Chapter 6 Risk and Term Structure of Interest Rates

The Purpose of Learning As we discuss theories in greater detail, we often find these theories are not as clear as we wish. How shall we deal with them? The purpose of learning –Learn the language of communication –Understand the deficiencies of the theories

Finance Theory as a Language We learn expectation theory, market segmentation theory so we can communicate with other people in the financial industry. This helps us land a job and be competent in our work. But it won’t help us make a fortune.

Understand the deficiencies of the theories Michael Milken His two insights –Equities were undervalued at the end of 70s and the beginning of 80s –There is a gap between equity market and risk free asset.

Under valuation of equities What if Milken worship Efficient Market Theory, which is taught in every investment textbook? Why market was underpriced that time? High inflation, high interest rate, and hence high discount rate But most people do not adjust income streams as much.

What is Inflation? Inflation is the increase of asset price. In a high inflation environment, asset price increases rapidly. For those asset rich entities, high inflation means their asset value increase rapidly. Hence their share price should increase instead of decreasing. Why inflation is generally considered a negative thing? Most people are fixed income earners.

Some formal discussion The ratio of house prices to rents (a real valuation number) should not be affected by inflation-induced changes in mortgage interest rates. Nevertheless, the data show that the ratio of house prices to rents in the U.S. economy has been trending up since the mid-1980s as inflation and mortgage interest rates have been trending down. (Kevin J. Lansing, 2004)

The observation that real valuation ratios are correlated with movements in nominal interest rates lends credence to the Modigliani-Cohn hypothesis. Investors and homebuyers appear to be adjusting their discount rates to match the prevailing nominal interest rate. However, for some unexplained reason, they do not simultaneously adjust their forecasts of future nominal cash flows, i.e., earning distributions or imputed rents.

The failure to take into account the influence of inflation on future nominal cash flows is an expectational error that is equivalent to discounting real cash flows using a nominal interest rate.

Why people discount future with nominal interest rate but estimate future earning with real rate? Probably it is born from most people’s personal experiences. The borrowing cost varies with nominal interest rate. But most people’s earnings are not adjusted for inflation. This is probably also true for rental incomes, minimum wages and other relatively fixed incomes.

Equities are seriously undervalued in early eighties. Anyone who can buy equities in any way can make a lot of money Milken put his understanding into action. His method of financing is related to another insight.

Blume, Marshall and Irwin Friend, 1973, A new look at the capital asset pricing model, Journal of Finance, 28, 19 – 34. Because there is a gap between high volatility equity market and low volatility risk free or near risk free bond market, the lack of supply created favourable prices. Milken read it, thought about it and put into action to create the junk bond industry. He is one of the rare people who read a lot of theories and put them into action.

A technique of risk arbitrage and its effect on the shape of yield curve Buy high yield longer maturity bond financed by lower yield short maturity bonds. This tends to drive the yield curve flatter. Only institutions can do this because of the transaction cost.

Definition of risk with respect to duration The price volatility of longer duration bonds is higher than the short duration bond. In general, longer duration bonds are considered riskier. Hence higher yield. However, for investors holding long term bonds to maturity, there is no risk. This poses a difficulty in defining and understanding risk.

Midterm: Try to catch our discussion and insight in the classes. But mostly from textbooks. Coverage: Chapter 1 to 6

Homework 6, 7, 8, 9, 10, 12