e w m o r e quickly than did those at national
banks. The result was that by 1907 the trusts in each
city controlled a volume of assets comparable to the
national banks.
T h e N a t i o n a l B a n k i n g A c t s of 1863 a n d 1864,
which limited the investment activities of federally
chartered banks, had set substantial reserve requirements in response to the perceived instability of banks
in the earlier free-banking era. State regulatory agencies, on the other hand, generally placed f e w e r constraints on trust c o m p a n i e s , with laws in N e w York
and Illinois d i f f e r i n g little. 6 U n l i k e national b a n k s ,
trusts could invest in real estate, underwrite stock market issues, m a k e loans against stock market collateral,
and o w n stock equity directly in addition to taking in
deposits and clearing checks. Trusts in Chicago also
provided unsecured lines of commercial credit (James
1938, 702). National banks could make loans against
March/April 1995
stock market collateral (call loans), but the National
Bank Acts prohibited the other activities, restricting
b a n k s to m a k i n g c o m m e r c i a l l o a n s , i s s u i n g b a n k
notes, and taking in deposits. The trusts thus offered a
way around these restrictions.
Initially trust c o m p a n i e s had been established to
hold accounts in trust for private estates, and they tended to be small, conservative institutions. Even though
they had been given substantial leeway to invest their
assets, trusts took advantage of their unregulated status
relatively late in the National Banking Era. By 1907,
however, trust companies in both N e w York and Chicago were fully exploiting their investment capabilities.
ship to their respective clearinghouses. In N e w York in
1907 national banks were m e m b e r s of the clearinghouse. Because trusts were not, they had limited access
to the clearinghouse. To avail themselves of clearinghouse s e r v i c e s — f o r e x a m p l e , to clear checks—trust
companies had to go through a bank that was a m e m ber of the clearinghouse. Not only was access to the
clearinghouse indirect but it was uncertain. To secure
these services, trusts left significant deposits at banks
as clearing balances. These balances, as well as some
bankers' balances held at trusts for banks, f o r m e d a
tight connection between banks and trusts even though
trusts were not clearinghouse members.
National banks in these cities sometimes operated
trust d e p a r t m e n t s or o w n e d c o n t r o l l i n g interests in
trust companies. Bankers sat on the boards of directors
of trust companies, and in Chicago one of the larger
trust c o m p a n i e s was o w n e d directly by a n a t i o n a l
bank. 7 N e v e r t h e l e s s , the largest trust c o m p a n i e s in
N e w York and Chicago were generally independent of
the national banks. T h e s e large trust c o m p a n i e s inc l u d e d the K n i c k e r b o c k e r Trust C o m p a n y and the
Trust C o m p a n y of America in N e w York and the Merchants Loan and Trust C o m p a n y and the Illinois Trust
and Savings Bank in Chicago.
Unlike in C h i c a g o , n a t i o n a l b a n k s in N e w York
viewed trusts as serious competitors. The two became
C l e a r i n g h o u s e s . T h e a b s e n c e of a central bank
made the rise of the private clearinghouse especially
dramatic in the United States, and its f u n c t i o n s expanded substantially during the National Banking Era
(Kevin D o w d 1994; Gary Gorton and D o n a l d Mullineaux 1987; Richard Timberlake 1984). Near the end
of the period the clearinghouses had taken on many of
the tasks usually associated with a central bank: holding reserves, e x a m i n i n g m e m b e r banks, and issuing
e m e r g e n c y currency. Actions by the clearinghouses
became central in containing panics.
to a crisis in their industry.
In both Chicago and N e w York the clearinghouse
c o u l d e x a m i n e the b o o k s of m e m b e r institutions if
there was reason to believe a m e m b e r was facing insolvency. The Chicago Clearinghouse helped formalize the examination powers of clearinghouses w h e n it
established an office of independent examiner in 1905,
a s s i g n i n g p o w e r to e x a m i n e in detail the b o o k s of
m e m b e r institutions at the request of the clearinghouse
committee. Many cities followed suit, including N e w
York (James 1938; Fritz Redlich 1968; Gorton 1985).
The N e w York Clearinghouse likewise required members regularly to submit balance sheets m a d e publicly
available through the clearinghouse or the state banking regulator.
New York. The most important difference between
the trusts in Chicago and N e w York was their relation-
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
The Panic of 1907 provides an example
of how private market participants, in the
absence of government institutions, react
intense rivals over time, with the banks believing they
h a d a "trust c o m p a n y p r o b l e m " ( C . A . E . G o o d h a r t
1969, 18-19; Redlich 1968, 2, 178). S o m e have even
s p e c u l a t e d that the N e w York b a n k s instigated the
panic in 1907 to bring down the trusts, although H.L.
Satterlee, J.P. M o r g a n ' s son-in-law, argued that no
bank would cause a run on another institution out of
fear that it might bring itself down (Tallman and M o e n
1990, 7). Evidence to date does not suggest a similar
adversarial relationship in Chicago.
Trust companies in N e w York had not always been
isolated from the clearinghouse. Many trusts had been
full m e m b e r s of the N e w York Clearinghouse up to
1903, but N e w York national banks complained that
the trusts' ability to engage in commercial bank activities without holding the large specie reserves of central reserve city national banks was unfair. In response,
the N e w York Clearinghouse passed a rule requiring
m e m b e r trusts after June 1, 1904, to maintain a cash reserve—between 10 and 15 percent of deposits—with
the clearinghouse. Until that time trusts had normally
Economic Review
3
held only 5 percent cash reserves. In response to the
rule trust companies quickly terminated their memberships and w i t h d r e w c o m p l e t e l y f r o m the c l e a r i n g house. 8 N e w York trusts o n o c c a s i o n discussed the
possibility of forming their o w n clearinghouse, but the
project never got beyond the discussion stage.
Chicago.
In s h a r p c o n t r a s t , the l a r g e r t r u s t s in
Chicago were full members of the clearinghouse, and
the larger trust c o m p a n i e s as well as national banks
cleared checks for the smaller banks and trusts. 9 Unlike
their c o u n t e r p a r t s in N e w York, trust c o m p a n i e s in
Chicago were not isolated f r o m the clearinghouse. The
Chicago Clearinghouse contemplated imposing on
m e m b e r trusts a reserve requirement similar to that in
New York, but such a rule was never adopted (James
1938, 729).
The composition of the Chicago Clearinghouse Committee, six men who served as the executives of the
clearinghouse, shows the close link between banks and
trusts. In 1907, three of the six were the presidents of
large national banks, and the other three were the presidents of the three largest trust companies in Chicago. 1 0
b a n k i n g Panics
P a n i c s — n a m e l y , b a n k i n g p a n i c s — a r e either foreign concepts to those unaware of their existence or a
distant memory to those who lived through t h e m . " A
bank panic can be described as a widespread desire on
the part of depositors in all banks to convert bank liabilities—their deposits—into currency. A panic entails
removal of bank deposits f r o m the depository system,
thus threatening the intermediation process. In contrast
to bank runs, bank panics are basically systemic problems. Related but distinctive are bank runs, which occ u r w h e n d e p o s i t o r s a t t e m p t t o l i q u i d a t e all t h e i r
deposits at a particular institution. Because the funds
may be redeposited at another bank, a bank run does
not necessarily imply the removal of f u n d s f r o m the
banking system. A n u m b e r of banks in a region can be
affected simultaneously, but the run still does not ext e n d to the e n t i r e b a n k i n g s y s t e m . P a n i c s c a n be
viewed as systemic bank runs.
Bank panics were dangerous especially to the national banking system. During this era, as throughout
most of its history, the U.S. banking system has operated on a fractional reserve basis, which is designed so
that the cash reserves of banks are only a fraction of
their outstanding liabilities. In addition, a high proportion of bank liabilities are demand deposits—that is,
4
Economic Review
deposits a bank is obligated to pay in cash on demand
to depositors. The exchange of deposits for currency at
banks may appear initially as equal reductions to both
cash holdings and deposits. However, banks keep cash
reserves at a reasonable percentage of outstanding liabilities. Thus, when a large amount of deposits is converted to cash, banks m a y be forced to liquidate some
of their interest-bearing assets to increase their cash
reserves. Under the National Banking System, without
a central bank, the fractional reserve system could not
satisfy a large-scale conversion of bank deposits into
currency.
Bank panics during the National Banking Era displayed similar characteristics. In general, according to
Philip Cagan (1965), bank panics followed business
cycle peaks. Often, panics occurred in either spring or
fall; this phenomenon can be partly explained by noting that, without a central bank, the seasonal movem e n t of f u n d s b e t w e e n the M i d w e s t and f i n a n c i a l
centers in the East put strains on bank reserve positions. T h e failure of a large business or financial institution usually preceded a panic. The length of panics
varied; the most intense part of a panic typically took
place in the span of a f e w weeks, and the remnants
usually subsided within a f e w months.
In addition, the stock market would frequently suffer substantial losses in the aggregate, before and during the panic. T h e s e could signal to depositors that
bank assets might be riskier, especially given the proportion of loans backed by stock m a r k e t collateral.
T h e s e l o a n s , k n o w n as call l o a n s , w e r e in n o r m a l
times liquid and d e m a n d a b l e loans. D u r i n g panics,
call loans were often viewed as highly risky because
the collateral backing them might have fallen to less
than the n o m i n a l v a l u e of the loan. In the Panic of
1907, the precipitous decline in the stock market cont r i b u t e d g r e a t l y to the p e r c e p t i o n that b a n k assets
were questionable.
Panics during the National Banking Era were also
c h a r a c t e r i z e d by c e r t a i n m e c h a n i s m s that p r i v a t e
bankers employed to survive the crises. Local clearingh o u s e s p r o v i d e d the m e d i u m t h r o u g h w h i c h t h e s e
m e c h a n i s m s were instituted. J a m e s G. C a n n o n has
described this fuller role of clearinghouses: " A Clearinghouse, t h e r e f o r e , m a y be d e f i n e d as a device to
simplify and facilitate the daily e x c h a n g e s of items
and s e t t l e m e n t s of b a l a n c e s a m o n g the [ m e m b e r ]
banks and a m e d i u m for united action upon all questions affecting their mutual welfare" (1910, 1).
T h e t w o primary methods for responding to bank
p a n i c s d u r i n g the N a t i o n a l B a n k i n g E r a w e r e (1)
clearinghouse loan certificates and (2) the restriction
March/ April 1995
or suspension of bank deposits' convertibility into currency. C l e a r i n g h o u s e loan c e r t i f i c a t e s , w h i c h w e r e
loans extended for the purpose of f o r m i n g reserves,
were written for clearinghouse association m e m b e r s
and were a c c e p t a b l e f o r settling c l e a r i n g h o u s e accounts. Thus, the clearinghouse and its loan certificates
offered the banking system an artificial mechanism to
e x p a n d the supply of available reserves in order to
prevent loan contraction.
W h e n restricting the convertibility of deposits into
currency, banks limited the amount of cash available
or r e f u s e d to pay cash in e x c h a n g e f o r deposits as
they w e r e legally b o u n d to do. T h i s p r o c e d u r e red u c e d the o u t f l o w of bank reserves by slowing the
l i q u i d a t i o n of d e p o s i t s . Both m e c h a n i s m s a l l o w e d
b a n k s to continue other operations such as m a k i n g
loans and clearing deposits, with restrictions applying
only to conversions of deposits into currency. Transa c t i o n s within the b a n k i n g s y s t e m w e r e s u p p o r t e d
through book entries of debits and credits to m e m b e r
institutions.
Similar Threats, Different Responses
The Panic of 1907 posed similar threats to money
markets in both Chicago and N e w York, and intermediaries' protective responses were in some ways similar. B o t h cities s a w t h e i s s u a n c e of c l e a r i n g h o u s e
certificates and the convertibility of deposits suspended to varying degrees. C h i c a g o banks, like those in
N e w York, i m p o r t e d gold directly f r o m L o n d o n to
m a i n t a i n r e s e r v e s ( J a m e s 1938, 7 6 4 - 6 5 ; O . M . W .
Sprague 1911, 297). Yet the outcomes were different.
In N e w York City, the panic hit trust c o m p a n i e s
hard. Their deposits contracted substantially, whereas
at the national banks they increased; the most significant runs occurred at the trusts ( M o e n and Tallman
1992). A number of N e w York banks and trusts failed.
In contrast, in Chicago the movements in deposits
at the trust c o m p a n i e s — a n d the national banks, for
that matter—were much less severe. N o obvious diff e r e n c e e m e r g e s b e t w e e n d e p o s i t o r s ' t r e a t m e n t of
trusts and national banks in Chicago: demand deposits
fell 6 percent at trusts and 7 percent at national banks
during the panic (Moen and Tallman 1994). N o banks
or trusts failed (F. Murray Huston 1926, 360).
Clearinghouse actions are key in explaining these
d i f f e r e n t o u t c o m e s . T h e p a n i c in N e w Y o r k w a s
sparked by F. Augustus Heinze's attempt to corner the
stock of United Copper Company. 1 2 The collapse of the
Federal
Reserve Bank of Atlanta
corner on October 16, 1907, revealed an intricate series
of connections linking Heinze to the banking system.
Depositors at the banks associated with Heinze and his
associates began a series of runs after the collapse, the
first being on M e r c a n t i l e National B a n k . T h e N e w
York Clearinghouse Association examined the bank's
assets, found it solvent, and announced that it would
support the bank if Heinze would relinquish control of
it. Depositors also ran several other Heinze banks, but
the c l e a r i n g h o u s e p r o m i s e of support quelled these
runs as well. By October 21 the Heinze banks had been
reorganized and reopened with new management with
the help of the clearinghouse.
On October 21 the panic in N e w York began in full
force, however. The National Bank of C o m m e r c e announced that day that it would no longer clear checks
for the Knickerbocker Trust Company, alarming the
trust's depositors. 1 3 In the evening after the news bec a m e public, J.P. Morgan, who had been organizing
relief efforts during the runs on the Heinze banks, organized a committee of five trust company executives
to discuss ways to halt the incipient panic at the trust
c o m p a n i e s . In the m e a n t i m e , B e n j a m i n S t r o n g h a d
been attempting to evaluate the financial condition of
the Knickerbocker Trust but reported to Morgan that he
had been unable to do so before it was to open the next
day. With this n e w s Morgan decided not to c o m m i t
funds to aid the trust; other institutions followed suit.
Because the clearinghouse did not regularly monitor
N e w York City trusts, it could not make decisive actions without tedious and protracted examination of
trust books first, and the national banks were unable
to grant the Knickerbocker Trust aid quickly. On the
morning of October 22 a massive run engulfed Knickerbocker, forcing it to close at noon after having paid
out over $ 6 million in cash. Runs picked up the next
day at several other large trust companies.
To c o m b a t the p a n i c at the trust c o m p a n i e s , the
c o m m i t t e e of trust c o m p a n y presidents J.P. Morgan
had organized a t t e m p t s to collect f u n d s f r o m other
trust c o m p a n i e s to stem the panic. W h e n f e w trusts
were willing to cooperate, the c o m m i t t e e turned to
Morgan. He asked several presidents of the large national banks in N e w York to assist him. Over the next
f e w days Morgan convinced other financiers to contribute to a " m o n e y pool" to aid the trust companies.
James (1938, 755-56) described the N e w York bankers' reluctance to unite to face the threat to the paym e n t s system, and he refers to the m o n e y p o o l s as
attempts at "piecemeal salvage."
The N e w York Clearinghouse issued clearinghouse
c e r t i f i c a t e s to i n c r e a s e liquidity a m o n g N e w York
Economic Review
5
national banks. Use of certificates instead of cash to
settle clearing balances between banks released cash
to be paid to depositors. Criticizing the clearinghouse
for delaying the use of loan certificates until the panic
was well under way, Sprague (1911, 257-58) argued
that earlier release of certificates would have calmed
financial markets, avoiding the cumbersome, ad hoc
money pools and sending aid directly to the troubled
banks and trusts.
In reality, however, because the trusts were outside
of the N e w York Clearinghouse, resorting to certificates earlier m a y have done little to stem the panic at
the trusts. Although the use of certificates certainly
freed up cash for the national banks to pay out to their
depositors, it is not clear h o w it would have reached
There is historical precedent for the development and growth of payments services
offered by nonbank providers, which can
become key players in the payments system
and should not be ignored.
the trust companies. The use of clearinghouse certificates may have signaled to depositors that the clearinghouse was willing to protect banks. For trusts, no
such signal could be inferred. 1 4
In Chicago the private sector response to the panic
unfolded differently. Most of it appears to have been
contained within the purview of the Chicago Clearinghouse Association, with no particular class of int e r m e d i a r y isolated f r o m the e f f o r t s to control the
panic. While there were unusually high demands for
cash by Chicago depositors during the panic, outright
runs like those on the N e w York trust companies did
not occur. In contrast to N e w York, where a lack of
"united action on the part of all N e w York bankers to
meet the situation" helped fuel the panic, bankers in
Chicago began shipping cash to correspondents. 1 "' As
the drain on reserves heightened, Chicago bankers began to worry.
U p o n learning that the N e w York C l e a r i n g h o u s e
was planning to issue clearinghouse loan certificates,
the Chicago Clearinghouse Committee convened and
6
Economic
Review
decided to issue loan certificates as well. Partial suspension of currency payments was imposed, with no
payments going to correspondent banks in the South
or the West. James (1938) criticized this action on the
grounds that the use of loan certificates was meant to
release cash to pay to depositors, and banks were using the c e r t i f i c a t e s to settle b a l a n c e s a m o n g t h e m selves. Sprague (1911) was similarly critical of N e w
York banks. James Forgan, president of the First National Bank of Chicago, decided after a f e w days that
suspension of currency payments combined with the
issuance of loan certificates was an ill-formed policy,
and the First National B a n k began to r e s u m e some
cash payments to correspondents. Reserves at Chicago
national banks fell rapidly to less than 18 percent, well
below the legal m i n i m u m reserve requirement of 25
percent. Reserves at N e w York national banks rarely
went below 25 percent. Nevertheless, cash payments
by Chicago banks did not restore confidence to depositors and correspondents.
The Chicago Clearinghouse eventually authorized
issuing some form of emergency currency, an action
that went far in relieving Chicago depositors' anxiety.
James indicates that the clearinghouse began issuing
c l e a r i n g h o u s e c h e c k s on N o v e m b e r 6, partly in response to a petition presented by 500 leading citizens
of Chicago. 1 6 This step apparently calmed the Chicago
m o n e y m a r k e t sufficiently, allowing the task of removing restrictions on payments to begin.
Several d i f f e r e n c e s b e t w e e n the C h i c a g o m o n e y
m a r k e t a n d N e w Y o r k ' s are w o r t h n o t i n g . J a m e s
( 1 9 3 8 , 7 5 7 ) argued that the institution of a f o r m a l
bank e x a m i n e r had a l l o w e d the C h i c a g o C l e a r i n g house to identify potential weak spots in the banking
system and therefore placed it in a sounder position
than the clearinghouse in N e w York in the early stages
of the panic in 1907. It was significant that no particular class of intermediary had been excluded from systematic examination in Chicago.
The C h i c a g o Clearinghouse also appears to have
been less hesitant to issue clearinghouse loan certificates to m e m b e r banks and trusts than the N e w York
C l e a r i n g h o u s e h a d b e e n . In c r i t i c i s m s i m i l a r t o
S p r a g u e ' s of the N e w York C l e a r i n g h o u s e , J a m e s
(1938, 761-62) faulted the Chicago Clearinghouse for
not issuing clearinghouse loan certificates as emergency currency with the general public soon enough. In
c o m p a r i s o n with the s y s t e m a t i c exclusion of trusts
f r o m the c l e a r i n g h o u s e in N e w York, h o w e v e r , the
speed with which the two clearinghouses resorted to
certificates may not have been as important a factor in
resolution of the panic.
March/ April 1995
T h e Chicago Clearinghouse had learned the value
of a united effort to protect the payments system several years earlier (James 1938, 714-19). In D e c e m b e r
1905, the Illinois State Auditor threatened closing a
chain of banks owned by John Walsh. Many bankers
at the time felt that outright failure of the banks would
teach a lesson to others about unsound banking. Wanting to avoid harmful effects on the larger banking system, however, James Forgan persuaded reluctant
m e m b e r s of the Clearinghouse to stand together and
guarantee payment on deposits at the Walsh banks in
spite of losses the clearinghouse banks would incur. As
a result, no runs ensued. It was this crisis that prompted the Chicago Clearinghouse Association's decision
to appoint a special bank examiner.
An earlier e x p e r i e n c e m a y h a v e a l s o taught the
Chicago Clearinghouse about the importance of clearinghouse access in preventing bank runs (James 1938,
677-78). On Saturday, December 26, 1896, officers of
the Atlas National Bank decided that the bank could
not reopen the following Monday. The clearinghouse
committee met and decided that the bank should be
liquidated and that m e m b e r banks of the clearinghouse
should provide the f u n d s (approximately $ 6 0 0 , 0 0 0 )
needed to close the bank and pay depositors. This action tended to relieve the general anxiety pervading
the Chicago banking system.
The Atlas National, however, had an affiliated savings bank managed by the same board of directors but
not included in the clearinghouse plan to liquidate the
national bank. Even though the savings bank had been
well managed and had a good reputation, the failure of
the parent institution and the savings bank's exclusion
from the clearinghouse liquidation plan quickly caused
a run on the savings bank. It was forced into receivership within a month (James 1938, 679).
Besides the different roles of the clearinghouses in
Chicago and N e w York, the close relationship between
the stock market and the banking system in N e w York
m a y have contributed to the panic's being more severe
in that city. B o t h national b a n k s and trusts in N e w
York were potentially more exposed to fluctuations in
the stock market. National b a n k s in N e w York deposited their bankers' balances—deposits from other
banks to meet reserve requirements established by the
National B a n k i n g A c t s — i n the short-term call loan
market at the stock exchange. Trust companies in N e w
York also held a large volume of call loans. Nevertheless, the greater exposure to the stock market would
serve to distinguish both banks and trusts in N e w York
from those in Chicago, not banks from trusts in either
city.
Federal
Reserve Bank of Atlanta
interpreting the Differences
T h e following interpretation of the differences in
deposit and loan behavior in N e w York and Chicago
takes into consideration the structural similarities and
differences in the two money markets. Direct access to
the liquidity of the clearinghouse prevented panic and
runs at Chicago trusts. Being associated with the clearinghouse, the trust companies were perceived as part
of the clearinghouse payments system in Chicago and
were treated like the national banks by depositors and
correspondents.
In New York the trusts had little access to the liquidity the clearinghouse provided and were not viewed as
internal to the clearinghouse payments system. The extreme contraction in deposits at trusts reflected depositors' awareness of the isolation of the trusts f r o m the
clearinghouse. In both cities there was a net reduction in
deposits during the panic, but depositors in C h i c a g o
m a d e little d i s t i n c t i o n b e t w e e n trusts and n a t i o n a l
banks, and the intermediaries were comparably liquid. 17
The N e w York trusts, outside of the clearinghouse,
were much less restricted than national banks. Their
ability to compete in the same markets as banks but at
lower costs added instability to the entire payments
system, and a run on one class of intermediary could
threaten the collapse of the entire interconnected system. Even if other intermediaries were viewed as safe,
a run on the trusts threatened to drain reserves f r o m
the entire system. This isolation of N e w York trusts
f r o m the clearinghouse seems a key element in propagating the runs on the trusts.
In Chicago, as in N e w York, the different intermediaries faced different degrees of government regulation. In C h i c a g o , h o w e v e r , the disparity in o f f i c i a l
regulation between trusts and banks was reduced by
allowing trusts reliable access to additional reserves
through the clearinghouse. The difference this access
m a d e supports T i m b e r l a k e ' s argument that clearinghouses could potentially serve the banking industry as
the lender of last resort. This history cautions, though,
that the s i m p l e e x i s t e n c e of a c l e a r i n g h o u s e is not
enough to provide stability to a banking system, particularly if the coverage of the clearinghouse is circ u m s c r i b e d . T h e b r o a d e r c o v e r a g e of the C h i c a g o
clearinghouse and its greater knowledge of the condition of intermediaries appear critical elements in the
prevention of widespread runs in the city.
Even though the clearinghouses had been evolving
into de facto central banks, it is clear that their development was not complete by the Panic of 1907. The
Economic Review
7
to the establishment of the National Monetary C o m mission and, eventually, to the creation of the Federal
Reserve System, which radically changed the banking
industry.
severity of the panic in N e w York and the absence of a
reliable mechanism to cope with financial crises convinced the leading bankers that a centralized and reliable source of liquidity was necessary as the m o n e y
market grew and became more complex. In particular
J.P. Morgan, who had been at the center of the efforts
to stop the panic in N e w York, probably expected that
subsequent panics might be even more severe and bey o n d his or the c l e a r i n g h o u s e ' s ability to c o n t r o l .
Rather than continuing to put his assets at risk, Morgan (and other N e w York bankers) sought a national
scheme for dealing with financial crises.
It should be made clear that the point of this article is
not to present the discussion and evidence as support
for extending the "safety net" to intermediaries not perceived as in the payments system. The Chicago Clearinghouse that monitored trusts as well as extended the
benefits of membership was a private coalition of member banks and trusts. T h e private market structure is
clearly different from modern regulator-bank relationships, and to make strong inferences for current circumstances from this instance takes the study beyond its
intended goal. Rather, the analysis suggests that there is
historical precedent for the development and growth of
payments services offered by nonbank providers, which
can b e c o m e key players in the payments system and
should not be ignored. The key lesson from history is
that such ignorance may be expensive.
The course of the panic in C h i c a g o suggests that
wider coverage by private sector institutions like the
clearinghouse could reduce the potential for financial
crises. A private sector solution, however, was only
temporary. In 1908 the Aldrich-Vreeland Act authorized national b a n k s to issue e m e r g e n c y currency. 1 8
The long-run impact of the Panic of 1907 and the impacts on the N e w York money market was that it led
Notes
1. The U.S. Treasury attempted on occasion to intervene in financial m a r k e t s near the end of the N a t i o n a l B a n k i n g
Era—the active Treasury period—but the volume of funds
controlled by the Treasury was not adequate to cope with
panics.
2. This article complements research in Moen and Tallman
(1994). That paper introduces data from Chicago trusts and
banks to help uncover the sources of the panic in New York
and uncover the differences in the New York and Chicago
experiences. The data allow extensive statistical investigation of the panic that the use of New York data alone would
not allow. Interested readers are directed to the working paper for further information.
3. St. Louis, the third central reserve city, basically abandoned
its role as a central reserve city during the Panic of 1907
(James 1938, 766 fn). This discussion therefore ignores the
role of St. Louis banks during the panic.
4. National banks were federally chartered institutions regulated by the Office of the Comptroller of the Currency; the
banks were restricted from owning real estate or stock equity directly and had strict requirements on their reserve ratio
(reserves/deposits). Trust companies, on the other hand,
were examined by state banking regulators and typically
had fewer restrictions placed on their investments and their
reserve ratios.
5. The Illinois Trust and Savings Bank had assets equal to
$107 million dollars in August of 1907 while the Knickerbocker Trust in New York had $69 million. The largest trust
8
Economic
Review
in New York was the Fanner's Loan and Trust Company,
with $90 million in assets.
6. Indeed, New York's statute was often used as a model by
other states drafting regulations covering state-chartered institutions (Magee 1913; Welldon 1910).
7. The First National Bank of Chicago, one of the two largest
banks in the nation by 1907, had established its own trust
company, the First Trust and Savings Bank. James B. Forgan, president of both the First National Bank and the First
Trust and Savings Bank, designed an ownership arrangement that gave the bank and several of its officers complete
control over its trust company by acting as trustee for the
bank's stockholders (James 1938, 693-95). Forgan was apparently concerned that if the stockholders of the First National Bank were given direct ownership of the trust's stock,
over time control of the trust company could slip away from
the bank as the bank's stockholders sold their trust shares to
outsiders.
8. See Smith (1928, 346-49). Trusts were readmitted to the
New York Clearinghouse in May 1911.
9. James (1938, 711-12) provides a list of clearinghouse members and institutions for which they cleared checks.
10. National bank presidents included J.B. Forgan. Ernest A.
Hamill, and George M. Reynolds. Trust company presidents
included John J. Mitchell, Byran L. Smith, and Orson Smith
(Huston 1926, 507-11).
11. The following description summarizes material explained in
more detail in Tallman (1988).
M a r c h / April 1995
12. The following account is based on the more detailed history
in Tallman and Moen (1990).
13. Why National Bank of Commerce refused is not clear.
14. In cases of troubled banks approaching illiquidity (as opposed to insolvency), the clearinghouse would guarantee the
deposits of the troubled institution in the form of a coinsurance scheme. Timberlake (1984) has pointed out the effectiveness of clearinghouses in preventing the collapse of a
fractional reserve system. He emphasizes the ability of the
clearinghouse to gather its members into a single force during a crisis, issuing a temporary currency—clearinghouse
loan certificates—to meet exceptional demands by depositors for currency.
15. Much of the story below follows from James (1938).
16. Clearinghouse checks were issued directly to depositors,
and c l e a r i n g h o u s e loan c e r t i f i c a t e s c i r c u l a t e d b e t w e e n
banks.
17. See Moen and Tallman (1994) for the theoretical implications of the panic in New York and Chicago.
18. Although such currency was issued only once, some scholars have argued that this device was effective for dealing
with financial crises and was preferable to the solution
eventually chosen (Friedman and Schwartz 1963, 172).
References
Barnett, George E. State Banks and Trust Companies since the
Passage of the National Bank Act. National Monetary Commission. Washington, D.C.: Government Printing Office,
1907.
Cagan, Philip. Determinants
and Effects of Changes in the
Stock of Money, 1875-1960. New York: Columbia University Press/NBER, 1965.
Cannon, James G. Clearinghouses.
National Monetary Commission. Washington, D.C.: Government Printing Office,
1910.
Dowd, Kevin. " C o m p e t i t i v e Banking, Bankers' Clubs, and
Bank Regulation." Journal of Money, Credit, and Banking
26, no. 2 (1994): 289-308.
Friedman, Milton, and Anna Schwartz. A Monetary History of
the United States, 1867-1960. Princeton, N.J.: NBER, 1963.
Goodhart, C.A.E. The New York Money Market and the Finance of Trade, 1900-1913. Cambridge, Mass.: Harvard
University Press, 1969.
G o r t o n , Gary. " C l e a r i n g h o u s e s and the Origins of Central
Banking in the United States." Journal of Economic History
45 (June 1985): 277-84.
Gorton, Gary, and Donald Mullineaux. "The Joint Production
of C o n f i d e n c e : E n d o g e n o u s Regulation and Nineteenth
Century C o m m e r c i a l Bank C l e a r i n g h o u s e s . " Journal of
Money, Credit, and Banking 19 (November 1987): 457-68.
Huston, F. Murray. Financing and Empire: History of Banking
in Illinois. Chicago: S.J. Clarke, 1926.
James, F. Cyril. The Growth of Chicago Banks. New York:
Magee, H.W. -4 Treatise on the Law of National and State
Banks. 2d ed. Albany, N.Y.: Bender and Co., 1913.
Moen, Jon R., and Ellis W. Tallman. "The Bank Panic of 1907:
The Role of Trust Companies." Journal of Economic History 52 (September 1992): 611-30.
. "Clearinghouse Access and Bank Runs: Trust Companies in New York and Chicago during the Panic of 1907."
Federal Reserve Bank of Atlanta, Working Paper 94-12,
November 1994.
Redlich, Fritz. The Molding of American Banking: Men and
Ideas. New York: Johnson Reprint Co., 1968.
Smith, James G. The Development of Trust Companies in the
United States. New York: Holt and Co., 1928.
Sprague, O.M.W. History of Crises under the National Banking
System. National Monetary Commission. Washington, D.C.:
Government Printing Office, 1911.
Tallman, Ellis W. " S o m e Unanswered Questions about Bank
Panics." Federal Reserve Bank of Atlanta Economic
Review
73 (November/December 1988): 2-21.
Tallman, Ellis W „ and Jon R. Moen. "Lessons from the Panic
of 1907." Federal Reserve Bank of Atlanta Economic Review 75 (May/June 1990): 2-13.
Timberlake, Richard. "The Central Banking Role of Clearinghouse Associations." Journal of Money, Credit, and Banking 41 (February 1984): 1-15.
Welldon, Samuel. Digest of State Banking Statutes. National
Monetary C o m m i s s i o n . W a s h i n g t o n , D.C.: G o v e r n m e n t
Printing Office, 1910.
Harper and Brothers, 1938.
Digitized forFederal
FRASERReserve B a n k of Atlanta
Economic
Review
9
Osing Eurodollar Futures Options:
Gauging the Market's View of
Interest Rate Movements
Peter A. Abken
W
^ ^ rices formed in competitive financial markets—both debt and
K
M equity markets as well as derivative markets—reflect market
m
^ ^
assessments of future events. O n e well-known example of a
K
measure of market expectation is the implied volatility of op-JL.
tions. 1 A phenomenon known as the volatility smile, a further
manifestation of expectations to be discussed shortly, occurs in most options
markets. A related but less intensively studied phenomenon that will be investigated here, implied skewness, likewise reflects market expectations. Unlike volatility, which pertains to the expected variability of asset prices,
s k e w n e s s g a u g e s the d i r e c t i o n and m a g n i t u d e of their e x p e c t e d m o v e ments—a subject of daily interest in financial markets.
The author is a senior
economist in the financial
section of the Atlanta Fed's
research
department.
He thanks Ben hum of the
Chicago Mercantile
Exchange
and Sailesh Ramamurtie of
Georgia State University for
very helpful
comments.
10
Economic
Review
This article focuses on shifts in market outlook on the direction of interest
rate movements since 1988 as well as market reaction to specific events influencing interest rate changes in the short run—namely, Federal Reserve
monetary policy and its periodic Federal Open Market Committee (FOMC)
meetings. The discussion examines the Eurodollar futures options traded at
the Chicago Mercantile Exchange, the largest interest rate options market,
which offers the best gauge of market interest rate expectations, and explains
how to infer the implied skewness of interest rates from these options.
Like simple discount or coupon-bearing bonds, options have definite maturity dates, but unlike bonds their future payoff or cash flow is contingent
on the value of an underlying price (used generically to mean the price of a
financial asset, exchange rate, or index value). A critical determinant of an
March/ April 1995
option's value is the expected variability or volatility
of the underlying price, which can be inferred f r o m
option prices, because it is this element that in part determines the probability of the option having value at
future dates. 2 Even though volatility itself is not directly o b s e r v a b l e , o p t i o n s t r a d e r s t y p i c a l l y a s s e s s
prices in terms of their views of volatility because they
can readily intuit volatility and its movements. Standard models make restrictive, simplifying assumptions
about volatility. Traders price options by forming judgments about volatility, which are not bound by the limitations of f o r m a l models, and then translating those
views into prices using a model. That process can be
reversed to uncover the market's average expectation
of volatility over some horizon (see Linda Canina and
Stephen Figlewski 1993). This is the point of departure
for this article.
Just as options can be used to infer volatility, they
can be used to infer skewness. The accuracy of interest rate option pricing models may be improved if they
incorporate information about systematic shifts in interest rate skewness. Better ability to price options is
important not only to those who trade options but also
to risk managers who use options to hedge interest rate
exposures.
The skewness of the underlying interest rate distribution affects the pricing of puts relative to calls and is
related to the volatility smile. Eurodollar futures puts
protect against rising interest rates and the corresponding calls against falling rates. (See Box 1 on page 26
for further discussion.) S k e w n e s s in the distribution
of an interest rate implies a greater likelihood that
over some future interval a rate will rise rather than fall,
or vice versa. Zero skewness—a symmetric distribution—would result in an equal probability of rate increases or decreases. A measurement of skewness does
not provide a particular prediction about the direction
and magnitude of change in an interest rate but rather is
part of the statistical description of how rates fluctuate. 3 Intuitively, the m o r e skewed a distribution is in
one direction, the farther its mean, the average of all
o b s e r v a t i o n s , lies f r o m its m e d i a n , the fiftieth p e r centile observation, because of the influence of outlying observations in the skewed tail of the distribution.
The method for assessing skewness is elaborated in
the sections below. The first part of this investigation
examines the behavior of the skewness measure computed daily throughout the sample to check for any regularities in its movements over time. The second part
considers changes in skewness coinciding with Federal
Reserve policy actions, in particular with changes in
the federal funds target.
DigitizedFederal
for FRASER
Reserve Bank of Atlanta
There is no firm theoretical reason to expect shifts
in skewness at the time of individual federal funds target changes. 4 The very loose hypothesis offered here is
that each action the Fed takes signals its intention and
resolve to the financial markets. Target changes take
place incrementally, with much speculation in financial
m a r k e t s about h o w m a n y m o r e actions will follow.
Many observers believe that the Fed won much credibility with the markets by virtue of its inflation-fighting
efforts in the early 1980s and the resulting subdued
levels of inflation that have prevailed. The unexpectedly sharp round of tightening actions that started in 1994
were accompanied by much discussion of credibility in
the financial press. Current policy moves can also convey information about the prospects for future moves.
The hypothesis under consideration is that once a
target change occurs, in particular one that is not fully
anticipated, the market reevaluates the likelihood of
further changes in the same direction and on the basis
of that information m a y expect a greater probability of
future rate moves in one direction rather than the other.
Even after four previous tightening moves in 1994, the
50 basis point increase in the federal funds rate on August 16, 1994, could still stimulate a reappraisal of the
Fed's intentions, as demonstrated in this example: "The
Fed's move triggered the rally in long-term bonds because it signaled the central bank's determination to
keep the economy from overheating and keep a lid on
inflationary p r e s s u r e s " ( T h o m a s T. Vogel, Jr., 1994,
C I , C I 9 ) . If options traders and other investors perceive a change in the Fed's policy stance—or simply
less uncertainty about its goals—their assessment of
the underlying interest rate skewness m a y also be influenced. In this case, a greater chance of further aggressive tightenings could increase skewness.
The basic conclusion of this article is that a marked
shift in market outlook on interest rate movements occurred in late 1992, a shift that has not previously been
measured or documented. The low short-term interest
rates that prevailed at that time coincided with a sharp
increase in the implicit skewness of the interest rate
distribution. The measured skewness indicates that the
likelihood of rising interest rates was much greater than
of falling interest rates. T h e analysis finds that during
1993 and 1994, skewness was manifested by a premium in the prices of Eurodollar futures puts, which offer
protection against rising interest rates, compared with
those of Eurodollar futures calls. The findings also indicate, t h o u g h , that the E u r o d o l l a r f u t u r e s o p t i o n s
prices are too "noisy" to detect changes in the markets'
view of future short-term interest rate movements following F O M C meetings.
Economic Review
11
/Eurodollar Futures and Options
The analysis in this article focuses on Eurodollar futures and options tied to m o v e m e n t s in t h r e e - m o n t h
LIBOR, which stands for London Interbank Offered Rate.
These contracts, which trade at the Chicago Mercantile
Exchange, are the dominant exchange-traded derivatives
contracts for hedging short-term interest rate risk. One of
the reasons for their popularity is that they are instrumental in hedging risks that arise from taking positions in
over-the-counter interest rate derivatives contracts such
as interest rate swaps, caps, and floors. Financial intermediaries in the over-the-counter markets, principally commercial and investment banks, turn to the Eurodollar
contracts to hedge their interest rate exposures.
Better ability to price options is important
not only to those who trade options but also
to risk managers who use options to hedge
interest rate exposures.
On the last day of the sample for this study (September 9, 1994), the total number of these contracts outstanding (the open interest) was 2,780,000, with the
open interest for the Chicago Board of Trades's Treasury bond futures a distant second at 438,000 contracts.
The volume of trading in Eurodollar futures on that day
was almost 500,000 contracts, a scale of trading activity that dwarfs that in any other futures market. The
open interest levels for Eurodollar f u t u r e s calls and
puts were m o r e than one million contracts for each
t y p e of o p t i o n , w i t h d a i l y v o l u m e s of 2 2 , 0 0 0 and
40,000 contracts, respectively. These numbers are huge
compared with other options markets, with the one exception of the Treasury bond futures options. For the
purposes of this study, these large trading volumes are
important because they make it more likely that prices
represent a market consensus and consequently that
implied volatility or skewness represents expectations
rather than market-related factors. 5 This issue is discussed more fully below.
12
Economic Review
L I B O R is the rate of interest paid on three-month
time deposits in the London interbank market. The interest is paid in the form of an add-on yield, calculated
on a 360-day calendar basis, for a $1 million deposit.
(The yield is computed for a deposit of a fixed sum of
money. In contrast, Treasury bills and other discount
securities accrue interest by price appreciation. Their
initial value is less than their face value by an amount
sufficient to yield a particular rate of return.) The market for Eurodollar time deposits is a wholesale market
in which international banks can borrow and lend funds.
To receive the rate of interest stipulated at the time the
futures contract was bought, the purchaser of a Eurodollar futures contract in effect is obligated to establish a
three-month Eurodollar time deposit of $1 million upon
expiration of the contract. The seller of a Eurodollar futures contract in effect agrees to pay that rate of interest
on a $1 million loan. In practice, the Eurodollar futures
contract is cash-settled, which means that a deposit or
loan is never made; only the interest payment changes
hands. Actual settlement of the $1 million notional
amount of the contract is unnecessary because of the
manner in which these futures are used to hedge other
positions, as discussed below.
Eurodollar futures contracts mature in a quarterly
cycle, with contracts maturing two L o n d o n business
d a y s b e f o r e the t h i r d W e d n e s d a y in M a r c h , J u n e ,
September, and December. On any day, Eurodollar futures are traded for these months out to ten years in the
future, with substantial open interest for contract
m o n t h s running out approximately three years. T h e
availability of long-dated Eurodollar contracts has increased year by year as the over-the-counter market
has g r o w n , driving the need for E u r o d o l l a r f u t u r e s
hedges.
The price of the Eurodollar futures contract is actually an index value constructed as 100 minus the addon yield expressed as a percent. T h e reason for this
arrangement is that a long position (a purchased contract) gains as the index rises, implying that the add-on
yield (LIBOR) falls. The index allows the Eurodollar
futures contract to behave like traditional commodity
futures contracts for which long positions gain as the
underlying commodity price rises. Conversely, a short
position gains as the index falls and L I B O R rises. The
m i n i m u m index movement is called the tick size. That
amount for the Eurodollar futures contract is 1 basis
point (one-hundredth of a percentage point). The addon yield is computed as a dollar value on a notional $ 1
million dollar, three-month deposit. The value of a onetick change in the index is therefore .0001 x 90/360 x
$1,000,000-$25.
March/April 1995
Unlike Treasury bill f u t u r e s or Treasury bond futures, which are traded on the basis of the prices of
these Treasury securities, Eurodollar futures and options
are linked directly to an interest rate. The Chicago Mercantile Exchange determines the final settlement price
of the Eurodollar contract based on L I B O R prevailing
in the cash market by the following procedure. On the
last day of trading for an expiring Eurodollar futures
contract, the exchange polls sixteen banks active in the
London Eurodollar market. These banks are randomly
selected from a group of no less than twenty banks. In
the final ninety minutes of trading, they are asked for
three-month LIBOR quotes at a random time during this
period and again at the close of trading. The Chicago
Mercantile Exchange specifically asks each bank for "its
perception of the rate at which three-month Eurodollar
Time Deposit funds are currently offered by the market
to prime banks" (Chicago Mercantile Exchange 1994,
chap. 39, 3). The four highest and four lowest quotes at
both the random and closing-time polls are eliminated
and the remaining q u o t e s are averaged together and
rounded to the nearest basis point to give the LIBOR
value for determination of the final settlement price.
Quarterly Eurodollar futures options that expire simultaneously with their underlying futures contracts
are effectively cash-settled. If an option is exercised, a
Eurodollar futures call writer (seller) b e c o m e s short
one Eurodollar futures contract while the call purchaser
receives one long Eurodollar futures contract. Eurodollar futures calls gain value as the index rises and
L I B O R falls. Thus, calls can protect against falling interest rates. (Conversely, the holder of a Eurodollar futures put gets a short position in a Eurodollar futures
contract. Puts can protect against rising interest rates.)
At expiration, the Chicago Mercantile Exchange automatically exercises options that are in the money, resulting in an i m m e d i a t e m a r k i n g to market (that is,
closing out) of the futures position. The tick size for
the Eurodollar futures options is also 1 basis point, implying a minimum price change of $25 for an option
contract. Another important feature of Eurodollar f u tures options is that they are American-style options,
which means that they can be exercised before their expiration date if early exercise is to the advantage of the
optionholder.
The futures and options price data in this study consist of daily closing prices for all three-month Eurodollar futures and options contracts traded at the Chicago
Mercantile Exchange. The sample period covered January 1988 through September 1994, which coincides
with information on F O M C federal f u n d s rate target
changes.
Federal
Reserve Bank of Atlanta
A final point about the data is that there is a close
relationship between L I B O R and the federal funds rate.
Federal Reserve open market operations have a direct
impact in the federal funds market because open market purchases and sales of Treasury securities alter the
availability of banking system reserves. Banks in need
of reserves can borrow them, usually overnight, in the
federal funds market, and banks with surplus reserves
can readily lend t h e m . Fed open m a r k e t o p e r a t i o n s
shift the supply of reserves. (See Marvin Goodfriend
and William Whelpley 1986 for a detailed description
of the f e d e r a l f u n d s m a r k e t . ) B e c a u s e l o n g e r - t e r m
yields are in part determined as the average of current
and future expected short-term interest rates, shifts in
the current federal funds rate or anticipated movements
in this rate translate into changes in longer-term yields
If investors perceive a change in the Feds
policy stance—or simply less uncertainty
about its goals—their assessment of the
underlying interest rate skewness may
also be influenced.
(see Peter A. Abken 1993). T h e purchase of fed funds
is equivalent to an unsecured loan, and thus the fed
f u n d s rate also includes a component for credit risk.
Similarly, three-month L I B O R also builds in a credit
spread reflecting the average credit risk of participants
in the Eurodollar time deposit market. Differences in
the terms to maturity of overnight fed funds loans and
t h r e e - m o n t h E u r o d o l l a r d e p o s i t s as well as in their
credit spreads result in a less than perfect correlation
between the movements in the fed funds rate and threemonth LIBOR. Nevertheless, the two are highly correlated, as seen in Chart 1.
inferring Skewness f r o m Option Prices
R e c e n t l y t h e r e h a s b e e n a f o c u s on a s e e m i n g
anomaly in actual market option prices. The standard
b e n c h m a r k f o r the p r i c i n g of e q u i t y o p t i o n s is the
Economic Review
13
Black-Scholes model, which makes a number of strong
assumptions about equity prices and interest rates (see
Fischer Black and Myron S. Scholes 1973). As discussed by Canina and Figlewski (1993), as well as others, there is a tendency, particularly since the October
1987 stock market crash, for implied volatilities to differ from one strike price to another. This phenomenon
is the so-called volatility smile. If the Black-Scholes assumptions were true, then volatility would be constant
across all strike prices for an option of a given maturity.
The implication of the shifting volatility is that the
probability distribution of the stock price differs from
the one assumed in the Black-Scholes model. 6 Using
several forms of the Heath-Jarrow-Morton interest rate
option pricing model (see David Heath, Robert A. Jarrow, and Andrew J. Morton 1992), Kaushik I. Amin
and Morton (1994) have observed a similar phenomenon in Eurodollar futures options.
In two articles, David S. Bates (1988, 1991) proposed a simple measure of skewness for European options and American options on futures contracts. 7 As
Bates and many other researchers have observed, traded options prices can be used to infer the underlying
probability distribution, which is pivotal for the pricing
of options. Chart 2, panel A, reproduces the simple
logic of Bates's skewness measure. The "risk neutral"
probability density function depicts the likelihood that
the underlying asset price takes values in certain
ranges. The area under the density curve is equal to
unity by definition. As noted above, Eurodollar futures
and options contracts have a 1 basis point tick size.
Any index value would therefore be represented by a
thin, 1 basis point sliver under the curve. The theoretical probability of observing that price would be the
area of that sliver.
Both European and American options have payoffs
that depend on the underlying index value settling
above the option strike for calls or below the strike for
puts. A standard equation of the value of an option
(Bates 1991; Jarrow and Andrew Rudd 1983) shows
the relationship between strike price, index value, and
the probability density. The value of a European call
option is
c,
= e-E *[Fl+j - KJFl+j > K]
x Prob*CF,+T >
K).
The value of the index T periods in the future is denoted by Fl+j. The strike level of the call option is Kc. This
equation simply says that the value of a call equals the
expected value of the payoff E * [ F ; + T - KJFi+j> K], if
the call finishes in the money, times the probability that
the call ends up in the money at expiration. (The asterisk
Chart 1
Federal Funds Rate versus Implied Eurodollar Futures Rate
Percent
14
Economic Review
March/ April 1995
Federal Reserve Bank of Atlanta
Chart 2
Example of a Symmetric Distribution
Example of an Asymmetric Distribution
Economic
Review 23
next to the mathematical expectation operator, E, and
the conditional probability, Prob, indicates that the relevant probability density is the risk neutral one, not the
actual or " t r u e " probability density. [See Jarrow and
Rudd 1983 or John C. Cox and Mark Rubinstein 1985
for the rationale for risk neutral valuation.]) The call has
no value at maturity if Ft+j < K(, and thus outcomes in
this range contribute no value to the call. Finally, the expected payoff is discounted by £TrT.8 The equation for a
European put is analogous to the call equation:
F=e-"E*[Kp-FJFl+T<Kp}
x Prob
*(Fl+j<Kp).
The price of a Eurodollar futures contract is approximately the f o r w a r d price of a t h r e e - m o n t h L I B O R
add-on yield payment to be made at the contract's m a turity. 9 Henceforth, forward and futures prices will be
used s y n o n y m o u s l y . T h e current E u r o d o l l a r f u t u r e s
price is equal to the index value expected to prevail at
the maturity date (if the market were risk neutral). In
contrast, an equity index price would be expected to
appreciate over time to compensate for the cost of financing a position in the stocks to deliver against a forward position in an equity index contract. A futures
position, to a first approximation at least, involves no
"cost of carry" because it costs nothing to initiate and
margin can be posted in the f o r m of interest-bearing
Treasury securities. Thus, the current forward price is
the mean of the risk neutral distribution of index values
to prevail at the maturity date.
Bates shows h o w European options that are symmetrically out of the money can give a measure of the
implicit skewness of the underlying distribution, as is
readily seen in C h a r t 2. 1 0 O u t - o f - t h e - m o n e y strike
prices for the index are shown as K for calls and Kp for
puts, which are equidistant from the forward price, the
mean, Ft, by an arbitrary x percent. Bates's skewness
measure is simply
SK(x) = c(Ft,T,Kc)/p(jFt,r,
K ) - 1,
(*)
where Kp = FJ{ 1 + x) <Ft< Ft{\ + x) = K for x>0. For
x, the call and put strikes are approximately x percent
out of the money. Ignoring the discount factor, the option value is the product of the expected payoff if the
option is in the money and the "tail" probability. For the
symmetric distribution depicted in Chart 2, panel A, the
skewness measure is zero. In this case both tails, the
shaded regions to the left of Kp and to the right of Kc,
have equal area, and therefore the probability of observing prices below the put's strike is the same as that of
observing prices above the call's strike. The expected
Economic
16
Review
option payoffs are also equal. Thus, the symmetrically
out-of-the-money call and put prices are the same.
Panel B shows a positively skewed distribution, that
is, one for which the chance of observing high prices is
much greater than of seeing low prices. The expected
payoff of the call, conditional on the underlying price
exceeding the strike, is greater than that for the put because of the upward-skewed tail. Although the area of
the upper tail of the skewed distribution (shown as the
shaded area on the right-hand side) is actually smaller
than that for the lower tail—implying a lower probability of the call expiring in the money than the put—this
lower probability is offset by the higher expected payoff
for the call compared to the put. After taking the product of the expected payoff and conditional probability
for the call and put, respectively, the net effect is that for
an u p w a r d - s k e w e d distribution an o u t - o f - t h e - m o n e y
call trades at a premium to a symmetrically out-of-them o n e y put. Conversely, a symmetrically out-of-them o n e y put trades at a premium to the corresponding
call when the underlying price distribution is skewed
downward. (In fact, this latter case describes the pricing relationship for Eurodollar calls and puts. L I B O R
itself has an upward-skewed distribution.)
As shown by Robert E. Whaley (1986), both American futures puts and calls may be rationally exercised
early. If an option is sufficiently in the money, the holder is better off exercising the option than keeping it. Except for sufficiently deep-out-of-the-money options that
have no probability of going into the money, American
options trade at a premium (referred to as an early exercise premium) to otherwise similar European options
because of the flexibility of being able to exercise them
before maturity. In the context of the Black (1976) futures option pricing model, the maximum value that the
early exercise premium can reach is the present value of
the interest income that can be earned by exercising early rather than holding the option. For example, the valu e of a d e e p - i n - t h e - m o n e y E u r o p e a n call is (F f K()e~rT, whereas the corresponding value of an AmeriK)e~rj
can call is Ft - Kc, which is greater than (Ft since the discount factor is less than one. The difference
between the exercisable proceeds and the European call
value is simply the interest that can be earned on the proceeds if that sum is invested at rate r over the remaining life T of the option. An analogous argument applies
to puts, except that the exercisable proceeds are Kp - Fr
In general, the possibility of early exercise and the
premium associated with it obscure inferences about the
underlying distribution because the early exercise decision is sensitive to the cash flows of the underlying asset. However, futures contracts are assumed to have a
March/ April 1995
1994. This smile is typical of those in the sample. Option volatility is plotted against its " m o n e y n e s s , " to
which it is clearly sensitive. The degree of moneyness
for the calculations was determined relative to the implied Eurodollar rate (100 - index) rather than relative
to the index. The strike prices of Eurodollar futures options are listed by index value, not implied Eurodollar
rate. If a constant degree of moneyness is defined in
terms of the index, the degree of moneyness will fluctuate in terms of the implied Eurodollar rate as the level of L I B O R varies. T h e c o n v e r s e is of course also
true; fixing m o n e y n e s s in terms of the implied Eurodollar rate results in variations in moneyness in terms
of the index. (It turns out that the results are qualitatively similar using either approach.) Moneyness is defined for a Eurodollar futures call (which is a put on
zero cost of carry and hence no cash flows so that the
decision to exercise early depends only on the distribution of the asset price. For a symmetric distribution, the
early exercise p r e m i u m s for puts and calls would be
equal and would have no impact on the skewness measure. For an asymmetric distribution, differences in early
exercise premiums between put and call are only a function of the asymmetry, and therefore the skewness measure remains valid using American futures options prices.
The Historical Behavior of Volatility
Chart 3, panels A and B, illustrates the volatility
smile in Eurodollar futures puts and calls for May 17,
Chart 3
Volatility Smile for Eurodollar Futures Puts
(May 17, 1994)
Annualized Volatility
Percent
25
A
-2.0
-1.5
-1.0
-0.5
0
Moneyness: Implied Eurodollar Rate-Strike
Percentage Points
Volatility Smile for Eurodollar Futures Calls
(,May 17, 1994)
Annualized Volatility
Percent
25
Federal Reserve Bank of Atlanta
Moneyness: Strike-Implied Eurodollar Rate
Percentage Points
Economic Review
17
the Eurodollar rate) by the difference between the option's strike (expressed as a Eurodollar rate rather than
as an index) and the current implied Eurodollar rate
and for a Eurodollar futures put (a call on the rate) by
the difference between the implied Eurodollar rate and
the option's strike.
Volatility is also known to be sensitive to an option's
maturity. The options plotted had maturities that ranged
f r o m 9 0 to 2 7 0 d a y s . O n c e the 9 0 - d a y b o u n d w a s
r e a c h e d , puts and calls were rolled f o r w a r d to the
longest available maturity under 270 days. This somewhat arbitrary choice was governed by two considerations related to the need to f o r m daily time series of
volatility and skewness with few missing observations.
First, fewer out-of-the-money options tend to be available for shorter maturities. T h e s e o u t - o f - t h e - m o n e y
positions tend to be infrequently traded. Second, longerterm options are generally less liquid, particularly in the
earlier years in the sample, when in fact many longdated maturities were not even traded. The option valuation model for extracting implied volatilities, described
next, also m a d e it desirable to avoid longer-term options (although this limitation does not affect the skewness measure, which is model independent).
Implied volatilities were computed using the model
for futures options of Black (1976) with the BaroneAdesi/Whaley approximation for early exercise value
(see Giovanni Barone-Adesi and Whaley 1987)." The
model has the virtue of being easy to use but makes the
assumption that the discount factor is constant over
time, an a w k w a r d supposition given that the raison
d ' ê t r e of Eurodollar f u t u r e s options is, of course, to
hedge uncertain short-term interest rates. More realistically, the discount factor would depend on the expected
path of the overnight rate over the life of the option. In
other words, the discount factor would be stochastic,
not deterministic. In practice, many users of Eurodollar
futures options employ Black's model, and one can argue that it is not a bad approximation for options having less than one year to maturity. (For such options,
the option price is much more sensitive to changes in
its expected payoff than to changes in the discount factor. See notes 9 and 12 for additional information.) The
early exercise premium was valued using the BaroneA d e s i / W h a l e y (1987) algorithm in conjunction with
Black's model.
In B l a c k ' s m o d e l a p p l i e d to E u r o d o l l a r f u t u r e s ,
volatility is technically the annualized value of the ins t a n t a n e o u s standard deviation of the p r o p o r t i o n a t e
change in the forward rate (100 - index). The forward
rate or implied Eurodollar rate rather than the index enters Black's formula when computing an option price.
18
Economic Review
The key application of this model is in translating option prices into volatilities. Different option pricing
models will generate qualitatively similar plots of the
time series of volatility. 12
T h e t i m e - s e r i e s b e h a v i o r of historical volatility
clearly implies that s k e w n e s s in the distribution of
L I B O R is important. Chart 4, panel A, depicts the fullsample history of volatility for out-of-the-money Eurodollar calls and puts. T h e options were out of the
money by 10 percent of forward L I B O R , the implied
Eurodollar futures rate. Since strikes are not quoted at
exactly 10 percent out of the money except by pure coincidence, an interpolation technique, cubic splining,
was used to estimate the call and put option prices that
were exactly 10 percent out of the money. 1 3 Implied
volatilities were computed from the interpolated prices.
Call and put volatility appear to be very close until early 1993, when put volatility rose above call volatility.
The spike in both call and put volatility in September
1992 corresponds to the breakdown of the European
Exchange Rate Mechanism, which had held major European c u r r e n c i e s in close a l i g n m e n t until m a s s i v e
speculative attacks forced central banks to abandon
their exchange rate targets (see Morris Goldstein and
others 1993). Thereafter put and call volatility diverge,
although it is not clear whether the exchange rate crisis
had a causal impact on the split in volatilities. As seen
in Chart 5, implied Eurodollar rates rose only slightly
during this crisis.
Panel B of Chart 4 shows the daily deviation of outof-the-money put volatility from out-of-the-money call
volatility for the full sample. Daily out-of-the-money
put volatility exceeded out-of-the-money call volatility
by an average 15.1 percent during 1993 and 1994, with
a standard deviation of 7.1 percent. In the earlier part
of the sample, the deviation was a mere 0.33 percent,
statistically insignificantly different from zero. There is
o b v i o u s l y c o n s i d e r a b l e v a r i a t i o n in the c o m p u t e d
volatility deviations. Particularly in 1993 and 1994,
this difference constitutes evidence of skewness: the
options indicate that during this period the chance of
observing large upward movement away from the forward rate was much greater than the chance of downward movement.
The analysis of skewness could be conducted using
the v o l a t i l i t y m e a s u r e s ; h o w e v e r , as n o t e d a b o v e ,
Bates's skewness measure is model independent and
therefore introduces f e w e r sources of error in the analysis. A n o t h e r point to note is that, in principle, the
volatility of in-the-money puts and calls could reveal
information about skewness, but in-the-money options
tend to be too thinly traded to be used in the analysis.
March/ April 1995
Chart 4
Eurodollar Futures Call and Put Volatility
10 Percent Out-of-the-Money Calls and Puts
Annualized Volatility
Percent
Percentage Deviation of Put Volatility from Call Volatility
10 Percent Out-of-the-Money Calls and Puts
Percent
40
-20
1988
—
*
1989
Federal Reserve Bank of Atlanta
t
1990
1991
1
1992
i
1993
1—
1994
Economic
Review 27
Chart 5
Implied Skewness of Eurodollar Futures Options
10 Percent Out-of-the-Money Calls and Puts
Percent
Call/Put-1
12
0.6
Skewness
0.4
10
0.2
8
0
6
-0.2
4
-0.4
2
-0.6
1989
1990
1991
71ie Historical Behavior of Skewness
The skewness measure for the Eurodollar futures options was computed daily for the entire sample. This
measure, given by equation (*) above, simply consists of
the ratio of call to put prices that are symmetrically out
of the money. Both options mature on the same date.
Chart 5 shows the skewness measure for 10 percent
out-of-the-money options. The most striking feature of
this plot is the shift in the level of skewness at the end
of 1992. The average daily skewness from January
1988 through December 1992 is -0.089 (with standard
deviation 0.103). This measure contrasts with the
volatility plots of Chart 3, in which call and put volatility are very close. However, as noted above, the Black
model introduces two important sources of error into
the assessment of skewness: the assumed constancy of
the discount factor and the approximation of the early
exercise premium.
From January 1993 to September 1994, the daily
average skewness increased markedly. The average for
this period was -0.344 (with standard deviation 0.110).
Note that a greater negative value corresponds to
greater skewness. This change reflects an increase in
the price of puts (protection against upward moves in
http://fraser.stlouisfed.org/
Economic Review
20
Federal Reserve Bank of St. Louis
1992
1993
1994
LIBOR) relative to calls. It is striking that the volatility
of skewness was almost unchanged across these two
periods. This is a clear-cut, statistically significant shift
in the skewness of the distribution of LIBOR—as perceived by option market participants.
The jaggedness of this measure indicates a great
deal of noise in the data. Some sources of noise include
errors introduced through the interpolation process in
constructing the skewness measure, inaccuracies in the
determination of settlement prices for puts, calls, and
futures prices, and supply and demand pressures on
prices stemming from short-term imbalances in order
flow in the Eurodollar futures and options pits. The
theory for inferring the characteristics of the distribution of LIBOR or other prices from options assumes
the existence of perfect, frictionless markets. However,
even the large Eurodollar futures and options markets
can have prices temporarily distorted by large buy orders (which drive prices up) or sell orders (driving
prices down) as other market participants take the other
side of the trades.
It is instructive to repeat the calculations for Chart 5
for at-the-money puts and calls. For European options,
a standard option pricing relationship known as putcall parity can be used to show that futures put and call
options with strike prices equal to the forward rate
March/ April 1995
Cal I/Put-1
0.06 -,
Chart 6
Implied Skewness of Eurodollar Futures Options
At-the-Money Calls and Puts
-0.02
-0.04
-0.06 J
1988
t
1
1
t
!
1989
1990
1991
1992
1993
have equal value. This result does not depend on the
underlying distribution governing LIBOR (or any rate,
price, or index). Systematic deviations from this prediction could indicate distortions in the price formation
process, which perhaps also could result in systematic
errors in the measurement of skewness for out-of-themoney options.
Chart 6 reveals that, apart from noise, the put-call
parity prediction is correct, even though Eurodollar futures options are American and the parity relationship
holds only in a weaker form (as an inequality relationship; see Jarrow and Rudd 1983). (In fact, European and
American Eurodollar futures options prices usually differ by only a very small amount.) The average daily
skewness in the sample for at-the-money Eurodollar futures options is 0.00024 (with standard deviation
0.0070). The average is insignificantly different from
zero. (Note that the values on the skewness axis are an
order of magnitude smaller for this chart than for the previous one for out-of-the-money options). As Bates found
in his work on equity options, the skewness measure is
roughly linearly related to the degree of moneyness.
Thus, 5 percent out-of-the-money options have a time series plot (not shown here) that has about the same shape
as that for 10 percent out-of-the-money options, but the
skewness values are half the size in absolute value.
Federal
Reserve Bank of Atlanta
t—
1994
The average - 0 . 0 9 skewness corresponds to a premium on puts, a price 10 percent higher compared with
the price of calls. This degree of skewness matches
closely the skewness of the lognormal distribution,
which has wide application in option pricing. The famous Black-Scholes option pricing model as well as its
modification for futures options (the Black model)
assume lognormally distributed prices. Bates (1988)
proves an "x percent" rule for options on assets whose
prices are lognormally distributed. For these prices, options that are x percent out-of-the-money will exhibit a
premium of calls over puts of x percent. For Eurodollar
futures options, it is puts that trade at a premium, and
the skewness measure is negative. The reason is that it
is the implied Eurodollar rate that is assumed to be lognormally distributed and thus skewed upward toward
higher rates, not its Chicago Mercantile Exchange index, which is skewed downward. In 1993 and 1994,
however, the distribution of LIBOR implicit in the
options became considerably more skewed, well in
excess of the degree of skewness for a lognormal distribution.
The increase in skewness corresponds, roughly, to
the low level of LIBOR and other short-term interest
rates that prevailed in 1993 and 1994. The implied Eurodollar rate is shown superimposed on the skewness
Economic Review
21
g r a p h in C h a r t 5. It w o u l d s e e m i n t u i t i v e that the
greater likelihood of upward movements in rates would
coincide with historically low short-term rates. T h e
m a r k e t m i g h t e x p e c t that rates w o u l d " r e v e r t " to a
higher long-run level. M a n y term structure and interest
rate option pricing models build in the assumption of
mean reversion (see Abken 1993). However, more than
simple mean reversion needs to be at work to explain a
shift in skewness because mean reversion can occur for
a stationary distribution, that is, o n e with constant
skewness (and other constant unconditional moments
like mean and variance). A regime change—a shift in
Federal Reserve policy that is external or exogenous to
current interest rate movements—would be needed to
account for a change in the statistical distribution of
short-term interest rates. 1 4 The j u m p in s k e w n e s s in
1992 followed immediately after the 25 basis point reduction in the fed funds target in September 1992, the
last easing action taken by the F O M C . Also, as noted
in the previous section, it followed the breakdown of
the European Exchange Rate Mechanism.
H o w e v e r , even if there are distinct regime shifts
that result in a so-called nonstationarity distribution,
one would expect this sort of relation to be symmetric
for high interest rates as well as low rates. The skewn e s s m e a s u r e s h o u l d turn p o s i t i v e or less n e g a t i v e
when rates are cyclically high, as in late 1988 and early 1989. However, the skewness measure is flat during
this period. There does not seem to be a satisfactory
explanation of the time-series behavior of the implied
skewness of the Eurodollar futures options.
As noted above, the standard statistical measure of
skewness will differ between the risk neutral and actual
probability distributions. The standard measure can be
computed from a time series of historical three-month
LIBOR. The resulting measure of skewness pertains to
the actual probability distribution. T h i s m e a s u r e of
skewness is very sensitive to the sample period select-
Table 1
Federal Reserve Policy Easings of the Federal Funds Rate Target
Date of Change
Prediction Date
Prediction
Actual
Surprise
Target Change
06/06/89
07/07/89
07/27/89
10/16/89
11/06/89
12/20/89
07/13/90
10/29/90
11/14/90
12/07/90
12/19/90
01/09/91
02/01/91
03/08/91
04/30/91
08/06/91
09/13/91
10/31/91
11/06/91
12/06/91
12/20/91
04/09/92
07/02/92
09/04/92
06/02/89
06/30/89
07/21/89
10/1 3/89
11/03/89
12/15/89
07/13/90
10/26/90
11/09/90
12/07/90
1 2/14/90
01/04/91
02/01/91
03/08/91
04/26/91
08/02/91
09/1 3/91
10/25/91
11/01/91
12/06/91
12/20/91
04/03/92
06/26/92
09/04/92
9.70
9.50
9.25
8.87
8.87
8.38
8.00
7.88
7.75
7.25
7.25
7.00
6.25
6.25
6.00
5.75
5.25
5.25
5.00
4.50
4.00
4.00
3.75
3.00
9.50
9.25
9.00
8.75
8.50
8.25
8.00
7.75
7.50
7.25
7.00
6.75
6.25
6.00
5.75
5.50
5.25
5.00
4.75
4.50
4.00
3.75
3.25
3.00
-0.20
-0.25
-0.25
-0.12
-0.37
-0.13
0.00
-0.13
-0.25
0.00
-0.25
-0.25
0.00
-0.25
-0.25
-0.25
0.00
-0.25
-0.25
0.00
0.00
-0.25
-0.50
0.00
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.50
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.25
-0.50
-0.25
-0.50
-0.25
Source: Federal Reserve Board of Governors. Rates are expressed in percent. Predictions are from the Money Market Services survey of
economists.
Economic
22
Review
March/ April 1995
ed and to the computed mean of L I B O R during that period because skewness is measured in terms of deviations of observations from the sample mean. (See note
10 for the formula for skewness.) To avoid the second
of these problems, the daily change in L I B O R can be
used because the mean daily change is close to zero.
From January 1988 to December 1992 the computed
skewness is significantly negative at better than the 1
percent significance level. In the remaining sample, it
is significantly positive. (The same results obtain for
computations done in the levels.) Therefore, concerning a shift in skewness, there is agreement between
Bates's skewness measure, which is a forward-looking,
options-based measure of the risk neutral distribution,
and the standard calculation of skewness, which is a
b a c k w a r d - l o o k i n g m e a s u r e of the actual probability
distribution.
However, it is surprising that for the period f r o m
January 1988 to December 1992 the standard statistical
computation of s k e w n e s s results in a negative value
while Bates's measure, in terms of the implied LIBOR,
finds a positive value. These are very different mea-
sures, but one w o u l d expect that they agree in sign.
Amin and Morton (1994) argue that Eurodollar futures
puts were overvalued and that, in fact, this overvaluation could have been exploited to generate trading profits, even after accounting for transactions costs. They
conducted trading-rule tests to demonstrate this possibility. Their sample of prices ran from January 1, 1987,
to November 10, 1992. It is possible that this overvaluation could explain the difference between the skewness
measures. Nevertheless, it would stretch credulity to believe that the increase in implied skewness in 1993 and
1994 resulted from increased mispricing of the puts in
one of the most active, liquid financial markets in the
world. (Amin and Morton's article was also in the public domain at this time, so the purported overvaluation
was presumably common knowledge.) In any case, the
sample skewness of LIBOR reversed in this period, taking the same sign as implied skewness.
T h e f o l l o w i n g analysis e x a m i n e s the behavior of
skewness around changes in the federal f u n d s targets.
Tables 1 and 2 show the history of Federal Reserve
target changes to the fed funds rate from March 1988
Table 2
Federal Reserve Policy Tightenings of the Federal Funds Rate Target
Date of Change
Prediction Date
Prediction
Actual
Surprise
Target Change
03/01/88
03/30/88
05/09/88
05/25/88
06/22/88
07/19/88
08/09/88
10/20/88
11/17/88
11/22/88
12/15/88
12/29/88
01/05/89
02/09/89
02/14/89
02/23/89
02/04/94
03/22/94
04/18/94
05/1 7/94
08/16/94
02/26/88
03/25/88
05/06/88
05/20/88
06/1 7/88
07/1 5/88
08/05/88
10/14/88
11/11/88
11/18/88
1 2/09/88
12/23/88
12/30/88
02/03/89
02/10/89
02/1 7/89
02/04/94
03/18/94
04/1 5/94
05/13/94
08/12/94
6.63
6.63
6.87
7.13
7.38
7.63
7.85
8.13
8.31
8.31
8.55
8.88
8.88
9.14
9.25
9.37
3.25
3.50
3.50
4.00
4.50
6.50
6.75
7.00
7.25
7.50
7.69
8.13
8.25
8.32
8.38
8.69
8.75
9.00
9.06
9.31
9.75
3.25
3.50
3.75
4.25
4.75
-0.13
0.12
0.13
0.12
0.12
0.06
0.28
0.12
0.01
0.07
0.14
-0.13
0.12
-0.08
0.06
0.38
0.00
0.00
0.25
0.25
0.25
0.13
0.25
0.25
0.25
0.25
0.19
0.44
0.12
0.07
0.06
0.31
0.06
0.25
0.06
0.25
0.44
0.25
0.25
0.25
0.50
0.50
Source:Federal Reserve Board of Governors. Rates are expressed in percent. Predictions are from the Money Market Services survey of
economists.
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
Economic Review
23
Table 3
W i l c o x o n Signed-Rank Test of Shift in Skewness
All Sample F O M C Dates
Policy Easings
Before
Policy Move
After
Policy Move
48
-0.090
0.017
48
-0.052
0.020
Number of observations
Mean skewness
Standard deviation
24
112
92*
Number of Pairs
Signed-Rank Test
Critical Value
Policy Tightenings
Before
Policy Move
After
Policy Move
42
-0.160
0.021
42
-0.146
0.020
Number of observations
Mean skewness
Standard deviation
21
106
68*
Number of Pairs
Signed-Rank Test
Critical Value
Note: An (*) denotes 10 percent significance level. The event window spans
two days before the policy move and two days after it. The day of the
move is excluded. The number of observations is the total number of
days included in all event windows; the number of before and after
pairs is the total number of policy moves considered. The Wilcoxon
signed-rank test critical value is the value at or below which a shift in
location is significant at the indicated level.
through August 1994. There were a total of forty-five
policy m o v e s : t w e n t y - f o u r e a s i n g s and t w e n t y - o n e
tightenings. Most of these occurred in 25 basis point
i n c r e m e n t s , with a f e w 50 basis point c h a n g e s and
some of 12.5 basis points (1/8 point) or smaller. In addition, the table shows the results of a Money Market
Services survey of economists taken a couple of days
before the policy moves. Most of the easing moves had
an element of surprise, as the economists on average
underpredicted the magnitude of the changes. The results reported below are stratified into "All F O M C
Sample Dates" and "Dates of Policy 'Surprises' Only."
If the Money Market Services survey reflects general
market expectations, Eurodollar futures prices would
be more likely to j u m p in reaction to a surprise, in the
http://fraser.stlouisfed.org/
24
Economic
Federal Reserve Bank of St. Louis
Review
direction of
more likely
ed b e c a u s e
views about
the target change. Skewness may also be
to change if a policy action is unanticipatm a r k e t p a r t i c i p a n t s m a y r e a s s e s s their
the distribution of LIBOR.
The behavior of skewness is examined around the
time of F O M C policy actions using a standard "event
study" approach. The Wilcoxon signed-rank test, explained in Box 2 (page 27), is used to test for a shift in
s k e w n e s s b e f o r e a n d a f t e r the d a t e o n w h i c h t h e
F O M C changes its federal f u n d s rate target. 1 5 M a n y
factors besides F O M C actions influence measured
skewness; they are unspecified and simply viewed as
"noise" in the data. To reduce some of the noise in the
sample skewness values, an average is taken of daily
values over a window of a fixed number of days before
and after the target-change date. In the tests reported
below, that window is two days before and two days
after a target-change date. The results turn out not to be
extremely sensitive to the number of days in the window; however, increasing the n u m b e r of days in the
average tends to reduce the difference between the before-and-after period. The wider the window, the more
likely other events and n e w s besides F O M C actions
are to affect skewness. (Another consideration is that
increasing the n u m b e r of days makes it m o r e likely
that a rollover into a n e w contract will occur in the
window, which affects skewness and volatility because
both of these moments vary with time to maturity.)
Tables 3 and 4 give the analysis of the skewness
m e a s u r e ' s m o v e m e n t s at the times of federal f u n d s
target changes. In light of the volatility of the skewness measure in Chart 5, it is not altogether surprising
that it is not possible to detect a statistically significant
shift in s k e w n e s s b e f o r e and a f t e r target changes. 1 6
The point estimate for skewness in the two-day window before a target change and that in a two-day wind o w a f t e r the c h a n g e d e c r e a s e f o r e a s i n g s on all
F O M C dates (from - 0 . 0 9 to - 0 . 0 5 ) , but the difference
is statistically insignificant. Furthermore, those dates
categorized as surprises to the market show virtually
no change in point estimates, and the standard deviat i o n s of the e s t i m a t e s are e v e n h i g h e r than f o r all
dates. The results for policy tightening dates are likewise insignificant.
Another piece of evidence that the market reactions
to individual F O M C action is very moderate c o m e s
f r o m examination of the level of the Eurodollar f u tures price. T h e average reaction of these prices to
F O M C m o v e s indicates that policy moves raising or
lowering the federal f u n d s target h a v e only a slight
impact on forward Eurodollar rates. The market may
reassess the likelihood of future policy moves in the
March/ April 1995
same direction, but the change in expectation is small.
Using the same event window as in the measurement
of volatility, an average reaction of the Eurodollar futures rate to target changes was computed. On average, the shortest maturity contract rate dropped about
0.5 percent following easings and j u m p e d about 0.2
percent following tightenings. This shift is slight and
amounts to only about a 1 to 2 basis point change for a
Eurodollar rate of 4 percent. Note that in this study the
shortest-maturity contract had at least ninety days to
maturity, implying that the reaction is to the likelihood
of future policy moves.
Conclusion
Investors and analysts frequently attempt to use financial market prices to divine market expectations.
This kind of exercise is difficult because of the myriad
influences on financial market prices. This article has
shown how the skewness of the distribution of a shortterm interest rate, LIBOR, can be inferred from market
prices. T h e study discussed Bates's (1988) skewness
measure for American futures options and reported a
daily time series of these m e a s u r e s c o m p u t e d f r o m
prices for Eurodollar futures options. Because it is not
clear what factors influence skewness, the recent behavior of the implied skewness is hard to interpret. Individual Federal Reserve policy actions do not have a
discernible impact on measured skewness. However,
the markedly increased degree of skewness in threemonth LIBOR, and perhaps in other short-term interest
rates, since 1992 is striking and potentially important
for the pricing of options and other interest rate contingent claims.
Future research should investigate the cause of the
shift in skewness and also examine skewness in other
interest rate markets. Another task needing attention is
to determine the economic significance of this variation in skewness. Would an option pricing model, such
as that of Steven L. Heston (1993), in which the degree
of skewness is estimated from data rather than imposed
by assumption, outperform standard models? Would
Federal
Reserve Bank of Atlanta
Table 4
W i l c o x o n Signed-Rank Test of Shift in Skewness
Dates of Policy "Surprises" O n l y
Policy Easings
Number of observations
Mean skewness
Standard deviation
Before
Policy Move
After
Policy Move
34
-0.073
0.021
34
-0.071
0.022
Number of Pairs
Signed-Rank Test
Critical Value
17
73
41"
Policy Tightenings
Number of observations
Mean skewness
Standard deviation
Before
Policy Move
After
Policy Move
32
-0.150
0.024
32
-0.146
0.021
Number of Pairs
Signed-Rank Test
Critical Value
16
64
24"
Note: An (*) denotes 10 percent significance level. The event window spans
two days before the policy move and two days after it. The day of the
move is excluded. The number of observations is the total number of
days included in all event windows; the number of before and after
pairs is the total number of policy moves considered. The Wilcoxon
signed-rank test critical value is the value at or below which a shift in
location is significant at the indicated level.
traders using such a model profit from their use of a
" b e t t e r " m o d e l at the e x p e n s e of c o m p e t i t o r s using
models with a poorer match to the actual distribution?
How important are these considerations for risk management and hedging operations? These questions are
fertile ground for continuing work on the topic of the
skewness of interest rate distributions.
Economic Review
25
Box 1
Hedging with Eurodollar Futures and Futures Options
T w o simple examples illustrate the use of Eurodollar
futures and options on those futures for hedging an underlying exposure. First consider the case of a corporate treasurer w h o wants to hedge a floating-rate bond against a
rise in L I B O R , the rate to which the bond is indexed. T o
h e d g e against a rise in three-month L I B O R , a portfolio
m a n a g e r would go short an appropriate n u m b e r of E u rodollar futures contracts. T h e basic hedging mechanism
is that as L I B O R rises, the short futures position gains,
offsetting increased interest payments on the floating-rate
bond.
Chart A shows the relation between cash flows on the
unhedged floating-rate bond and the hedged short futures
and bond position. O n e futures contract with contract size
of $1 million would be sold short for each $1 million in
f a c e v a l u e of the debt. 1 T h e 4 5 - d e g r e e u p w a r d - s l o p i n g
line from the origin represents the interest payout for o n e
floating-rate payment on the bond at a particular date. Assume a futures contract expires on that s a m e date (if not, a
" b a s i s r i s k " will exist b e c a u s e of t h e m i s m a t c h in the
dates for cash flows on the futures and the bond). T h e unhedged bond requires an increase in the interest paid that
m o v e s o n e - f o r - o n e with increases in L I B O R and c o n versely for decreases in L I B O R . Selling a futures contract
short effectively obligates the treasurer to pay the difference between the prevailing L I B O R at expiration of the
futures and the implied L I B O R (that is, 100 - index) at
the time the f u t u r e s contract w a s sold. 2 For e x a m p l e , a
contract sold at 95.00 implies L I B O R of 5 percent. The
short futures sale effectively locks in the implied L I B O R .
For each basis point that L I B O R falls below 5 percent,
the futures contract generates a loss of a basis point, or
$25, while the interest payment on the bond with $1 million face value also drops by $25, an interest saving that
is exactly offset by the future's loss. Conversely, as LIBOR
rises above 5 percent, the futures contract gains a basis
point and the b o n d ' s payment increases by the same, offsetting amount. In other words, the futures contract is a liability when L I B O R is below 5 percent and an asset w h e n
L I B O R is above 5 percent. Chart A depicts the interest
p a y m e n t for the u n h e d g e d and floating-rate b o n d positions. ( T h e interest p a y m e n t is expressed in p e r c e n t a g e
points.) Chart A could also illustrate the use of a long Eurodollar f u t u r e s position in conjunction with a floatingrate b o n d held as an asset. T h e combination locks in a
fixed interest p a y m e n t to the bondholder.
The treasurer could use Eurodollar futures puts as an alternative hedge of the floating-rate bond. These puts hedge
against increases in L I B O R while retaining the possibility
of realizing l o w e r interest costs if L I B O R falls. Strike
prices on the options are available in a range of prices in 25
basis point increments around the implied LIBOR of the
futures contract expiring at the s a m e time as the option.
A s s u m e that the selected strike is a price of 95.00 or 5
percent. Chart B s h o w s h o w the b o r r o w i n g cost varies
with L I B O R on the date an interest p a y m e n t is due. As
before, the u n h e d g e d case has a 45-degree line.
T h e option price is quoted in basis points, each valued
at $25. T h u s , if the option costs 8 basis points, the dollar
cost is $ 2 0 0 for a $1 million face value of bonds being
hedged. B e l o w the strike level of 5 percent, adding the
option increases the total borrowing cost by 8 basis points.
Chart B
Chart A
Interest
Payment
Interest
Payment
Economic
26
Review
M a r c h /April 1995
This cost is properly viewed as that of insuring against a
future level of L I B O R above the strike. For LIBOR at 5
percent and higher, the total borrowing cost levels out at
5.08 percent. Analogous reasoning applies to the case of a
Eurodollar futures call that hedges a floating-rate asset.
Notes
1. In actual practice, a hedge is "tailed," that is, the number
of contracts held long or short is reduced to adjust for the
effect of daily resettlement and interest on futures margin
accounts (see Duffie 1989, 239-41). Futures require daily
marking-to-market, which effectively settles and reestablishes the futures position each day. Tailing a futures position achieves a better hedge between the futures position
on which daily gains and losses are realized immediately
and the underlying position on which those gains and losses are deferred until a future date.
2. The description in the text is a simplification that treats a
futures contract as a forward contract. As observed in the
previous note, futures contracts are marked to market
daily.
Box 2
Testing for a Shift in Skewness
T h e W i l c o x o n s i g n e d - r a n k test is a n o n p a r a m e t r i c
test; it does not rely on any assumptions about the distribution of the sample statistic. Specifically, no assumption
is m a d e about how skewness is distributed. The sample
under consideration consists of twenty-four easings and
twenty-one tightenings, which are e x a m i n e d separately.
T h e s e c o n s t i t u t e small s a m p l e s , and c o n s e q u e n t l y the
measurement of average skewness is subject to a nontrivial sampling error that is accounted for in evaluating the
statistical s i g n i f i c a n c e of the b e f o r e a n d a f t e r a v e r a g e
skewness.
T o use t h e s i g n e d - r a n k test, the d i f f e r e n c e s in the
measured s k e w n e s s b e f o r e and after the p o l i c y - c h a n g e
date are computed for each of the twenty-four easing and
twenty-one tightening dates, which as just noted are tested separately. If there is no shift in skewness, both the
sign and magnitude of the differences in skewness will
vary purely because of sampling variation—that is, because of r a n d o m errors in the m e a s u r e m e n t of skewness.
The signed-rank test is based on the intuition that if the
null hypothesis of equal before-and-after distributions is
true, half of the skewness differences will be positive and
half negative in large samples. Furthermore, positive and
negative differences of the s a m e absolute value in magnitude should be equally likely to be observed.
Federal
Reserve B a n k of Atlanta
T h e c o m p u t a t i o n of t h e W i l c o x o n s i g n e d - r a n k test
statistic is s t r a i g h t f o r w a r d . T h e s k e w n e s s d i f f e r e n c e s
f r o m each of the dates of Fed f u n d s target changes are
ranked by absolute value of the difference f r o m smallest
to largest. (They are ranked 1, 2, 3 , . . . , with ties getting
an averaged rank.) Then the sum of the rankings for negative d i f f e r e n c e s and that f o r p o s i t i v e d i f f e r e n c e s a r e
c o m p u t e d . T h e null hypothesis is that the positive and
negative rank sums are equal. T o be conservative, no a
priori view of h o w s k e w n e s s c h a n g e s b e f o r e and after
target-change dates is made, and consequently a so-called
t w o - s i d e d test of the signed-rank statistic is used. T h e
smaller of the positive and negative rank s u m s is c o m p a r e d w i t h t a b u l a t e d critical v a l u e f o r t h e W i l c o x o n
signed-rank test. (See William M e n d e n h a l l , Richard L.
Scheaffer, and Dennis D. Wackerly 1981 for further details about this lest and for a table of the critical values.)
If the c o m p u t e d rank sum is less than or equal to the critical value, the null hypothesis is rejected and a d i f f e r e n c e
in the mean of the before-and-after distributions is detected (subject to the usual caveat about statistical type I errors).
Economic
Review
27
Notes
1. T w o other familiar examples of the anticipatory nature of
prices are the dividend discount model of slock prices and
the expectations theory of the term structure for bond prices
(or, equivalently, interest rates). The dividend discount model collapses a future expected, infinite stream of dividend
payments into a present value, the stock price, by discounting each of the expected cash flows by a discount factor (see
Bodie, Kane, and Marcus 1989). Changes in either the discount factor—the time value of money and an adjustment
for risk—or the expected dividend affect the current stock
price. Similarly, the expectations theory links longer-term
bond prices with shorter-term bond prices through expected
future bond prices that equate holding period returns (sec
Abken 1993). Both of these examples are of a market's evaluation of the mean or average prices of cash flows that will
occur.
2. Option-implied volatility has been extensively analyzed.
Feinstein (1988) and Canina and Figlewski (1993) discuss
the accuracy of implied volatility in equity index options as
forecasts of volatility.
3. Skewness is technically the normalized third central moment
of a distribution. See note 10 for the formal definition. The
first moment is the mean and the second central moment is
the variance. Some distributions are uniquely characterized
by a small set of moments. For example, the normal distribution, which has zero skewness, is completely characterized
by its mean and variance.
4. One study in a similar vein to this article but conducted using a much different methodology is Das (1995). He estimated a model of short-term interest rate movements that allows
for gradual (that is, continuous) rate changes and jumps (discontinuities in the path of rates.) He found that there is a statistically significant increase in the " j u m p " probability
immediately following F O M C meetings. He concluded that
during the 1980s markets tended more to react to F O M C actions than to anticipate them. He also found evidence of
skewness, although his focus is on kurtosis. Kurtosis is related to the fourth moment of a distribution (whereas skewness
is related to the third) and refers to the thickness of the tails
of the distribution. The occurrence of jumps in interest rates
increases the thickness of the tails—there is a greater probability of observing "outliers" for such a distribution compared with one for which jumps do not occur.
5. Alternative contracts to three-month Eurodollar futures are
one-month LIBOR and 30-day federal funds futures contracts. These have shorter maturities and might be more sensitive to Federal Reserve policy actions. However, they are
too thinly traded (volumes of only a few thousand contracts)
and, most important, do not have options associated with
them.
6. A number of researchers have independently formulated a
new approach to option valuation that attempts to "back out"
the implied probability distribution of equity index prices
from quoted option prices on the index. Rubinstein (1994),
Shimko (1993), Derman and Kani (1994), and Dupire (1994)
http://fraser.stlouisfed.org/
Economic
28
Federal Reserve Bank of St. Louis
Review
all extract the implied probability distribution from traded,
liquid options in order to price other, less liquid options consistently across instruments. Their objective is to price exotic
options like barrier and lookback options. Rather than assuming a particular distribution that governs the movements
of the underlying price, they infer the distribution from quoted prices and recognize that this distribution can vary over
time.
7. The following discussion derives from Bates (1991).
8. The exposition makes the simplifying assumption that the
expected payoff can be discounted at a fixed instantaneous
rate, r. Making this assumption is justified in the context of
Eurodollar futures options later in the text.
9. Forward prices are equal to futures prices only if interest
rates are deterministic (see Cox, Ingersoll, and Ross 1981).
For a short Eurodollar futures position, rising interest rates
will result in positive marked-to-market cash Hows that are
not realized by a short forward position. For both types of
contracts to be held in equilibrium, futures prices have to be
higher than forward prices. Flesaker (1993) points out that in
practice the difference is negligible for contract maturities
less than one year.
10. Bates's measure of skewness in options prices is distinct
from the standard statistical measure of skewness based on
the central third moment of a data sample of N observations:
N i=i
t
•--•Tèi!«-1*
Skewness =
N'
(N-l)(N-2)
m3
s3 .
(from Doan 1994, p. 14-238). Furthermore, the skewness
measured using option prices is that of the risk neutral distribution, whereas skewness computed from actual data, in this
case a time series of LIBOR, is that of the actual probability
distribution.
11. See also Tompkins (1989) for an application to Eurodollar
futures options. However, Tompkins incorrcctly ignores the
early exercise feature of these options in discussing valuation.
12. The plotted implied volatility of the HJM model with proportional volatility in Figure 1 of Amin and Morton (1994)
is very close to that in Chart 4 below. Both plots show the
history of a proportional volatility of the " s p o t " rate, although in the HJM model the spot rate is stochastic and the
early exercise premium is evaluated by backward recursion
through a nonrecombining binomial tree. However, Amin
and Morton find that the average implied volatility of puts is
greater than that for calls during January 1987 to November
1992.
13. Cubic splines were fit to the call and put option prices on
any given day. The method of natural cubic splines de-
M a r c h / April 1995
scribed in Press and others (1988) was used. The value oi 10
percent out of the money was used because, by trial and error, it was determined that this is the maximum degree of
out-of-the-moneyness that could be used to plot a time series
of volatilities with relatively few missing daily observations.
A greater degree of out-of-the-moneyness resulted in an increasing lack of availability of puts or calls to make the computations. Also, as Bates (1988) points out, in-the-money
options can also be used to assess skewness. However, these
tend to be less liquid and the skewness measures derived
from them tend to differ substantially from those derived
from the out-of-the-money options.
14. Federal Reserve monetary policy could be viewed as being
endogenous to the business cycle. Skewness may be conditional on the stage of the business cycle as perhaps gauged
by the level of short-term interest rates. Unconditional skew-
ness could be constant in the long run. In that case an endogenous shift in conditional skewness may have occurred
in late 1992. Unfortunately, the sample contains only one
observation on this kind of shift. On the basis of the Eurodollar futures evidence, there is no way to tell whether the
shift in skewness (and Fed policy) is exogenous or endogenous.
15. During the period of this study, Federal Reserve interventions in the federal funds market occurred between 10:30
A.M. and 10:45 A.M. Chicago time, although on occasion
open market operations took place outside of these times
(see Smith and Webb 1993).
16. A similar test was done for changes in volatility for both
puts and calls. The results also indicated statistically insignificant changes in volatility.
References
Abken, Peter A. "Innovations in Modeling the Term Structure of
Interest Rates." In Financial Derivatives: New
Instruments
and Their Uses. Atlanta: Federal Reserve Bank of Atlanta,
1993.
Amin, Kaushik I., and Andrew J. Morton. "Implied Volatility
Functions in Arbitrage-Free Term Structure Models." Journal of Financial Economics 35 (1994): 141-80.
Barone-Adesi, Giovanni, and Robert E. Whaley. "Efficient Analytic Approximation of American Option Values." Journal of
Finance 4 2 (June 1987): 301-20.
Bates, David S. "The Crash Premium: Option Pricing under
A s y m m e t r i c Processes, with Applications to Options on
Deutschemark Futures." Rodney L. White Center for Financial Research, Working Paper 36-88, October 1988.
. "The Crash of '87: Was It Expected? The Evidence from
Options Markets." Journal of Finance 46 (July 1991): 100944.
Black, Fischer. "The Pricing of Commodity Contracts." Journal
of Financial Economics 3 (1976): 167-79.
Black, Fischer, and Myron S. Scholes. "The Pricing of Options
and Corporate Liabilities." Journal of Political Economy 81
(May/June 1973): 637-54.
Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments. Homewood. 111.: Irwin, 1989.
Canina, Linda, and Stephen Figlewski. "The Informational Content of Implied Volatility." Review of Financial Studies 6
(1993): 659-81.
Chicago Mercantile Exchange. Rules of the CME. November
1994.
Cox, John C., Jonathan E. Ingersoll, and Stephen A. Ross. "The
Relation between Forward Prices and Futures Prices." Journal of Financial Economics 9 (1981): 321 -46.
Cox, John C., and Mark Rubinstein. Options Markets. Englewood Cliffs, N.J.: Prentice-Hall, 1985.
Das, Sanjiv R. "Jump-Diffusion Processes and the Bond Mark e t s . " Harvard B u s i n e s s S c h o o l , Division of Research,
Working Paper 95-034, 1995.
DigitizedFederal
for FRASER
Reserve B a n k of Atlanta
Derman, Emanuel, and Iraj Kani. "Riding on a Smile." Risk 1
(February 1994): 32-39.
Doan, Thomas A. RATS User's Manual, Version 4. Evanston,
111.: Estima, 1992.
Duffie, Darrell. Futures Markets. Englewood Cliffs, N.J.: Prentice Hall, 1989.
Dupire, Bruno. "Pricing with a Smile." Risk 7 (January 1994):
18-20.
Feinstein, Steven P. "A Source of Unbiased Implied Volatility
Forecasts." Federal Reserve Bank of Atlanta, Working Paper
88-9, December 1988.
Flesaker, Bjom. "Arbitrage Free Pricing of Interest Rate Futures
and Forward Contracts." Journal of Futures Markets 13
(1993): 77-91.
Goldstein, Morris, David Folkerts-Landau, Peter Garber, Liliana
Rojas-Suárez, and Michael Spencer. International
Capital
Markets, Part I: Exchange Rate Management and International Capital Flows. World Economic and Financial Surveys. Washington, D.C.: International Monetary Fund, April
1993.
Goodfricnd, Marvin, and William Whelpley. "Federal Funds."
In Instruments of the Money Market, edited by Timothy Q.
Cook and Timothy D. Rowe. Richmond: Federal Reserve
Bank of Richmond, 1986.
Heath. David, Robert A. Jarrow, and Andrew J. Morton. "Bond
Pricing and the Term Structure of Interest Rates: A New
Methodology." Econometrica 60 (January 1992): 77-105.
Heston, Steven L. "Yield Curves and Volatility." Yale School of
Organization and Management, unpublished manuscript, July 1993.
Jarrow, Robert A., and Andrew Rudd. Option Pricing. Homewood, 111.: Irwin, 1983.
Mendenhall, William, Richard L. Scheaffer, and Dennis D.
Wackerly. Mathematical Statistics with Applications. 2d ed.
Boston, Mass.: Duxbury Press, 1981.
Press, William H., Brian P. Flannery, Saul A. Teukolsky, and
William T. Vetterling. Numerical Recipes in C: The Art of
Economic
Review
29
Scientific
Computing.
New York: C a m b r i d g e University
Press, 1988.
Rubinstein, Mark. "Implied Binomial Trees." Journal
of Fi-
nance 49 (July 1994): 771-818.
Shimko, David. "Bounds of Probability." Risk 6 (April 1993):
33-37.
Smith, David G „ and Robert I. Webb. "The Volatility of Eurodollar Futures Prices around Fed Time." The Journal of
Fixed Income 2 (March 1993): 58-73.
http://fraser.stlouisfed.org/
Economic
30
Federal Reserve Bank of St. Louis
Review
Tompkins, Robert. "The A-Z of Caps." Risk 2 (March 1989):
21-23,41.
Vogel, Thomas T., Jr. "Fed Rate Boost Spurs Rally in Bond
Markets." Wall Street Journal, August 17,1994, C I , CI 9.
Whaley, Robert E. "Valuation of American Futures Options:
Theory and Empirical Tests "Journal of Finance 41 (March
1986): 127-50.
M a r c h / April 1995
FYI
Examining Small
Business Lending in
Bank Antitrust Analysis
W. Scott Frame
J
g
r
K
f
j
^
ueled by the repeal of many depression-era interstate banking
and intrastate branching laws, the U.S. banking industry has entered an unprecedented period of consolidation and reorganization. In fact, between 1990 and 1994 there were more than 1,500
_ J L
b a n k m e r g e r s and a c q u i s i t i o n s (Ed Dillon 1995). T h i s bank
merger wave has sparked public policy debate about the desirability of such
combinations, particularly in the context of antitrust evaluation. The U.S. Department of Justice and bank regulators, such as the Federal Reserve, are responsible for preserving and protecting competition in the midst of industry
consolidation. 1
The author is an economic
analyst in the financial
section
of the Atlanta Fed's research
department and a Ph.D.
candidate in the economics
department of the University
of Georgia. He thanks
Christopher Holder, Frank
King, Larry Wall, and
especially Aruna
Srinivasan
for helpful
comments.
Federal
Reserve Bank of Atlanta
Although all corporate merger applications are evaluated uniformly (as
outlined in U.S. Department of Justice 1992), legal precedent has established
unique parameters for analyzing bank mergers. 2 Given the large technological and regulatory changes the financial services industry has experienced in
recent years, many have questioned whether a m o v e toward a more traditional product-based antitrust analysis would better reflect today's market realities, in which many retail and large-firm lending markets have numerous
nonbank competitors (competing over wider geographic areas) whose presence reduces concentration concerns in these markets. At the same time, the
market for small business loans has been of particular interest to both bank
Economic Review
31
regulators and the Justice Department because of the
lack of nonbank competitors and the local limitations
of customers.
The increased attention to small business lending in
bank merger applications has effectively m o v e d antitrust authorities away f r o m an aggregate approach to
product market definition. 3 Macroeconomic concerns
as well as changes in the banking industry have driven
this shift in focus. The importance of small businesses
within the U.S. economy was highlighted during the
most recent economic recession (1990-92) as the credit crunch stifled innovation and employment in many
small firms.
Recent academic literature on banking antitrust analysis has found the market for unsecured small business
loans to be u n i q u e b e c a u s e of the " l o c a l " nature of
these loans and the lack of nonbank competition. Alt h o u g h t h e o r e t i c a l l y a p p e a l i n g , d i s a g g r e g a t i n g the
product market for banking (and examining small business lending) suffers f r o m several measurement problems resulting from a lack of reliable data.
This article intends to provide an overview of recent developments in banking antitrust analysis, particularly in the area of small business lending. T h e
article begins by outlining the traditional approach to
antitrust analysis. The next section provides a historical perspective on legal precedents in banking antitrust
analysis and discusses h o w changes in the financial
services marketplace m a y influence such analysis in
the future. In particular, through a summary of the academic literature, the article examines the importance
of small business lending as a unique product market.
Finally, the article discusses the potential costs and
benefits to disaggregating the product market for purposes of antitrust analysis and highlights some policy
considerations.
Antitrust Analysis
Defining the relevant product and geographic markets is critical to conducting a complete competitive
analysis of any corporate merger. All firms that influence (or could potentially influence) market prices of
the goods or services in question should be included in
the analysis. 4 In general, a market includes buyers and
sellers in a geographic area that can significantly influence the price, the quality, or the quantity of the specific commodities or services traded. A market can also
be delineated as a geographic area in which the prices
of all similar (substitute) goods are dependent on each
Economic
32
Review
other but are unaffected by prices for such goods outside of this area.
The Product Market. Dennis Carlton and Jeffery
Perloff (1994) note that a proper definition of the product dimension of a market should include all products
that are close demand or supply substitutes. For example, Product B is a demand substitute for Product A if
an increase in the price of A causes consumers to use
more B instead. Product B is a supply substitute for
Product A if, in response to an increase in the price of
A, firms producing B switch some of their production
facilities to the production of A. In both cases, the presence of Product B significantly constrains the pricing
of Product A, provided that an increase in the price of
A would result in either a significant decline in the
quantity of A consumed as consumers switch from A
to B or a significant increase in the supply of A as
firms switch production from B to A.
Two Supreme Court decisions, both involving nonfinancial institutions, stand out as providing guidance
in establishing relevant markets in antitrust matters:
United States v. E.I. DuPont de Nemours & Co. (1956)
and Brown Shoe Co. v. United States (1962). 5 In the
DuPont ruling, the court recognized that all products
have substitutes and that a m a j o r task of antitrust analysis is the identification and evaluation of these substitute products. The court stated that product markets are
to be determined by the cross-elasticity of demand between the product claimed to be monopolized and other products. (Cross-elasticity of demand refers to the
relationship b e t w e e n the quantity d e m a n d e d of one
product and a change in the price of another. The more
responsive the quantity of a product demanded is to a
price c h a n g e in another good, the higher the crosselasticity and the more the products are viewed as substitutes for each other.) Depending on the degree of
cross-elasticity, products may be categorized as either
perfect substitutes, close substitutes, or nonsubstitutes.
In the Brown Shoe Company case, the court affirmed
its position regarding cross-elasticities of demand and
p r o v i d e d the f o l l o w i n g seven criteria to be used in
defining antitrust markets and/or submarkets: (1) industry or public recognition, (2) a product's peculiar
characteristics and uses, (3) unique production facilities, (4) distinct customers, (5) distinct prices, (6) sensitivity to price changes, and (7) specialized vendors.
On the supply side, the Justice Department's 1992
Horizontal Merger Guidelines specify that the relevant
antitrust market includes firms that are currently producing and selling the relevant product as well as "uncommitted entrants," or firms that likely would readily
enter the market without significant sunk costs in re-
March/ April 1995
sponse to a " s m a l l but significant nontransitory increase" in the market price. 6 Because additional market
entrants help deter the original firm from exercising its
market power (its ability to profitably maintain a price
above the opportunity costs of its resources), their presence enhances competition. In theory, a measurement
of cross-elasticity of supply would be relevant in determining the level of potential competition in a market.
In practice, however, cross-elasticities cannot be used to
precisely determine markets because estimation is difficult and current theory does not define specific numerical levels at which one product is viewed as an adequate
substitute for another. Also, substituting products may
not be feasible in the short term because it could involve changing production processes. As a result, the
courts' definition of the relevant market includes only
those producers that might have a direct and immediate
effect on competition.
Geographic Markets. Once the relevant products
have been identified, g e o g r a p h i c m a r k e t s are determined for each product. The geographic limit of a market is determined by simply answering the question of
whether an increase in price in one location substantially affects price in another. If so, then both locations are
in the same market. 7
Market Concentration and Structure. After both
the product and geographic markets have been determined, the level of competition must be assessed. In assessing market power, economists are concerned with
the level of the sellers' concentration in a market. This
level is a function of both the number of firms and their
respective market shares, or the percentage of the market supplied (or controlled) by a particular firm during a
specified time period. 8 The most popular measure of
market concentration is a concentration ratio, which
shows the level of market shares accounted for by the
largest firms in a particular market. 9 S o m e analysts,
h o w e v e r , c o n s i d e r the H e r f i n d a h l - H i r s c h m a n Index
(HHI) to be analytically superior to a simple concentration ratio because it takes into account both the number
and size distribution of the sellers in the market. 1 0
Competitive analysis of corporate mergers (including
those in banking) relies heavily on theories developed
in the subfield of economics known as industrial organization. Specifically, the structure-conduct-performance
(SCP) paradigm serves as the cornerstone of antitrust
analysis because the structure of a market (that is, its
degree of concentration) is viewed as revealing information about the level of competition within it." In the
SCP paradigm, an industry's competitive performance
depends on the conduct of buyers and sellers, which
depends on the structure of the market. The structure,
Federal
Reserve Bank of Atlanta
in turn, is based on conditions such as technology and
demand for a product.
The relationship between market structure (level of
concentration) and performance (profits or prices) implied by the structure-conduct-performance theory has
been studied extensively. Alton Gilbert (1984) reviewed
the earliest structure-performance studies of the banking industry, noting that they provided limited support
f o r the S C P p a r a d i g m a n d s u f f e r e d f r o m v a r i o u s
methodological flaws. Of particular concern was that
many of these early studies treated market structure as
exogenous (that is, determined outside of the marketplace), implying that competition between firms has no
effect on structure. 12 A s a result, these studies were unable to distinguish between market power and production e f f i c i e n c y as the s o u r c e of c o n c e n t r a t i o n and
profitability. Sherill S h a f f e r (1994) pointed out that
economic theory implies that an efficient firm (one delivering either a superior product or operating at a lower
cost) can drive its rivals out of a competitive market unless the rivals are able to emulate the successful firm. It
follows that such superiority would result in both high
profitability and a large market share for the successful
firm, resulting in a more concentrated market (despite
the vigor of competitors).
Other recent articles, such as Michael S m i r l o c k ' s
(1985) and Allen Berger's (1991), have addressed the
need to account for cost d i f f e r e n c e s b e t w e e n institutions. Both Smirlock and Berger find that the link
between concentration and profitability largely disapp e a r s a f t e r a c c o u n t i n g for relative p r o d u c t i o n e f f i ciency. However, Douglas Evanoff and Diana Fortier
(1988) f o u n d that s o m e of the p r o f i t - c o n c e n t r a t i o n
linkage may persist, even after considering efficiency,
in markets with substantial barriers to entry. In addition, Shaffer (1994) noted that studies of the relationship between prices and concentration have generally
found evidence that high market concentration is correlated with prices unfavorable to the consumer. 1 3 Inherent in all of these results is the notion that commercial
banking is a distinct line of commerce, that banks compete in local market areas, and that nonbank competition is negligible.
Competition in the Banking Industry
The evaluation of competition within banking markets begins with a discussion of the relevant product
market. Legal precedent has established commercial
banking as a distinct line of c o m m e r c e — e f f e c t i v e l y
Economic Review
33
bundling together the various products and services offered by these institutions. This definition does not reco g n i z e n o n b a n k financial institutions as significant
competitors in several of the individual banking products. 14 Yet, in fact, competition from nonbanks serves to
lessen b a n k s ' market power, and, if formally recognized, such competition lowers the level of concentration within these product markets.
The Cluster Approach. In a 1963 case involving
Philadelphia National Bank the Supreme Court clarified the m e a n s by which regulators should m e a s u r e
competition in the banking industry." Christopher L.
Holder (1993a) noted that this ruling established three
m a j o r legal precedents still used by the Federal Reserve. First, the court confirmed that the Sherman and
Clayton Antitrust Acts apply to banking and used market structure as an indicator of competition within the
market. Second, the ruling determined that "the cluster
of products (various kinds of credit) and services (such
as checking accounts and trust administration) denoted
by the term 'commercial banking' . . . composes a distinct line of c o m m e r c e " f o r C l a y t o n Act p u r p o s e s .
Third, the decision indicated that the sections of the
country affected by an acquisition (the geographic market) must be taken into account. 1 6 In sum, the Philadelphia National case established commercial banking as
a distinct line of commerce, defined the relevant product market as including only those institutions offering
the full cluster of bank products and services (including
d e m a n d deposits and c o m m e r c i a l loans), and determined the relevant geographic market to be local. This
ruling runs counter to the typical product market analysis employed in other industries.
The Philadelphia National judgment establishing the
so-called cluster approach was reaffirmed by rulings in
cases involving Phillipsburg National Bank (1970) and,
more recently, Central State Bank (1985). 17 In the Central State Bank case, the Department of Justice proposed
that the relevant product market be strictly composed
of transactions accounts and small business loans, the
p r o d u c t s in which b a n k s generally h a v e the f e w e s t
competitors. 1 8 T h e court dismissed these a r g u m e n t s
and stated that, while there may be identifiable submarkets within the commercial banking market, "submarkets are not a basis for the disregard of a broader line
of commerce that has economic significance. In selecting between two product markets, the court must select
the one which will reflect the full brunt of any and all
anticompetitive effects of the challenged acquisition or
m e r g e r " (1291). Therefore, in the Central State Bank
case the Supreme Court determined that the cluster of
products and services termed "commercial banking" has
Economic
34
Review
economic significance well beyond the various products and services involved.
The individual bank products discussed in the Philadelphia National case represented varying degrees of
geographic market delineation. The "cluster of banking
products and services" not only aggregated products
but it also defined (in essence) a local market that represented some sort of "average" of the actual geographic
markets of the individual products. In measuring the
" c l u s t e r , " the court used d e p o s i t s as a p r o x y f o r a
b a n k ' s capacity to provide cluster products and services and then estimated market shares in an attempt to
uncover any existing market power. This approach to
product market analysis serves to reduce costs to both
potential bank acquirers and regulators performing the
analysis by reducing uncertainty about the appropriate
product market definition. However, as the financial
services industry has evolved and the levels of competition in various products have changed in response to
t e c h n o l o g y and n o n b a n k entry, legal p r e c e d e n t has
lagged because the courts have not yet recognized subproduct markets in banking.
T h e I m p a c t of N o n b a n k Competitors. E x a m i n ing the relevant antitrust product market-for banking is
challenging because the distinctions a m o n g different
types of financial institutions have blurred in the last
two decades. Deregulation, market innovation, and advances in electronic technology in recent years have
widened the range of institutions and the distance over
which households and firms select financial services.
T h e a u t h o r i z a t i o n of i n t e r e s t - b e a r i n g c h e c k i n g accounts, the spread of automated teller machines, and
the growth of nationwide issuers of credit cards have
been instrumental changes for financial institutions.
Regulatory changes have allowed thrifts and other nonbank financial institutions to offer a greater number of
services and have permitted producers of specialized
financial services (such as mortgage and finance companies) to offer services in any market.
In a 1974 case involving Connecticut National Bank
the S u p r e m e Court upheld its Philadelphia National
ruling but noted that thrifts and other nonbank institutions had made competitive inroads in some services. 19
However, the court concluded that thrifts should not, at
that time, be a factor in assessing the competitive effects of bank mergers because thrifts were not c o m petitive in the area of commercial lending. With the
passage of the Depository Institutions Deregulation
and Monetary Control Act of 1980 ( D I D M C A ) and the
Garn-St Germain Act of 1982, thrifts were authorized
to compete with banks in providing the cluster of products previously unique to banking. 2 0 Nevertheless, al-
March/ April 1995
though m a n y thrifts h a v e b e c o m e competitive retail
lenders, m o s t h a v e not been aggressive c o m m e r c i a l
lenders. For this reason, the Federal Reserve, in assessing the competitive effects of a merger using the "cluster" approach, accords thrift deposits 50 percent weight
to reflect both actual and potential c o m p e t i t i o n by
these firms. 2 1 Tn addition, the Fed's assessment makes
allowances in the threshold levels of changes in the
Herfindahl-Hirschman Index (HHI) for bank mergers
to reflect n o n b a n k competition. 2 2 In short, n o n b a n k
firms have significantly enhanced retail banking competition, resulting in the modification of bank merger
analysis. H o w e v e r , the m a r k e t for u n s e c u r e d small
business loans has experienced little competition from
nonbanking firms.
The Role of Small Business Lending
Although the "cluster" of banking services remains
the appropriate product market definition as defined by
legal precedent, the Department of Justice has recently begun examining subproducts, particularly loans to
small businesses, in its merger analysis. 23 Recent academic literature has indicated that special attention to
small business lending may be warranted because of
the "local" nature of these loans and the relative absence
of nonbank competitors in the provision of unsecured
business credit. 2 4 Such a disaggregated analysis, while
in the mainstream of antitrust, stretches legal precedent
for banking. This approach has been somewhat controversial in that it has increased uncertainty for merging
parties and has not yet been tested in the courts, principally because banks are reluctant to incur the costs associated with prolonged litigation. 25
Whether sanctioned or not by legal precedent, there
may be an economic basis for treating small business
loans as a unique product. Two recent studies have examined the behavior of small firms and their banking
relationships. Gregory Elliehausen and John Wolken
(1990) f o u n d that small f i r m s are m o r e likely than
large firms to depend on their primary institution for
credit and to use fewer financial institutions in general.
T h e i r research c l a i m s that the costs financial institutions incur for credit evaluation, monitoring, and
bankruptcy tend to be higher, relative to the size of the
transaction, for small firms than for large firms. This
cost difference is enhanced when the financial institution is a distant one. As a result, distant suppliers (or
lenders) are less likely to accept credit applications
from small firms, particularly distant ones, than from
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
large firms, especially when the desired credit would
be unsecured.
Mitchell Peterson and Raghuram Rajan ( 1994) discuss the ways in which the relationship between a firm
and its creditors a f f e c t s the availability and cost of
f u n d s to f i r m s . 2 6 Using a s a m p l e of small b u s i n e s s
loans, Peterson and Rajan find that the availability of
f u n d s increases and the cost of f u n d s decreases, although relatively less so, as a result of a continuing
relationship. The authors discuss two important dimensions of credit relationships—duration and the interaction over a number of products. Duration is important:
the longer a business has been servicing its loans, the
more likely the business is to be viable and the owner
trustworthy. Therefore, the lender expects the loans to
be less risky, reducing the expected cost of lending and
increasing the willingness to provide funds. A f i r m ' s
use of multiple products can also affect future borrowing by either increasing the precision of the lender's
information or by spreading the fixed costs of information gathering over multiple products.
Peterson and Rajan also point out that information
asymmetries between small firms and potential public
investors are substantial because these firms are unlikely to be monitored by rating agencies or the financial
press. This asymmetric information, by increasing the
uncertainty of lenders, implies that lenders will charge
borrowers higher interest rates to compensate for higher
risk. In fact, Joseph Stiglitz and Andrew Weiss (1981)
show that the interest rate charged determines not only
the demand for capital but also the riskiness of borrowers. If this observation is true, lenders may optimally
choose to ration the quantity of loans they grant rather
than raising the rate to clear the market. This second
effect may imply that the problems of adverse selection
and moral hazard m a y have a sizable effect for small
firms. 2 7 As a result, small firms generally must rely on
their primary local institution for unsecured credit because their close relationship will reduce these information asymmetries. 2 8
C o m p e t i t i o n in b u s i n e s s lending f r o m n o n b a n k s ,
such as commercial finance companies and factoring
companies, is primarily concentrated in collateralized
(secured) lending. In contrast to collateralized lending,
monitored (unsecured) lending requires the lender to
watch the borrower's financial condition closely. Banks
are c o n s i d e r e d to h a v e a c o m p a r a t i v e a d v a n t a g e in
monitored lending because they are better able to obtain information about the financial condition of borrowers. 2 9 Specifically, banks can monitor loans through
their access to borrowers' transaction accounts. Leonard
Nakamura (1992/1993) notes that a small firm's checking
Economic Review
35
account sheds light on its revenues and expenses because the firm's cash flows are typically documented
completely within that one account. Nakamura proposes this "checking account hypothesis" as an explanation of the resolution of information asymmetries that
arise in some small-business lending situations.
Nonbanks provide only a very limited amount of unsecured small business credits. The issue of small business loan securitization has been explored recently in
search of ways to improve small businesses' access to
credit. George Benston (1992) and Christopher Beshouri and Peter Nigro (1994) concluded that the characteristics of small firm finance (especially informational
asymmetries and ongoing monitoring) impose significant costs that may offset any funding advantages to
securitization. Thrift institutions, while having both the
authority to underwrite business loans and access to
transactions accounts, have not become a significant
competitor in this area. The financial troubles faced by
thrifts in the last ten years have, in fact, resulted in substantial cutbacks in their c o m m e r c i a l and industrial
loan portfolios. Timothy H a n n a n and J. Nellie Liang
(1995) assessed the competitive influence of thrift institutions on the pricing of commercial loans m a d e by
commercial banks. The study's empirical tests suggest
that thrifts should not be given consideration in antitrust
evaluations of business lending for bank mergers.
Contrasting the Cluster and Disaggregated Approaches to Antitrust Analysis
T h e Justice D e p a r t m e n t ' s m a n n e r of d e f i n i n g the
relevant p r o d u c t m a r k e t ( s ) f o r b a n k i n g — i n d i v i d u a l
products and services (particularly loans to small businesses)—parallels analysis conducted in other industries and is consistent with both theoretical and empirical
evidence. However, legal precedent still maintains that
"the cluster of commercial blinking products and services" is the relevant product market. To examine the
policy implications of changing the approach to bank
merger analysis, an accounting of the various costs and
benefits must be made.
In evaluating the cluster approach, the potential cost
to be considered is that of market power arising from
an approved merger, which results in a consumer welfare loss. 30 This loss would typically result from borr o w e r s p a y i n g h i g h e r rates on loans and d e p o s i t o r s
receiving lower interest on savings. Because many retail and large-firm lending markets appear to have access to a wide range of nonbank competitors, market
Economic
36
Review
power does not seem, in general, to be the important
consideration it is in other product markets. However,
there is evidence that unsecured loans to small businesses (working capital loans) do tend to be local and
are not often provided by nonbank lenders. As a result,
any market power realized as a result of a combination
would likely be in the area of loans to small businesses.
In fact, Hannan (1991) provides evidence that small
commercial loans are local in nature and that the level
of concentration in a market significantly affects the
pricing of these loans. Hannan's findings suggest that a
closer examination of the market for small business
loans is warranted when regulators are evaluating the
competitive effects of a merger.
The cluster approach to bank merger analysis does
have an advantage in that institutions, when considering a merger, can o v e r c o m e most of the uncertainty
surrounding antitrust evaluations. Specifically, banks
can analyze the necessary data themselves prior to perf o r m i n g due diligence analysis or e n g a g i n g consultants, resulting in substantial cost savings. 31 Institutions
can thus tender offers m o r e confidently, having addressed antitrust concerns in advance. In addition, regulators save valuable public resources - by conducting
fewer detailed investigations in antitrust cases involving merging parties that have not examined these competitive issues prior to filing an application. Such cases
generally result in the withdrawal of the application—
after the parties involved and their respective regulators have expended significant resources.
Another possible approach would be to break up
the cluster (and analyze individual product markets),
but doing so would present a significant cost in that uncertainty would be increased for actual (and potential)
applicants. This uncertainty would concern which particular subproduct(s) markets would be examined (and
how these markets would be defined geographically)
as well as the lack of accurate data for analysis. 32 For
example, in assessing competition for small business
loans, if a bank operates in several geographic markets,
regulators may be unable to surmise the level of business lending within a particular market area. A s a result, estimates must be constructed for each institution
based on its total deposits, total small business loans,
and market deposits. (See the box on page 38 for a discussion of the determination of market shares for small
business lending.)
These estimations raise questions as to the accuracy
of competitive evaluations of small business lending
for several reasons. First, conditions within individual
markets may differ, and the commercial loan-to-deposit
ratio for the whole institution may bear little resem-
March/April 1995
blance to its ratio in a specific market. In fact, this
problem may become even greater after interstate
branching takes effect in 1997, as banks consolidate
their individual subsidiaries into branches. S e c o n d ,
evaluations are made by examining total small business
loan amounts outstanding rather than using the number
of loan originations. Institutions with very few (but relatively large) loans or those that have recently been inactive business lenders may be given disproportionate
weight. Third, it is not disclosed in the Call Report submitted by banks (see the box) whether the loans are secured. Fourth, the Call Report defines loans to small
b u s i n e s s e s as " s m a l l l o a n s , " or loans with original
amounts of less than $ 1 million. Information on the size
of the businesses receiving these loans is not available.
Efforts to overcome the aforementioned problems
have centered on calling each of the individual institutions in the relevant geographic market. In theory, more
accurate data could be obtained directly f r o m bank
branches; however, this approach only poses a new set
of problems. First, these efforts can be quite costly (in
terms of labor hours) to the institutions not involved in
the proposed merger. A s a result, they have little incentive to c o m p l y with the regulatory request for data.
Second, most institutions do not separate the relevant
data by branch. In other words, the Call Report is generated for the institution, and its own records are kept
in the same format. Third, even if branch-level data are
available, some institutions may confuse (or combine)
commercial and industrial and commercial real estate
loans.
Overall, the cluster (as a reasonable product market
proxy) seems to significantly reduce information costs
between banking institutions, their regulators, and federal antitrust e n f o r c e m e n t agencies. H o w e v e r , c o m pelling theoretical and empirical evidence suggests that
the market for small business loans deserves additional
scrutiny in antitrust evaluations. Although a disaggregated approach to product market definition is more in
line with analysis performed in other industries, a number of m e a s u r e m e n t problems cloud any conclusion
that an exclusive subproduct market approach would
provide substantial benefits in excess of the aforementioned information costs. 33
Federal
Reserve Bank of Atlanta
Conclusion
More than thirty years ago, legal precedent established the relevant antitrust product market for banking
as the "cluster of banking products and services." This
a g g r e g a t e a p p r o a c h to p r o d u c t m a r k e t d e f i n i t i o n is
unique to banking and contrasts with traditional antitrust analysis. Technological advancements have consistently raised the level of competition in most banking
products as more banks and nonbank competitors find
it feasible to compete in distant geographic markets.
However, while nonbank competition has been significant in many retail banking markets, unsecured lending
to small businesses remains primarily a "bank" product.
Both theoretical and empirical evidence has confirmed
that, because of problems caused by information asymmetries, unsecured working capital loans are provided
almost exclusively by local banks. A s a result, geographic markets for these loans are generally defined
m o r e narrowly than those for the cluster of banking
products and services, resulting in greater market concentration. It is this concentration (and its resulting effects on economic performance) that is of interest to
antitrust authorities when evaluating bank mergers.
W h e t h e r or not the c o m p e t i t i v e analysis of b a n k
mergers can benefit f r o m e x a m i n i n g small business
lending markets depends on a n u m b e r of factors, including (1) the reliability of concentration estimates,
(2) the e f f e c t s of this c o n c e n t r a t i o n o n c o n s u m e r s ,
(3) supply reactions to concentration, (4) the development of supply substitutes (such as securitization), and
(5) the adequacy and cost of information on small business lending in each local geographic market. Even if a
disaggregated approach were adopted, it might be reasonable to continue the cluster analysis as a low-cost
initial screen for bank merger applications. In sum, as a
policy of examining small business loans is clearly articulated and data become more reliable, the benefits
to consumers from examining particular subproducts
(such as small business loans) in banking antitrust evaluations will become clearer.
Economic Review
37
Market Share Calculation for Small Business Lending
In order to determine the market shares of each institution competing in a particular market, data f r o m the Consolidated Reports of Condition and Income (Call Reports)
on small loans to businesses are compiled. 1 Because Call
Reports g i v e aggregate m e a s u r e m e n t s (for each institution as a whole), the level of lending within an individual
market will often h a v e to b e estimated. These estimates
are constructed by first determining the relative presence
of each bank in the market by dividing its in-market deposits by its total (institution-wide) deposits. 2 This ratio is
then multiplied by the b a n k ' s loans to small businesses
outstanding (from the Call Report) to determine an estimate of in-market small business lending. O n c e these es-
timations are completed for all market participants, individual market shares m a y be computed. See Table A for
an e x a m p l e of how market shares are calculated for small
business loans.
Notes
1. The Consolidated Reports of Condition and Income collect basic financial data of commercial banks, including
balance sheet, income statement, and supporting schedules. Each bank submits these reports quarterly to its primary regulator.
2. A s m e n t i o n e d previously, deposit data by branch are
available, but loan data are not.
Table A
Athens, Georgia, Banking Market
Small Business Loans (SBLs)
(Data as of June 30, 1994)
Total
SBLs
Total
Deposits
In-Market
Deposits
Estimated
In-Market
SBLs
SBL
Market
Share
Synovus Financial Corporation/Athens First Bank and
Trust Company
19,217
372,847
296,519
15,283
15.00
Suntrust Banks, Inc/Trust Company Bank of NE Georgia
22,035
241,156
204,479
18,684
18.34
Holding Company/Institution
868,004
8,645,894
200,395
20,119
19.75
First Commerce Bancorp/First National
Bank of Commerce
NationsBank Corporation/NationsBank of Georgia
6,333
104,779
87,761
5,304
5.21
Oconee State Bank
9,901
73,524
73,524
9,901
9.72
252,811
4,403,626
72,904
4,185
4.11
2,505
68,309
68,309
2,505
2.46
First National BankcorpVFirst National Bank of
Jackson County
9,070
55,273
55,273
9,070
8.90
Georgia National Bancorp/Georgia National Bank
6,958
53,713
53,713
6,958
6.83
Community Bankshares/Community Bank and
3,850
42,745
42,745
3,850
3.78
665
0.65
Bank South Corporation/Bank South NA
First American Bancorp/First American Bank and
Trust Company
Trust Company-Jackson
Bank of Danielsville
665
42,023
42,023
TCB Bancshares/Commercial Bank
808
35,825
35,825
808
0.79
1,505
34,852
34,852
1,505
1.48
255
32,903
32,903
255
0.25
Main Street Banks/Southern Heritage Savings Bank
1,101
22,641
22,641
1,101
1.08
Southtrust Corporation/Southtrust Bank of Georgia
88,084
2,067,791
12,234
521
0.51
7,027
95,102
11,247
831
0.82
347
5,637
5,637
347
0.34
1,300,476
16,398,640
352,984
101,892
100.00
Bank of Georgia
Merchants and Farmers Bank
Peoples Holding Company/Peoples Bank
First Security Bankshares/Braselton Banking Company
Total Market
*Also includes deposits of a branch of Bank of Banks County.
38
Economic Review
M a r c h /April 1995
Notes
1. The Federal Reserve has jurisdiction over mergers of state
member banks and mergers or acquisitions by bank holding
companies. The Comptroller of the Currency has primary
responsibility for mergers of national banks. The Federal
Deposit Insurance Corporation oversees insured state nonmember banks.
2. Specifically, United States v. Philadelphia National Bank,
374 U.S. 321 (1963), found commercial banking to be the
relevant product market (or a distinct line of commerce) and
the geographic market to be local for Clayton Act purposes.
(The Clayton Act of 1914, along with the Sherman Act
[1980] and the Federal Trade Commission Act 11914], is
one of three major statutes governing antitrust policy. The
Clayton Act is directed primarily against four specific practices: price discrimination that lessens competition, tie-ins
and exclusive dealing that lessen competition, mergers that
reduce competition, and interlocking directorates among
competing firms.)
3. It should be noted that the Board of Governors of the Federal Reserve has not made a public statement about its willingness to examine small business lending in analyzing merger
applications.
4. In practice, approximations are made in specifying both
product and geographic markets. In fact, the definition of the
relevant market(s) is often contested in antitrust cases.
5. See United States v. E.I. DuPont de Nemours & Co., 351
U.S. 377 (1956), and Brown Shoe Co. v. United States, 370
U.S. 294 (1962). These cases are discussed in Carlton and
Perloff (1994).
6. Ordinarily, this price increase is assumed to be 5 percent.
7. The Justice Department's 5 percent test is applicable to geographic market definitions as well as those for product markets.
8. Market shares are based on the percentage of total deposits
controlled by each firm within a specific market.
9. The most often cited concentration ratios are the three-firm
(CR3) and four-firm (CR4) ratios.
10. The HHI measures the sum of squared market shares of each
firm in the market. Thus, the HHI ranges from zero in a perfectly competitive market with an infinite number of firms to
10,000 in a purely monopolistic market with one firm. In the
1992 Horizontal Merger Guidelines, a market in which the
HHI is less than 1,000 is considered unconcentrated; between 1,000 and 1,800, moderately concentrated; and exceeding 1,800, highly concentrated.
11. See Carlton and Perloff (1994) for an overview of the structure-conduct-performance paradigm.
12. Structure-performance studies have been conducted for numerous industries. In addition, the methodological critique
presented by Gilbert (1984) is not unique to studies of the
banking industry. See Carlton and Perloff (1994) for a discussion of both of these issues.
13. See Berger and Hannan (1989), Calem and Carlino (1991),
and Hannan (1991).
14. For example, secured commercial lending is dominated by
commercial finance companies, factoring companies, and
Reserve Bank of Atlanta
DigitizedFederal
for FRASER
the use of trade credit. In addition, mortgage companies,
thrifts, credit unions, and finance companies all originate
mortgage loans.
15. See United States v. Philadelphia National Bank, 374 U.S.
321 (1963).
16. The court opined that "in banking, as in most service industries, convenience of location is essential to effective competition. Individuals and corporations typically confer the bulk
of their patronage on banks in their local community; they
find it impractical to conduct their banking business at a distance" (358).
17. See United Slates v. Phillipsburg National, 399 U.S. 350
(1970), and United States v. Central State Bank, 621 F.Supp
1276(1985).
18. Transactions accounts and small business loans are offered
by few nonbank providers. In addition, customers for these
products arc considered to be "locally limited," resulting in a
more narrowly defined geographic market. These points are
discussed below.
19. See United States v. Connecticut National Bank, 418 U.S.
656(1974).
20. D I D M C A allowed savings and loan associations to make
consumer loans and offer consumer checking (NOW) accounts and phased out interest rate ceilings on time and savings deposits. The Garn-St Germain Act, in turn, allowed
federally chartered thrifts to hold up to 10 percent of their
assets in commercial loans and to enhance their consumer
lending activities and allowed both banks and thrifts to offer
money market accounts.
21. The Justice Department, on the other hand, recognizes thrift
deposits at only 20 percent of their total.
22. In the 1992 Horizontal Merger Guidelines, mergers in highly
concentrated markets (those with an HHI exceeding 1,800)
must not produce a c h a n g e in the HHI of more than 50
points. For bank mergers, a change of 200 points is allowed
in recognition of nonbank competition. In practice, these
threshold levels represent only a reference point in examining
mergers that exceed them. See Holder (1993b) for a discussion of "mitigating factors," or additional considerations examined by antitrust authorities in these merger applications.
23. The Department of Justice considers firms with up to $10 million in annual revenues as small businesses. Some merger
cases of interest include First Hawaiian/First Interstate of
Hawaii (1990), Flcet-Norstar/Bank of New England (1991),
Society/Ameritrust (1992), and Bank of America/Security
Pacific (1992).
24. Commercial banks and small businesses have a unique relationship. Small businesses rely almost exclusively on local
commercial banks for working capital loans. In turn, many
smaller banks rely on these businesses for the bulk of their
commercial lending, as many middle-market and large firms
have taken their business to only the largest banks or to public capital markets.
25. In such a case an individual bank would bear the entire social
cost of resolving this issue while accruing only the private
benefit.
Economic
Review
39
26. Such a credit relationship can be described as a close and
continuous interaction between borrower and lender that
generates useful information about the borrower's financial
state.
27. Adverse selection implies that as higher interest rates are
charged, riskier borrowers may solicit loans, while moral
hazard implies that (creditworthy) borrowers may take on
riskier investments.
28. The issues presented above are not applicable for secured
credit. The differences between secured and unsecured credit
are discussed below.
29. If the borrower's financial condition deteriorates, the bank
must either refuse future loans or call the loan if the firm violates any covenants.
30. In such a case, structural numbers (as measured by the HHI)
for the cluster of banking products and services (for which
deposits are proxies) would not exceed Justice Department
guidelines, while numbers for an individual product (such as
small business loans) might exceed threshold levels. The op-
posite scenario, of course, would be a situation in which the
merger passed an antitrust screening using a subproduct
market approach, while it would have failed the cluster test.
This second scenario, however, is believed to be much less
likely because geographic markets for small business loans
are generally defined more narrowly.
31. Summaries of deposit data, which are used as a proxy for the
cluster of bank products and services, are readily available
from the Federal Deposit Insurance Corporation and from a
number of commercial vendors. Also, most Federal Reserve
Banks have predefined geographic market definitions that
are available upon request.
32. For example, when analyzing competition within small business lending, the geographic market may be defined more
narrowly than that for the traditional (cluster) analysis.
33. It should be mentioned that these measurement problems
would exist in analysis of almost any industry. In fact, as a
regulated industry, banking data are unusually uniform and
complete.
References
Benston, George. "The Future of Asset Securitization: The Benefits and Costs of Breaking up the Bank." Journal of Applied
Corporate Finance 5 (Spring 1992): 71-82.
Berger, Allen. "The Profit-Concentration Relationship in Banking." Board of Governors of the Federal Reserve System, Finance and Economic Discussion Series, No. 176, November
1991.
Berger, Allen, and Timothy Hannan. "The Price-Concentration
Relationship in Banking." Review of Economics and Statistics 71 (May 1989): 291-99.
Beshouri, Christopher, and Peter Nigro. "Securitization and
Small Business Loans." Office of the Comptroller of the Currency. Economic and Policy Analysis Paper Series, No. 94-8,
December 1994.
Calem, Paul, and Gerald Carlino. "The Concentration/Conduct
Relationship in Bank Deposit Markets." Review of Economics and Statistics 73 (May 1991): 268-76.
Carlton, Dennis, and Jeffery Perloff. Modern Industrial Organization. New York: Harper-Collins, 1994.
Dillon, Ed. SNL Securities. Telephone conversation with author,
April 20, 1995.
Elliehausen, Gregory, and John Wolken. "Banking Markets and
the Use of Financial Services by Small and Medium-Sized
Businesses." Federal Reserve Bulletin 76 (October 1990):
801-17.
Evanoff, Douglas, and Diana Fortier. "Réévaluation of the Structure-Conduct-Performance Paradigm in Banking." Journal of
Financial Services Research 1 (June 1988): 277-94.
Gilbert, Alton. "Bank Market Structure and Competition: A Survey." Journal of Money, Credit, and Banking 16 (November
1984): 617-45.
Hannan, Timothy. "Bank Commercial Loan Markets and the
Role of Market Structure: Evidence from Surveys of Com-
40
Economic
Review
mercial L e n d i n g . " Journal of Banking and Finance 15
(February 1991): 133-49.
Hannan, Timothy, and J. Nellie Liang. "The Influence of Thrift
Competition on Bank Business Loan Rates." Journal of Financial Services Research 9 (June 1995): 107-22.
Holder, Christopher L. "Competitive Considerations in Bank
Mergers and Acquisitions: Economic Theory, Legal Foundations, and the Fed." Federal Reserve Bank of Atlanta Economic Review 78 (January/February 1993a): 23-36.
. "The Use of Mitigating Factors in Bank Mergers and
Acquisitions: A Decade of Antitrust at the Fed." Federal Reserve Bank of Atlanta Economic Review 78 (March/April
1993b): 32-44.
Nakamura, Leonard. "Monitoring Loan Quality via Checking
Account Analysis." Journal of Retail Banking 14 (Winter
1992/1993): 16-33.
Peterson, Mitchell, and Raghuram Rajan. "The Benefits of Lending Relationships: Evidence from Small Business Data."
Journal of Finance 49 (March 1994): 3-37.
Shaffer, Sherill. "Bank Competition in Concentrated Markets."
Federal Reserve Bank of Philadelphia Business
Review
(March/April 1994): 3-16.
Smirlock, Michael. "Evidence on the (Non) Relationship between Concentration and Profitability in Banking." Journal
of Money, Credit, and Banking 17 (February 1985): 69-83.
Stiglitz, Joseph, and Andrew Weiss. "Credit Rationing in Markets with Imperfect Information." American Economic Review 71, no. 3 (1981): 393-410.
U.S. Department of Justice. Horizontal Merger
Guidelines.
W a s h i n g t o n , D.C.: U.S. Department of Justice, April 2,
1992.
M a r c h / April 1995
F E D E RAL
Bulk Rate
U.S. Postage
RESERVE
PAID
B A N I I OF
ATLANTA
Public Affairs Department
104 Marietta Street, N . W .
Atlanta, Georgia 30303-2713
( 4 0 4 )
5 2 1 - 8 0 2 0
Atlanta, GA
Permit 292
@FedFRASER