Discussing Risk: some major factors that cause interest rates to differ

 

Preferential tax treatments (tax structure), yield to risk (risk structure – the higher the risk, the higher the yield), and yield to maturity (term structure – depending upon market conditions, longer term rates can differ from short term…why? Yield curve)

 

Excerpts from “Financial Economics”
Donald R. Byrne

 

Uncertainty of Cash Flow

The ongoing budgetary difficulties of various states such as Michigan and of financial firms (Goldman Sachs, American Insurance Group, etc) and manufacturing concerns such as General Motors, point out clearly that the ability to meet contractual payments such as debt service is not a certainty. In many cases, the probability of paying interest and principal or of distributing an expected dividend is less than 100%. The lower the probability of receiving an expected cash flow, the greater will be the perceived risk by an investor. An individual investor or a financial intermediary that is anticipating the purchase of a financial claim, will assess the risk of not receiving the cash flow as contractually agreed to by the debtor, and will demand a risk premium commensurate with the degree of uncertainty of the expected cash flow. If the market consensus agrees, the interest rate on borrowed funds will reflect such a risk premium to reward the lender for the uncertainty of the cash flow.

When a bank makes a loan it assesses the uncertainty of the borrower paying interest and principal in a timely fashion. This is called credit risk. Similarly, analysts estimate the uncertainty of the timely payment of coupon interest and maturity values on notes and bonds. In this case the term default risk or credit risk is often used. In assessing the uncertainty of the expected cash flow in terms of the stock market, the uncertainty of the cash flow from a stock in relation to the market as a whole is often referred to as the beta of a stock. These examples all refer to the risk resulting from the uncertainty of the cash flow from an investment be it a loan, bond, stock, etc.

An analysis of what is involved is helpful in order to clarify this concept. A surplus budget unit or a financial intermediary that agrees to lend or sell funds to a deficit budget unit or another financial intermediary expects a cash flow in return. In the case of debt arrangement, cash flow is clearly defined in terms of interest payments and the amortization of principal. In an equity arrangement, for example the purchase of stock, that cash flow is less clearly defined, but nonetheless is expected despite its vagary. In some cases of an equity arrangement, the expected cash flow is expected dividends and the market price that can be converted into a cash flow by selling the security in the market.

Regardless of the legal nature of the claim, a cash flow of some expected yield or rate of return plus return of original investment is expected. Whether the claim matures and is paid off or whether the original investment is re-obtained only by sale of the security, it makes only a minor difference analytically. Whether the cash flow comes from conversion of a capital gain by liquidation into money or simply a result of a contractual periodic payment without the necessity of liquidating the principal claim, the difference is not major, it is a question of timing. The risk premium will adjust the differences in the probability of the cash flows being received. The critical point to see is that these arrangements, no matter how they differ legally, all involve reciprocal cash flows. The lender (investor), whether it is a individual investor or a financial intermediary, offers a lump sum cash flow over time. The greater the certainty of the return cash flow, the lower the risk. The lower the anticipated risk of that cash flow, the lower the risk premium required to the lender or investor. The more uncertain that cash flow to the lender or investor, the greater the risk premium. This uncertainty is usually termed credit or default risk but on equity investments that is an inappropriate term since there is no such thing as default on an equity claim. The firm cannot default to its owner. Nonetheless, the uncertainty on an equity claim is truly there, and on the average, the uncertainty or risk of the cash flow expected from an equity claim is on the average greater than on the average of debt claims.

The cash flow to the owner of stock is riskier than debt in general, because equity claims generally hold out the prospect of a cash flow that is less clearly defined and occurs only if sufficient profits are earned by the firm that issued the stock. In some cases, that cash flow can only materialize through the selling of the stock claim by the investor. Some firms pay low or no dividends but reinvest their cash flows. The rise in the market price of the stock is a potential cash flow that can be realized only by the sale of the stock claim.

 

The Capital Asset Pricing Model (CAPM)

 

The CAPM is an attempt to estimate the value of a stock.

 

It has several building blocks with built in assumptions. While it can be used for all assets, its most common use is in the valuation of common stock. The initial building block is the need to diversify one’s portfolio. A stock by itself bears a lot of risk. However, putting that stock in a portfolio reduces what is called unsystematic risk or risk specific to that stock outside of a portfolio. By adding additional stock to a portfolio, the unsystematic risk of each stock is lessened and the unsystematic risk or diversifiable risk approached zero. The argument continues that in efficient markets, the bearer of unsystematic risk will NOT be rewarded since most investors are efficiently diversified and do not bear unsystematic risk. The stock market approaches efficiency, especially over the longer run. Real estate markets, where location, location is the buzzword, are less efficient. Some of the unsystematic risk would then be rewarded to the investor.

First, a share of stock outside of a portfolio is much riskier than when it is part of a diversified portfolio of stocks, because it bears two types of risk.

• Unsystematic risk is specific to the stock and can be eliminated by efficient diversification. In efficient markets, the bearing of unsystematic risk is not rewarded; no risk premium is received.

• Systematic risk cannot be eliminated by diversification. The investor, however, can choose the level of systematic risk desired and does receive a risk premium for bearing the risk. The higher the level of systematic risk borne by the investor, the higher the reward. The level of systematic risk is called the beta of the stock. It is a measure of the relative covariance of the stock to the portfolio.

 

Note…approximately 2/3 of risk is unsystematic

 

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