Sunday, April 8, 2012

Markets Disappointed by Signs of Recovery?

This week's equity market losses have been attributed, to a large degree, on fed meeting minutes indicating further economic stimulus is not warranted. An article from Bloomberg, here, provides the basic message.  According to the media, the market logically sold off upon hearing this news, as further stimulus was unlikely.

First, I have to point out that I am skeptical of singular causes for market activity described by the media.   Due to the complexity of the market and the interaction between multiple sources of information and expectations, media commentary on market movements is highly specious.

Even if the Fed's comments about stimulus did spark the market decline, I question why such news should rationally cause a sell-off.  Fed stimulus is used to help rehabilitate a struggling economy.  Stimulus is not a standard part of our economy, as evident from opposite actions occasionally adopted by the Fed (e.g. early 1980s), designed to slow our economy.  Given the Fed believes stimulus is not necessary, this should be a positive sign of our economic recovery, and the need for additional stimulus should be worrisome.  All else equal, I would view the Fed's announcement as bullish for our market.

A good analogy here is a hospitalized patient.  When the patient shows signs of of sickness, medication may be warranted.  Similarly, monetary stimulus may be helpful when economy is sluggish.  If I had a friend or family member on medication in the hospital, and were told that he or she would be well enough to come off medication soon, I would view that as promising news for his or her long term health.  I see no reason why the Fed's comments that further stimulus is not necessary would be any different as it applies to our economic well being.

Thursday, April 5, 2012

"Expected" is Not the Same as "Most Likely" -- the Case of Bond Valuation

A common valuation approach is the discounted cash flow method.  Future cash flows are discounted to present value using a risk adjusted rate. The mechanics behind this valuation approach are important in establishing an appropriate valuation mindset.  In the case of standard bond valuation, I believe the widely accepted discounted cash flow valuation mechanics are incorrect, and fail to incorporate an important valuation consideration.

The standard bond valuation equation is:

V = SUM{C/ [(1+d)^(t)]} + Px / [(1+d)^(x)], where 

V = bond value
C = bond coupon
t = time period, beginning at t=1 and ending at t=x
d = risk adjusted discount rate
P = bond principal
x = remaining life of bond, expressed in number of periods

Here and here are two websites that provide bond valuation equations like the one shown above.

The problem with such a valuation lies in the cash flows used.  The appropriate cash flows to use are expected cash flows, a standard valuation concept.  Coupon and principal payments represent the maximum cash flow possible, not the expected cash flow.   Therefore, the cash flows used to value bonds should be lower than the coupon and principal amount if there is any risk of default.  Even if the bond will probably pay off in full, expected cash flows should incorporate probabilities of possible scenarios.  Thus, I draw an important distinction between "expected" and "most likely."  Coupon and principal payments can only represent expected cash flow if the investor (naively) believes default probability is zero.

For highly rated, low risk bonds, I concede the difference between the standard approach and the probability adjusted approach is likely negligible.  Nevertheless, the importance of illuminating the theoretical shortfall in the standard valuation approach remains.  Thinking in probabilistic terms is challenging. Substituting a shortcut approach for a theoretically sound approach encourages intellectual laziness.  I think students and practitioners would benefit from reinforcing the need to assess alternative scenarios and the probability of occurrence for each.

 An approach incorporating scenario probabilities is useful for more than determining the expected cash flows of an investment.  It also is highly relevant in evaluating the appropriate risk adjusted discount rate.*  After all, in the standard bond equation noted above, the expected cash flows are the promised, or maximum, cash flows.  Implicitly, using them as expected cash flows implies no chance of default.  Conversely, the discount rate used in the equation is a risk adjusted discount rate, with credit risk a component of the risk premium.  This creates a schizophrenic proposition--that bond's cash flows have no risk, yet are discounted using a risk adjusted rate.

Even if it does not always result in a meaningful valuation difference, better to use probability adjusted cash flows with a risk adjusted discount rate.  When done properly, the cash flow scenarios will be consistent with the expected cash flows (numerator) and the risk adjusted discount rate (denominator).used in the valuation equation.*

* The risk adjusted discount rate depends on more than simply the variability of the cash flows.  The correlation of the cash flows  with those of other assets is another factor in determining the appropriate risk adjusted discount rate.  

Friday, March 30, 2012

Deleveraging and Financial Intermediation

One consequence of the financial crisis was that our economy had to experience a period of deleveraging.  This period, according to conventional wisdom, constrains the ability of an economy to grow.  I thought it would be interesting to examine the economics of  deleveraging and how the process harms the economy.

In this discussion of deleveraging, I focus on deleveraging that occurs in financial services industry, as that was the primary focus of the deleveraging concerns following the financial crisis.  Nevertheless, the same principles apply to any industry whose participants utilize nonequity capital (e.g. debt, deposits, etc.) to fund its operations.

Financial services companies help savings equal investment in the economy.  Individuals can make direct investments in stocks, bonds, or real estate.  Many, though, don't have the expertise or familiarity with risky investment opportunities to make informed decisions. Financial services companies, also known as financial intermediaries, allow investors to contribute to valuable, yet risky investments, without having to select the investments and, in many cases, accept the risk of the investment.  For example, a bank depositor may earn a small return on his or her deposit, which is guaranteed by the bank and the FDIC.  Meanwhile, the deposit can be used to make a mortgage or small business loan, investments with considerably more risk.  The financial intermediary has expertise in selecting quality investments from among those available, channeling individuals' savings into the most productive investments.  For this service, the intermediary keeps the difference in return between its investment (mortgage or small business loan) and the individual's investment (savings deposit).

The critical contribution that financial intermediaries make to our economy is they allow uninformed, risk adverse individuals to provide capital for risky investments.  Although their investments are risky, financial intermediaries (generally) possess the expertise to select only those investments where the expected return compensates for the risk borne.  When financial intermediaries take lower risk capital and use it in higher risk investments, they are creating financial leverage.  The use of financial leverage requires that the providers of low risk capital have confidence in the financial intermediary to select the appropriate investments and perform appropriate investment monitoring.  

When intermediaries have lost the confidence of those seeking lower risk investments, they can no longer rely on financial leverage.  Deleveraging is the process by which financial intermediaries have to decrease their use of low risk capital sources to make their investments, likely because of a loss of confidence from these low risk investors. Companies can lose investor confidence through a variety of means, including making poor investment selections, experiencing accounting irregularities, or through bad publicity.  During the financial crises, all of these examples were present in some capacity.

When financial leverage is unavailable, the intermediary may be able to raise equity capital to fund its investment opportunities.  As described above, however, many investors don't have the expertise or familiarity to make risky investments in equity.  These investors seek lower risk investments, and when traditional low risk investment alternatives become unacceptable, no investment occurs.  In essence, the individuals with capital to invest don't have the expertise to determine which investments are profitable; during the process of deleveraging they are also unwilling to provide the capital to institutions that do have such expertise.  Profitable investment opportunities are lost as a result, and economic growth suffers.