As many of you already know, I am a little fixated on the equity risk premium. More than any variable, it explains what happens in equity markets both in the short term and the long term. In fact, I have at least a dozen posts over the last year and a half on the evolution of the equity risk premium in the US and globally.
The equity risk premium measures what investors collectively demand as a premium over and above the riskfree rate to invest in equities as a class. In practice, many analysts use historical data to estimate this premium. Thus, if investors have earned 9% on stocks over the last 80 years and 4% on treasury bonds over that same period, the historical premium is 5% and it is also used as the equity risk premium in valuation. My problem with this approach is that it is not only backward looking (you want a premium for the next decade, not the last 8 decades) but yields extremely noisy estimates. On my website, for instance, I estimate the historical risk premium for stocks over treasury bonds from 1928 - 2009 to be 4.29% but I also estimate the standard error in this number to 2.40%.
It is to remedy these problems that I compute an implied equity risk premium, where I back out the premium from the current level of stock prices and expected cash flows; it is analogous to estimating the yield to maturity on a bond. While this approach requires its share of inputs - expected growth rates and cash flows on stocks - the estimate of the premium is not only forward looking but comes with a far tighter range on the value. Furthermore, it is dynamic and reflects what is happening in the world around you.
On September 12, 2008, a couple of weeks before I made my first posting to this blog, the implied equity risk premium in the US was 4.36%. In the next 13 weeks, that implied premium rose to 6.43%, varying more than it had in the previous 25 years put together. It taught me an important lesson: even in developed markets, equity risk premiums can change quickly and need to be updated frequently. Since the crisis, I have been updating premiums every month and the implied equity risk premium at the start of March 2010 was 4.44%, back to where it was before the crisis.
How do we explain this rapid back tracking to pre-crisis premiums? While some view it as irrational, there is a rational explanation. One component in the equity risk premium is the fear of catastrophe. What is a catastrophe? It is that infrequent event, which if it occurs, essentially puts you under water as an investor for the rest of your investing life. The Great Depression was a catastrophe for the US: an investor in US stocks in 1928 would not have recovered his principal for almost 20 years. The Japanese market collapse in the late 1980s was a catastrophe. Investors who had their investments in the Nikkei in 1989 will not make their money back in their lifetimes. In good times, that fear recedes and investors are lulled into complacency; stocks go down, but it assumed that the long term trend is always up. In fact, we hear nonsensical stories about how stocks always win in the long term; if these stories were true, the equity risk premium should be zero for really long term investors. In crisis times, the fear of catastrophe rises to the top of all concerns and drowns out all other information. In December 2008, there was the real possibility of a complete financial meltdown and the equity risk premium reflected that. In January 2010, that fear had dropped off enough that people were reverting back to the pre-crisis premiums. It is entirely possible that we over estimated the likelihood of catastrophe in December 2008 and are under estimating it now, but I think that it is the only explanation that I can provide.
I have pointed you to a paper on equity risk premiums that I have. I just completed my 2010 update to the paper. Most of the changes are in the data and the text of the paper itself is relatively unchanged. If you are interested, try this link:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1556382
You can rest assured that I will nag you on this topic for as long as I maintain this blog.
Tuesday, 9 March 2010
Sunday, 21 February 2010
The Fed Effect: Central Banks and Equity Value
Last week, the Federal Reserve announced that it would increase the Fed Funds rate by 0.25%. While the increase was small and the overall rate still remains low, by historical standards, concerns about the implications to the stock market surfaced almost immediately.
http://www.nytimes.com/2010/02/19/business/19fed.html
While, at first sight, this seems like unmitigated bad news - higher interest rates, after all, hurt stock prices - the effects of central bank interest rate policies on equity values is a little more ambiguous. There are several forces that come into play:
a. The Interest rate effect: Did the Fed raise interest rates last week? Not really. First, the only rate that the Fed has direct control over is the Fed Funds rate, i.e., the rate at which banks borrow from the Fed for emergency short term funding, a very small proportion of overall loans. Second, while it is true that the Fed's actions can affect market interest rates, the effect is more at the short end of the term structure than the long end. Thus, an expansionary central bank can push short term rates down but has relatively little influence over long term rates. That is also the reason why yield curves can become downward sloping, when central banks adopt restrictive monetary policies. In both valuation and corporate finance, it is the long term interest rate that determines discount rates and value.
b. The Inflation effect: Monetarists have long argued that the primary job of a central bank is to keep the currency from being debased, by holding inflation in check. Building on that theme, it has also been shown fairly conclusively that the biggest factor driving long term interest rates is expected inflation. Thus, a central bank that raises short term rates may be viewed by markets as fighting inflation, which can cause long term interest rates to fall contemporaneously.
c. The Economic Growth effect: For better or worse, central banks have also been assigned the role of custodians of economic growth. Thus, central bankers have to weigh the inflation fears against the real growth consequences, when raising or lowering rates. Markets therefore view the central bank's final actions as signals of what the central bank thinks about future economic growth. Thus, it is argued that a central bank that raises rates will do so only because it has information that leads it to believe that economic growth is strong enough to withstand the rate increase. Ironically, a rate increase can then be viewed as good news about future economic growth.
So, what do I think will happen to stock prices if central banks raise interest rates? Rather than give you the classic, "It depends ..." response, let me take a stand.
- If the central bank is viewed by markets as informed, independent and credible, a rate increase should be good news for markets; the real growth effect should dominate the effect on short term rates.
- If central banks are viewed as weak and/or uninformed, their actions will have little effects on markets, in the most benign case, and have negative effects, in other cases. As an example of the former, think of Japan in the 1990s, where the central bank was viewed as ineffectual. As an example of the latter, think of almost any Latin American country's central bank in the 1980s.
The bottom line. It is in every economy's best interests to have a central bank that is viewed as strong and effective, since the actions of the bank may be the last, best defense against economic meltdowns. Unfortunately, central banks become easy scapegoats for politicians, when economies stumble. Take the president of Argentina, Christina Kirchner, who recently fired the Argentine central banker (after repeatedly misfiring):
http://online.wsj.com/article/SB10001424052748704533204575047631291330838.html
Count me among those who will not be investing in Argentine companies in the near future. And how about the US? Ben Bernanke, the Fed Chair, was made to jump through hoops by senators, before they voted on renewing his chairmanship. Not surprisingly, they wanted him to promise that he would put employment above inflation in his decision making..... Poltical short sightedness knows no borders.
http://www.nytimes.com/2010/02/19/business/19fed.html
While, at first sight, this seems like unmitigated bad news - higher interest rates, after all, hurt stock prices - the effects of central bank interest rate policies on equity values is a little more ambiguous. There are several forces that come into play:
a. The Interest rate effect: Did the Fed raise interest rates last week? Not really. First, the only rate that the Fed has direct control over is the Fed Funds rate, i.e., the rate at which banks borrow from the Fed for emergency short term funding, a very small proportion of overall loans. Second, while it is true that the Fed's actions can affect market interest rates, the effect is more at the short end of the term structure than the long end. Thus, an expansionary central bank can push short term rates down but has relatively little influence over long term rates. That is also the reason why yield curves can become downward sloping, when central banks adopt restrictive monetary policies. In both valuation and corporate finance, it is the long term interest rate that determines discount rates and value.
b. The Inflation effect: Monetarists have long argued that the primary job of a central bank is to keep the currency from being debased, by holding inflation in check. Building on that theme, it has also been shown fairly conclusively that the biggest factor driving long term interest rates is expected inflation. Thus, a central bank that raises short term rates may be viewed by markets as fighting inflation, which can cause long term interest rates to fall contemporaneously.
c. The Economic Growth effect: For better or worse, central banks have also been assigned the role of custodians of economic growth. Thus, central bankers have to weigh the inflation fears against the real growth consequences, when raising or lowering rates. Markets therefore view the central bank's final actions as signals of what the central bank thinks about future economic growth. Thus, it is argued that a central bank that raises rates will do so only because it has information that leads it to believe that economic growth is strong enough to withstand the rate increase. Ironically, a rate increase can then be viewed as good news about future economic growth.
So, what do I think will happen to stock prices if central banks raise interest rates? Rather than give you the classic, "It depends ..." response, let me take a stand.
- If the central bank is viewed by markets as informed, independent and credible, a rate increase should be good news for markets; the real growth effect should dominate the effect on short term rates.
- If central banks are viewed as weak and/or uninformed, their actions will have little effects on markets, in the most benign case, and have negative effects, in other cases. As an example of the former, think of Japan in the 1990s, where the central bank was viewed as ineffectual. As an example of the latter, think of almost any Latin American country's central bank in the 1980s.
The bottom line. It is in every economy's best interests to have a central bank that is viewed as strong and effective, since the actions of the bank may be the last, best defense against economic meltdowns. Unfortunately, central banks become easy scapegoats for politicians, when economies stumble. Take the president of Argentina, Christina Kirchner, who recently fired the Argentine central banker (after repeatedly misfiring):
http://online.wsj.com/article/SB10001424052748704533204575047631291330838.html
Count me among those who will not be investing in Argentine companies in the near future. And how about the US? Ben Bernanke, the Fed Chair, was made to jump through hoops by senators, before they voted on renewing his chairmanship. Not surprisingly, they wanted him to promise that he would put employment above inflation in his decision making..... Poltical short sightedness knows no borders.
Monday, 15 February 2010
Transactions Costs and Beating the Market
One of my books, Investment Fables, is directed at answering one of the most puzzling questions in investments: How is that there seem to be so many ways to beat the market on paper but that so few money managers seem to do it in practice? A key reason, in my view, is that transactions costs have a much greater impact on returns than we realize.
Let's start with the good news. Both academics and practitioners have found dozens of ways to beat the market. To see the academic list of market inefficiencies, try this link:
http://www.amazon.com/Inefficient-Stock-Market-Robert-Haugen/dp/0130323667
And here is a link to sure fire money makers from practitioners:
http://www.amazon.com/Ways-Beat-Market-Hundred-Stock/dp/0793128544
Wow! Hundred ways to beat the market! Each new finding in academia seems to offer fresh opportunities for the "smart, informed" investor. The latest wave of schemes build off the behavioral finance literature. In fact, two prominent behavioral finance economists have set up their own money management firm (showing you that academics are not immune from greed):
http://www.fullerthaler.com/
Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver "excess returns". Ergo, a money making strategy is born.. books are written.. mutual funds are created.
Now let's look at the bad news. The average active portfolio manager, who I assume is the primary user of these can't-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to "bad" portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year...
So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs - the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This "loser" stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading - you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.
In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.
In closing, I am not trying to dissuade you from being an active investor; I am one. My point is that you should be careful about taking the claims by anyone - academic on practitioner - about market-beating strategies. The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes. Talking about making money is easy.. actually making money is far more difficult.
Let's start with the good news. Both academics and practitioners have found dozens of ways to beat the market. To see the academic list of market inefficiencies, try this link:
http://www.amazon.com/Inefficient-Stock-Market-Robert-Haugen/dp/0130323667
And here is a link to sure fire money makers from practitioners:
http://www.amazon.com/Ways-Beat-Market-Hundred-Stock/dp/0793128544
Wow! Hundred ways to beat the market! Each new finding in academia seems to offer fresh opportunities for the "smart, informed" investor. The latest wave of schemes build off the behavioral finance literature. In fact, two prominent behavioral finance economists have set up their own money management firm (showing you that academics are not immune from greed):
http://www.fullerthaler.com/
Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver "excess returns". Ergo, a money making strategy is born.. books are written.. mutual funds are created.
Now let's look at the bad news. The average active portfolio manager, who I assume is the primary user of these can't-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to "bad" portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year...
So, why do portfolios that perform so well in back testing not deliver results in real time? The biggest culprit, in my view, is transactions costs, defined to include not only the commission and brokerage costs but two more significant costs - the spread between the bid price and the ask price and the price impact you have when you trade. The strategies that seem to do best on paper also expose you the most to these costs. Consider one simple example: Stocks that have lost the most of the previous year seem to generate much better returns over the following five years than stocks have done the best. This "loser" stock strategy was first listed in the academic literature in the mid-1980s and greeted as vindication by contrarians. Later analysis showed, though, that almost all of the excess returns from this strategy come from stocks that have dropped to below a dollar (the biggest losing stocks are often susceptible to this problem). The bid-ask spread on these stocks, as a percentage of the stock price, is huge (20-25%) and the illiquidity can also cause large price changes on trading - you push the price up as you buy and the price down as you sell. Removing these stocks from your portfolio eliminated almost all of the excess returns.
In perhaps the most telling example of slips between the cup and lip, Value Line, the data and investment services firm, got great press when Fischer Black, noted academic and believer in efficient markets, did a study where he indicated that buying stocks ranked 1 in the Value Line timeliness indicator would beat the market. Value Line, believing its own hype, decided to start mutual funds that would invest in its best ranking stocks. During the years that the funds have been in existence, the actual funds have underperformed the Value Line hypothetical fund (which is what it uses for its graphs) significantly.
In closing, I am not trying to dissuade you from being an active investor; I am one. My point is that you should be careful about taking the claims by anyone - academic on practitioner - about market-beating strategies. The market is certainly not efficient, if you define efficiency as an all-knowing, rational market, but it certainly seems efficient, if you define efficiency as investors being unable to take advantage of market mistakes. Talking about making money is easy.. actually making money is far more difficult.
Friday, 12 February 2010
The Credit Default Swap (CDS) Market
The Credit Default Swap (CDS) market has been in the news recently, as Greece goes through the throes of imminent or not-so-imminent default. I thought it would make sense to put down my thoughts on the market:
a. What is a CDS?
A CDS allows you to buy insurance against default by a specific entity - government or corporate. Consider, for instance, the 5-year CDS against Brazilian default. On February 11, 2010, it would have cost you 137 basis points to buy this swap on the CDS market. In practical terms, if you had $ 100 million in $ denominated 5-year bonds issued by the Brazilian government, you would pay $1.37 million each year for the next 5 years for protection against default If the Brazilian government defaulted during the period, you would receive $ 100 million.
There are CDS available on more than 50 governments, dozens of quasi-government instiutions and many large corporations. You can, in effect, make your investment in any of these institutions close to riskfree by buying CDS on any of them.
One feature of the CDS market that needs attention is that there is the possibility of counter party risk on both sides. In effect, both the buyer and the seller may default. Thus, in the 5-year Brazil CDS example, the buyer may not be able to deliver $1.37 million a year for the next 5 years and the seller may not be in a position to deliver $ 100 million, in the event of default.
b. History and growth of the CDS market
The CDS market was devised by a group of bankers at J.P. Morgan as a measure to protect the bank and clients against potential default in the late 1990s. Initially, the market was a very small one, used by investors to to hedge default risk in large positions. In the last decade, the market exploded as both buyers and sellers flocked into it. By 2008, the dollar value of securities covered by Credit Default Swaps exceeded $ 50 trillion and in fact was larger than the actual bond market. Put another way, people were buying insurance against default risk in securities that did not even exist.
c. Why would anyone buy a CDS?
The answer may seem obvious. Investors will buy a CDS to protect an open position that they have in a bond with default risk. That facile answer can be challenged with an obvious riposte: if you want to take no risk, why not just buy a default-free investment in the first place. Clearly, though, the sheer volume of trading suggests that hedging is only part of the story. The other reason for buying a CDS is because you expect the default spread in an entity to widen in the near future. Thus, an investor who expects Brazil's default risk to increase in the future may buy a 5-year CDS at 137 basis points and turn around and sell it for a much higher price later, if he is right.
In fact, one critique of the CDS market is that it is less about hedging and more about speculating. The Greek and Portuguese governments have complained that the CDS markets have deepened their woes:
http://online.wsj.com/article/SB40001424052748703382904575058881703896378.html?mod=WSJ_Markets_section_Heard
d. Why would anyone sell a CDS?
Again, there are two reasons. One is to operate as a broker and make money of transaction volume. If this is the rationale, you would hedge your exposure to risk by both buying and selling CDS and keeping your net exposure close to zero. The other is to speculate. If you expect the default risk in an entity to narrow quickly, you could sell the CDS at a high price and cover at a lower price.
While banks, investment banks and hedge funds are the biggest sellers of CDS, the seller does not have to be a regulated entity though the major sellers are subject to bank capitalization requirements. There is the very real danger that an entity may be tempted to sell CDS to collect cash now and worry about the potential liabilities later (AIG and Lehman come to mind...)
e. What information is in a CDS spread (and changes in it)?
The price on a CDS market is a function of demand and supply. For better or worse, it gives you a measure of what the market thinks about the default risk in an entity at a point in time. Note that this is true, whether investors are hedgers or speculators.
The overlay of counter-party risk affects the prices of CDS. This is one reason why the CDS on even default-free entities will trade at non-zero prices. When perceptions of counter-party risk rise across the board, as they did after the Lehman default, the prices of all credit default swaps will go up.
f. How can we use that information in corporate finance/valuation?
There are at least two places where the CDS market can be put to good use:
a. Country equity risk premiums: The equity risk premium for a risky emerging market should be greater than the equity risk premium for a developed market. One way to compute the additional risk premium is to compute a default spread for the riskier market and the CDS price provides a good starting (or even ending) point. In the Brazil example above, this would translate into using an equity risk premium for Brazil that is at least 1.37% (the CDS price) higher than the premium for the US. In more sophisticated versions of this approach, the 1.37% will be modified to account for additional equity market risk.
b. Cost of debt: The cost of debt for a firm can be obtained by adding a default spread for the firm to a riskfree rate. While this default spread can be difficult to obtain for many companies, we can use the CDS spread for a company (if one exists) to the riskfree rate to get to a pre-tax cost of debt.
In closing, there is useful informaton in the CDS market that we ignore at our own peril, when doing financial analyses and valuation. While there is substantial volatility in the market, the prices in the market allow us to get a sense of what investors think about default risk in entities and the price they would charge for bearing or eliminating that default risk. While it does open the door to those betting on default risk changes, it makes no sense to shoot the messenger and to ignore the message. The default risk problems faced by the Greek, Spanish and Portuguese governments are of their own doing and have been a decade in the making. Blaming the CDS market for these problems makes no sense!
a. What is a CDS?
A CDS allows you to buy insurance against default by a specific entity - government or corporate. Consider, for instance, the 5-year CDS against Brazilian default. On February 11, 2010, it would have cost you 137 basis points to buy this swap on the CDS market. In practical terms, if you had $ 100 million in $ denominated 5-year bonds issued by the Brazilian government, you would pay $1.37 million each year for the next 5 years for protection against default If the Brazilian government defaulted during the period, you would receive $ 100 million.
There are CDS available on more than 50 governments, dozens of quasi-government instiutions and many large corporations. You can, in effect, make your investment in any of these institutions close to riskfree by buying CDS on any of them.
One feature of the CDS market that needs attention is that there is the possibility of counter party risk on both sides. In effect, both the buyer and the seller may default. Thus, in the 5-year Brazil CDS example, the buyer may not be able to deliver $1.37 million a year for the next 5 years and the seller may not be in a position to deliver $ 100 million, in the event of default.
b. History and growth of the CDS market
The CDS market was devised by a group of bankers at J.P. Morgan as a measure to protect the bank and clients against potential default in the late 1990s. Initially, the market was a very small one, used by investors to to hedge default risk in large positions. In the last decade, the market exploded as both buyers and sellers flocked into it. By 2008, the dollar value of securities covered by Credit Default Swaps exceeded $ 50 trillion and in fact was larger than the actual bond market. Put another way, people were buying insurance against default risk in securities that did not even exist.
c. Why would anyone buy a CDS?
The answer may seem obvious. Investors will buy a CDS to protect an open position that they have in a bond with default risk. That facile answer can be challenged with an obvious riposte: if you want to take no risk, why not just buy a default-free investment in the first place. Clearly, though, the sheer volume of trading suggests that hedging is only part of the story. The other reason for buying a CDS is because you expect the default spread in an entity to widen in the near future. Thus, an investor who expects Brazil's default risk to increase in the future may buy a 5-year CDS at 137 basis points and turn around and sell it for a much higher price later, if he is right.
In fact, one critique of the CDS market is that it is less about hedging and more about speculating. The Greek and Portuguese governments have complained that the CDS markets have deepened their woes:
http://online.wsj.com/article/SB40001424052748703382904575058881703896378.html?mod=WSJ_Markets_section_Heard
d. Why would anyone sell a CDS?
Again, there are two reasons. One is to operate as a broker and make money of transaction volume. If this is the rationale, you would hedge your exposure to risk by both buying and selling CDS and keeping your net exposure close to zero. The other is to speculate. If you expect the default risk in an entity to narrow quickly, you could sell the CDS at a high price and cover at a lower price.
While banks, investment banks and hedge funds are the biggest sellers of CDS, the seller does not have to be a regulated entity though the major sellers are subject to bank capitalization requirements. There is the very real danger that an entity may be tempted to sell CDS to collect cash now and worry about the potential liabilities later (AIG and Lehman come to mind...)
e. What information is in a CDS spread (and changes in it)?
The price on a CDS market is a function of demand and supply. For better or worse, it gives you a measure of what the market thinks about the default risk in an entity at a point in time. Note that this is true, whether investors are hedgers or speculators.
The overlay of counter-party risk affects the prices of CDS. This is one reason why the CDS on even default-free entities will trade at non-zero prices. When perceptions of counter-party risk rise across the board, as they did after the Lehman default, the prices of all credit default swaps will go up.
f. How can we use that information in corporate finance/valuation?
There are at least two places where the CDS market can be put to good use:
a. Country equity risk premiums: The equity risk premium for a risky emerging market should be greater than the equity risk premium for a developed market. One way to compute the additional risk premium is to compute a default spread for the riskier market and the CDS price provides a good starting (or even ending) point. In the Brazil example above, this would translate into using an equity risk premium for Brazil that is at least 1.37% (the CDS price) higher than the premium for the US. In more sophisticated versions of this approach, the 1.37% will be modified to account for additional equity market risk.
b. Cost of debt: The cost of debt for a firm can be obtained by adding a default spread for the firm to a riskfree rate. While this default spread can be difficult to obtain for many companies, we can use the CDS spread for a company (if one exists) to the riskfree rate to get to a pre-tax cost of debt.
In closing, there is useful informaton in the CDS market that we ignore at our own peril, when doing financial analyses and valuation. While there is substantial volatility in the market, the prices in the market allow us to get a sense of what investors think about default risk in entities and the price they would charge for bearing or eliminating that default risk. While it does open the door to those betting on default risk changes, it makes no sense to shoot the messenger and to ignore the message. The default risk problems faced by the Greek, Spanish and Portuguese governments are of their own doing and have been a decade in the making. Blaming the CDS market for these problems makes no sense!
Saturday, 6 February 2010
Thoughts on the riskfree rate
Early in my blogging life, September 20, 2008, to be precise, I posted my thoughts on riskfree rates generally and about using the US treasury bond rate as a riskfree rate, in particular. With the turmoil sweeping through the European sovereign bond market right now, the time may be ripe to revisit the topic.
Let us start by stating the obvious. Knowing what you can make on a riskfree investment is a prerequisite for any type of corporate financial analysis or valuation. In most textbooks on finance, though, the riskfree rate is taken as a given.
Backing up a bit, consider the three conditions that have to be met for an investment to have a guaranteed return over its life. First, the cash flows have to be specified up front; this essentially rules out any residual cash flow investment (equity) and puts into play investments where the cash flows are contractually defined (fixed income). Second, there can be no default risk in the entity promising the cash flows; a corporate bond rate can never be a riskfree rate. Third, there can be no reinvestment risk; a six-month treasury bill is not riskfree for a five year cash flow, since the rates in the future can change. The bottom line is that we generally try to find a long-term, default-free rate to use as a riskfree rate.
Given this premise, it is not surprising that most books suggest using the US treasury rate (ten or thirty year) as the risk free rate in US dollars. Implicit in this practice is the assumption that the US treasury is default free. One troubling story from last week related to Moody's potentially downgrading the US from Aaa (and thus introducing the possibility of default into the equation).
http://abcnews.go.com/Technology/wireStory?id=9732868
Now, let's think about a Euro riskfree rate. There are a dozen European governments that issue ten-year bonds and the link below provides rates as of last Friday.
http://markets.ft.com/markets/bonds.asp
Note that the rates vary from 3.11% for Germany to 6.66% for Greece. Since the bonds are all in one currency (Euros), the differences have to be due to default risk. Thus, the German Euro bond rate is likely to be closer to the riskfree rate in Euros than any of the other bonds; in fact, the true riskfree rate is probably a little bit lower than the German bond rate.
Let's now look at an even more complex scenario. Assume that you want a riskfree rate in Indian rupees. At the start of the year, the Indian government ten-year bond rate (denominated in rupees) had an interest rate of 7%. If we accept Moody's rating for India of Ba2 and estimate a default spread of 2.5% for Ba2 rated bonds, the riskfree rate in Indian rupees is 4.5%:
Rupee riskfree rate = 7% - 2.5% = 4.5%
One last rung of complexity. In some emerging markets, there are no long term government bonds in the local currency. Here, the choices are either to do the analysis in a different currency or in real terms.
Ultimately, if riskfree rates in different currencies are measured right, differences between rates should be entirely due to expected inflation. Once that is accomplished, valuations will become currency neutral (as they should be).
In summary, estimating riskfree rates is not always easy. I have a paper on the topic that examines the estimation of riskfree rates in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1317436
I hope you find it useful.
Let us start by stating the obvious. Knowing what you can make on a riskfree investment is a prerequisite for any type of corporate financial analysis or valuation. In most textbooks on finance, though, the riskfree rate is taken as a given.
Backing up a bit, consider the three conditions that have to be met for an investment to have a guaranteed return over its life. First, the cash flows have to be specified up front; this essentially rules out any residual cash flow investment (equity) and puts into play investments where the cash flows are contractually defined (fixed income). Second, there can be no default risk in the entity promising the cash flows; a corporate bond rate can never be a riskfree rate. Third, there can be no reinvestment risk; a six-month treasury bill is not riskfree for a five year cash flow, since the rates in the future can change. The bottom line is that we generally try to find a long-term, default-free rate to use as a riskfree rate.
Given this premise, it is not surprising that most books suggest using the US treasury rate (ten or thirty year) as the risk free rate in US dollars. Implicit in this practice is the assumption that the US treasury is default free. One troubling story from last week related to Moody's potentially downgrading the US from Aaa (and thus introducing the possibility of default into the equation).
http://abcnews.go.com/Technology/wireStory?id=9732868
Now, let's think about a Euro riskfree rate. There are a dozen European governments that issue ten-year bonds and the link below provides rates as of last Friday.
http://markets.ft.com/markets/bonds.asp
Note that the rates vary from 3.11% for Germany to 6.66% for Greece. Since the bonds are all in one currency (Euros), the differences have to be due to default risk. Thus, the German Euro bond rate is likely to be closer to the riskfree rate in Euros than any of the other bonds; in fact, the true riskfree rate is probably a little bit lower than the German bond rate.
Let's now look at an even more complex scenario. Assume that you want a riskfree rate in Indian rupees. At the start of the year, the Indian government ten-year bond rate (denominated in rupees) had an interest rate of 7%. If we accept Moody's rating for India of Ba2 and estimate a default spread of 2.5% for Ba2 rated bonds, the riskfree rate in Indian rupees is 4.5%:
Rupee riskfree rate = 7% - 2.5% = 4.5%
One last rung of complexity. In some emerging markets, there are no long term government bonds in the local currency. Here, the choices are either to do the analysis in a different currency or in real terms.
Ultimately, if riskfree rates in different currencies are measured right, differences between rates should be entirely due to expected inflation. Once that is accomplished, valuations will become currency neutral (as they should be).
In summary, estimating riskfree rates is not always easy. I have a paper on the topic that examines the estimation of riskfree rates in more detail:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1317436
I hope you find it useful.
Sunday, 31 January 2010
Emerging versus Developed Markets: The margin shrinks in 2010
One final post based upon 2010 data. I have been interested in emerging markets, in general, and the challenges of valuing companies in these markets, in particular, for a long time. When I started on this endeavor in the 1990s, the fault lines between developed and emerging markets were stark and could be categorized on the following dimensions:
1. Financial markets versus Economy: In emerging economies, financial markets were a very small and unrepresentative sampling of the underlying economy. Thus, the bulk of the market capitalization in most emerging markets came from recently privatized infrastructure companies, a few large banks and family controlled corporations. In developed markets, especially the US, Japan and the UK, much of the economy was corporatized and publicly traded.
2. Liquidity and capital access: Emerging markets were subject to ebbs and flows in liquidity, with crises, where liquidity and capital access dried up for almost all firms in the market. Only those emerging market companies that had access to foreign capital were able to maintain life lines during these periods. In developed markets, it was accepted that while some segments of the economy would have trouble raising capital, liquidity and capital access would remain available to most mid cap and large cap firms.
3. Default risk in government: Investors in bonds issued by governments in emerging markets assumed that would be a significant risk of default in these governments, even when they borrowed in the local currency, and priced in this default in the form of high interest rates. Investors in bonds issued by governments in developed markets did not even give thought to the possibility of default in the local currency.
4. Government role in company/economic health: Governments in emerging markets played a much more intrusive (and larger) role in their economies and the fates of their companies (through both explicit controls and licenses and implict threats of nationalization or expropriation). They were also viewed as more volatile and unpredictable. Consequently, when valuing emerging market companies, assumptions about government competence (or incompetence) and actions (or inactions) could affect company value substantially. In developed markets, the value of a company was largely a function of its management qualities and competitive advantages, and governments were viewed as predictable, side players.
5. Currency and inflation: In emerging markets, there was distrust of the local currency, often motivated by bouts of inflation and political uncertainty in the past. This distrust manifested itself in many ways, from an unwillingness by any entity in that market to borrow/lend long term in the local currency, to all analysis being done in U.S. dollars. In developed markets, investors may have been susceptible to complaining about the strength/weakness of the local currencies but inflation was mostly viewed as a controllable problem and currency longevity was taken as a given.
The crisis of 2008 may have precipitated this shift, but it is a shift that has been occurring over much of the last decade. Today, the gap between emerging and developed markets has shrunk and, in some cases, disappeared.
a. Financial markets and economy: While there remain many emerging economies, where financial markets lag the economy, the biggest emerging markets (India, China and Brazil) have seen explosive growth in both the number of companies that are publicly traded and the portion of the economy that is covered by financial markets.
b. Liquidity and capital access: In the last quarter of 2008, we witnessed the almost unimaginable sight of GE being unable to issue commercial paper. In effect, developed markets discovered that you could have a liquidity crisis that affected all companies and all sources of capital. At the same time, the expansion of local investor bases has made emerging markets more liquid and expanded capital access to companies in these markets.
c. Default risk in government: As emerging market governments establish a track record of paying their obligations on time and without fanfare, and developed market governments (Greece, Iceland) reveal significant potential for default, the notion that there is no default risk in developed market governments is coming under assault. In fact, the argument that the US and the UK may not be AAA rated forever no longer sounds far fetched.
4. Governments and Economy: While I was valuing Citigroup and Bank of America early in 2009, I realized how much my valuations of these two firms was dependent upon government action or inaction and I found myself using techniques that I had developed to value emerging market companies in the 1990s. At the same time, I find myself valuing well run Brazilian and Indian companies, without paying much heed to the governments in the markets. (I am afraid I cannot say this yet for Chinese companies, because of corporate governance concerns)
5. Currency and Inflation: As I noted in an earlier post, I see a much greater willingness in large emerging markets to analyze investments and value companies in the local currency. Investors in these markets have more faith in their currencies and seem to be less scarred by inflation worries than in periods past. At the same time, investors in developed markets seem to be jumpy about potential inflation in the future; this fear may not be manifested in current inflation or interest rates but it can be seen in the flight to gold and talk about hyperinflation.
In closing, the gap between developed and emerging market companies is closing, both in economic and analytical terms. The former are displaying some of the most troublesome characteristics of the latter, whereas the latter are maturing. For analysts and investors, the lessons should be clear. Developed market investors who have become lazy over decades of stability need to wake up and use techniques that emerging market analysts and investors have used for that same period. Emerging market investors and analysts who have made their money by playing the macro and government forecasting game have to start thinking more seriously about company fundamentals and value. There is work to do!
1. Financial markets versus Economy: In emerging economies, financial markets were a very small and unrepresentative sampling of the underlying economy. Thus, the bulk of the market capitalization in most emerging markets came from recently privatized infrastructure companies, a few large banks and family controlled corporations. In developed markets, especially the US, Japan and the UK, much of the economy was corporatized and publicly traded.
2. Liquidity and capital access: Emerging markets were subject to ebbs and flows in liquidity, with crises, where liquidity and capital access dried up for almost all firms in the market. Only those emerging market companies that had access to foreign capital were able to maintain life lines during these periods. In developed markets, it was accepted that while some segments of the economy would have trouble raising capital, liquidity and capital access would remain available to most mid cap and large cap firms.
3. Default risk in government: Investors in bonds issued by governments in emerging markets assumed that would be a significant risk of default in these governments, even when they borrowed in the local currency, and priced in this default in the form of high interest rates. Investors in bonds issued by governments in developed markets did not even give thought to the possibility of default in the local currency.
4. Government role in company/economic health: Governments in emerging markets played a much more intrusive (and larger) role in their economies and the fates of their companies (through both explicit controls and licenses and implict threats of nationalization or expropriation). They were also viewed as more volatile and unpredictable. Consequently, when valuing emerging market companies, assumptions about government competence (or incompetence) and actions (or inactions) could affect company value substantially. In developed markets, the value of a company was largely a function of its management qualities and competitive advantages, and governments were viewed as predictable, side players.
5. Currency and inflation: In emerging markets, there was distrust of the local currency, often motivated by bouts of inflation and political uncertainty in the past. This distrust manifested itself in many ways, from an unwillingness by any entity in that market to borrow/lend long term in the local currency, to all analysis being done in U.S. dollars. In developed markets, investors may have been susceptible to complaining about the strength/weakness of the local currencies but inflation was mostly viewed as a controllable problem and currency longevity was taken as a given.
The crisis of 2008 may have precipitated this shift, but it is a shift that has been occurring over much of the last decade. Today, the gap between emerging and developed markets has shrunk and, in some cases, disappeared.
a. Financial markets and economy: While there remain many emerging economies, where financial markets lag the economy, the biggest emerging markets (India, China and Brazil) have seen explosive growth in both the number of companies that are publicly traded and the portion of the economy that is covered by financial markets.
b. Liquidity and capital access: In the last quarter of 2008, we witnessed the almost unimaginable sight of GE being unable to issue commercial paper. In effect, developed markets discovered that you could have a liquidity crisis that affected all companies and all sources of capital. At the same time, the expansion of local investor bases has made emerging markets more liquid and expanded capital access to companies in these markets.
c. Default risk in government: As emerging market governments establish a track record of paying their obligations on time and without fanfare, and developed market governments (Greece, Iceland) reveal significant potential for default, the notion that there is no default risk in developed market governments is coming under assault. In fact, the argument that the US and the UK may not be AAA rated forever no longer sounds far fetched.
4. Governments and Economy: While I was valuing Citigroup and Bank of America early in 2009, I realized how much my valuations of these two firms was dependent upon government action or inaction and I found myself using techniques that I had developed to value emerging market companies in the 1990s. At the same time, I find myself valuing well run Brazilian and Indian companies, without paying much heed to the governments in the markets. (I am afraid I cannot say this yet for Chinese companies, because of corporate governance concerns)
5. Currency and Inflation: As I noted in an earlier post, I see a much greater willingness in large emerging markets to analyze investments and value companies in the local currency. Investors in these markets have more faith in their currencies and seem to be less scarred by inflation worries than in periods past. At the same time, investors in developed markets seem to be jumpy about potential inflation in the future; this fear may not be manifested in current inflation or interest rates but it can be seen in the flight to gold and talk about hyperinflation.
In closing, the gap between developed and emerging market companies is closing, both in economic and analytical terms. The former are displaying some of the most troublesome characteristics of the latter, whereas the latter are maturing. For analysts and investors, the lessons should be clear. Developed market investors who have become lazy over decades of stability need to wake up and use techniques that emerging market analysts and investors have used for that same period. Emerging market investors and analysts who have made their money by playing the macro and government forecasting game have to start thinking more seriously about company fundamentals and value. There is work to do!
Wednesday, 27 January 2010
The likelihood of venture finance becoming more available.
Interesting blog post from ROSALIND RESNICK a few weeks ago, talking about the likelihood of venture finance becoming more available.
Last week, as I was testing out the very latest business plan software technology, I got a call from a client of mine I hadn’t heard from in a while. Turns out, when he and his partner couldn’t raise money from investors to launch their business last year, they did what many intrepid entrepreneurs do. They went back to corporate America and got jobs, and used their own money to build the prototype they needed to prove that their concept was more than just a business plan and a dream.
Now that they’ve launched their product, signed up their first pilot customer and started generating revenue, is it time to start pitching venture capital firms again, they want to know. After all the bad news they’d read about VC funding last year, did the VC industry still have a pulse?
According to the quarterly MoneyTree report released last week by PricewaterhouseCoopers and the National Venture Capital Association, the answer may be “yes”–and not just for later-stage companies but for startups and early-stage ventures, too.
First, the bad news: Venture capital investment in 2009 declined to its lowest levels in more than in a decade, the report found. Last year, venture capitalists put $17.7 billion in 2,795 deals nationwide, the lowest level of dollar investment since 1997. This marked a 37 percent decline in dollars and a 30 percent decrease in deal volume from 2008.
Now, the good news: In the fourth quarter of 2009, VCs put $5 billion to work in 794 deals. But while funding declined 2 percent from the third quarter of 2009, the number of deals actually grew by 15 percent. The report also had good news for startups: While first-time financings fell to the lowest dollar and deal level since the report began tracking VC investing in 1995, the Q4 numbers showed increases in the number of first-time and early-stage deals completed.
Does this mean the ice is finally thawing?
“The venture capital industry had no choice but to slow the investment pace in 2009,” Mark Heesen, president of the National Venture Capital Association, said in a statement. “The weak exit environment resulting from an unstable public market combined with a challenged limited-partner base sent a strong message to the venture community to pull back the reins–and the VC’s listened. Now that the economy has begun to show signs of improvement, we expect to see dollars flow more freely back into those sectors that offered the most promise before the recession began–clean technology, life sciences and IT.”
With bank financing still tight for small businesses, the VC turnaround couldn’t come at a better time for cash-starved startups and early-stage companies. Seed-stage companies attracted 9 percent of dollars and 11 percent of deals in 2009 compared with 6 percent of dollars and 12 percent of deals in 2008, the report found. Early-stage investments saw double-digit increases in the fourth quarter, with $1.6 billion going into 277 deals, a 32 percent increase in dollars and 26 percent increase in deals from Q3.
Now, don’t get me wrong. Despite the fact that you may have used top of the range business plan software the create your business plan, startups and early-stage companies face long odds when it comes to raising venture capital–even in good times. Still, it’s exciting to see the river of VC money starting to flow again. It may be winter in the financial markets now, but you don’t need to be an economist to see that spring is right around the corner.
Last week, as I was testing out the very latest business plan software technology, I got a call from a client of mine I hadn’t heard from in a while. Turns out, when he and his partner couldn’t raise money from investors to launch their business last year, they did what many intrepid entrepreneurs do. They went back to corporate America and got jobs, and used their own money to build the prototype they needed to prove that their concept was more than just a business plan and a dream.
Now that they’ve launched their product, signed up their first pilot customer and started generating revenue, is it time to start pitching venture capital firms again, they want to know. After all the bad news they’d read about VC funding last year, did the VC industry still have a pulse?
According to the quarterly MoneyTree report released last week by PricewaterhouseCoopers and the National Venture Capital Association, the answer may be “yes”–and not just for later-stage companies but for startups and early-stage ventures, too.
First, the bad news: Venture capital investment in 2009 declined to its lowest levels in more than in a decade, the report found. Last year, venture capitalists put $17.7 billion in 2,795 deals nationwide, the lowest level of dollar investment since 1997. This marked a 37 percent decline in dollars and a 30 percent decrease in deal volume from 2008.
Now, the good news: In the fourth quarter of 2009, VCs put $5 billion to work in 794 deals. But while funding declined 2 percent from the third quarter of 2009, the number of deals actually grew by 15 percent. The report also had good news for startups: While first-time financings fell to the lowest dollar and deal level since the report began tracking VC investing in 1995, the Q4 numbers showed increases in the number of first-time and early-stage deals completed.
Does this mean the ice is finally thawing?
“The venture capital industry had no choice but to slow the investment pace in 2009,” Mark Heesen, president of the National Venture Capital Association, said in a statement. “The weak exit environment resulting from an unstable public market combined with a challenged limited-partner base sent a strong message to the venture community to pull back the reins–and the VC’s listened. Now that the economy has begun to show signs of improvement, we expect to see dollars flow more freely back into those sectors that offered the most promise before the recession began–clean technology, life sciences and IT.”
With bank financing still tight for small businesses, the VC turnaround couldn’t come at a better time for cash-starved startups and early-stage companies. Seed-stage companies attracted 9 percent of dollars and 11 percent of deals in 2009 compared with 6 percent of dollars and 12 percent of deals in 2008, the report found. Early-stage investments saw double-digit increases in the fourth quarter, with $1.6 billion going into 277 deals, a 32 percent increase in dollars and 26 percent increase in deals from Q3.
Now, don’t get me wrong. Despite the fact that you may have used top of the range business plan software the create your business plan, startups and early-stage companies face long odds when it comes to raising venture capital–even in good times. Still, it’s exciting to see the river of VC money starting to flow again. It may be winter in the financial markets now, but you don’t need to be an economist to see that spring is right around the corner.
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