Robert B Litterman

Money, Real Interest Rates, and Output: A Reinterpretation of Postwar U.S. Data

This paper reexamines both monthly and quarterly U.S. postwar data to investigate if the observed comovements between money, real interestrates, prices and output are compatible with the money-real interest-output link suggested by existing monetary theories of output, which include both Keynesian and equilibrium models.The major empirical findings are these;1) In both monthly and quarterly data, we cannot reject the hypothesis that the ex ante real rate is exogenous, or Granger-causally prior in the context of a four-variable system which contains money, prices, nominal interest rates and industrial production.2) In quarterly data, there is significantly more information con-tained in either the levels of expected inflation or the innovationof this variable for predicting future output, given current and lagged output, than in any other variable examined (money, actualinflation, nominal interest rates, or ex ante real rates). The effect of an inflation innovation on future output is unambiguously negative. The first result casts strong doubt on the empirical importance of existing monetary theories of output, which imply that money should have a causal role on the ex ante real rates. The second result would appear incompatible with most demand driven models of output.In light of these results, we propose an alternative structural model which can account for the major dynamic interactions among the variables.This model has two central features: i) output is unaffected by money supply;and ii) the money supply process is motivated by short-run price stability.

Managing Market Exposure

KURT D. WINKELMANN is an executive director in fixed-income research at Goldman Sachs International in London. or most investment managers, the fundamental portfolio management problem is to select portfolios of assets that outperform their F benchmarks. The benchmark can be a liabhty stream (for a pension fund manager); a performance index (for an investment plan counselor); or cash (for a trader). Naturally, solutions to this problem depend on security valuation, but solving the problem also requires a robust risk management framework. Two developments have amplified the complexity of risk management for many investors in recent years. First, investors have increased their purchases of non-domestic securities. Second, many are using derivatives more frequently. Both these activities have exposed investors to risks with which they have had little previous experience. Investors thus need more and more to understand their global market exposures and manage unfamiliar combinations of risk. The development of risk management tools has not kept pace with these investment trends. It is becoming harder for investors to answer the question: How much risk does my portfolio have relative to my benchmark? This article introduces a risk management tool we have developed at Goldman Sachs to help manage our own portfolios, as well as to help our customers manage theirs. We call t h s tool the “market exposure.” In this article, we show that t h s simple concept can be very useful for understanding and managing global portfolio risk. Indeed, it plays the same role for global and multiasset portfolios that duration and beta

The Active Risk Puzzle

While almost all institutional investment funds take active risk, the amount is almost uniformly a tiny fraction of the market risk that they expose themselves to. Readily available financial engineering techniques today allow funds to separate market risk from active risk. Given the lack of correlation between the two, the optimal allocation to active risk is very sensitive to the net aggregate information ratio from active management. It makes no sense that this assumption should be virtually the same, around 0.04, for all funds. Some funds will focus on indexing to reduce costs. Others will seek to increase the amount and improve the quality of their active risk. If these developing trends continue, look for interesting implications for the asset management industry.