Monday, October 26th, 2009
The correlation between the debt and equity markets’ measures of risk has been extremely strong over the recent years. External shocks, for example the tragic events of September 11, 2001, the LTCM disaster in 1998 or the Asian crisis, have a substantial impact on credit spreads as well as on implied equity volatility. Consider the relationship between implied volatility of call options on Dow Jones Euro Stoxx 50, and the spread versus government bonds of the MSCI Euro corporate bond index.
One way of interpreting implied volatility on an equity index is as the compensation that the investors receive for taking on equity risk. The index of credit spreads represents the additional yield investors demand for holding corporate debt over benchmark government debt. While there have at times been brief periods of divergence, these two risk measures typically move together. For example, in 1993/94 banks in the United States cleaned up their balance sheets by writing down nonperforming assets, causing the VIX index, representing the implied volatility of put and call options on the S&P 100, to fall to a historical low just above 10 percent. The decline in implied equity volatility triggered a credit spread rally. Asimilar thing happened in 2002. Average credit spreads collapsed by half, as did optionimplied volatility. So the decline in volatility was a major driver of credit spread tightening. However, one tends to find that when implied volatility falls below a certain threshold the effect of small changes on spreads is rather subdued.
Tags: business, crisis, finances, foreclosure, investments, loans, money advice, money problems, stock, stock exchange
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Sunday, October 25th, 2009
The level of implied volatility is a widely used indicator for risk appetite, and, on the individual company level, for the uncertainty related to future earnings. It is also considered a good measure of equity-market risk, because the higher the implied volatility the higher the price of equity options, and thus the higher the cost of insuring against equity-market downturns. Corporate bond spreads reflect the compensation that the investors demand for taking on credit risk. While the debt and equity markets’ estimates of risk, as explained by the Merton model, tend to move together, temporary disconnections do occur. The combination of low levels of implied equity volatility and wide credit spreads suggests the potential for the credit spreads to tighten, as the divergence in the equity and credit market eventually gets corrected. Conversely, when implied equity volatility appears high relative to credit spreads, credit markets are more optimistic about business risks in the corporate sector. The decoupling in the second half of 2003, however, was not an indication that credit spreads were rich relative to implied equity volatility. Rather credit markets were faster to cash in on the reduced risks in the corporate sector because of the massive balance sheet deleveraging, especially in the telecom sector.
Corporate managers were selling off assets, issuing equity and keeping cash for the debtholders, as opposed to using the cash to buy back stock for the first time in 10 years. By the end of the year, equity volatility came down significantly, closing the gap in the assessment of risk.
Tags: foreclosure, loans, mortgage, shares, tax, taxes, tenancy, Tenancy-in-Common, tenant, trade value
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Wednesday, July 29th, 2009
At one point product sales may be brisk and revenues over cost of goods sizable. There is no problem there. Then suddenly demand will pick up and costs will escalate—a by-product of needing more of everything to increase production and keep up with increased demand. Just about that time, a major creditor will run into a snag and will have to slow up payments.
Suddenly the company is caught in a cash crunch—more money is going out than is coming in when it’s needed. Then the company doesn’t have the capital it needs to help meet customer demand. Despite having a highly profitable profile on paper, the company isn’t receiving funds in the timely manner that it needs to pay its bills. Think of it like this: You just ordered a new car because you won $25,000 in the lottery. The dealer wants the money, but the lottery officials just told you that they can’t send the check for three months. Uh-oh.
Cash flow problems happen to all of us from time to time. If you plan sufficiently, you may avoid many of those rapids, but not all.
Tags: bank payment, cash flow, floats, management
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Tuesday, July 7th, 2009
As you battle to get out of debt and to use debt wisely, it’s of the utmost importance to realize how your credit scores affect your situation. In fact, there is nothing that may affect the money that flows in and out of your household more than your credit score.
I’ll discuss the importance of salvaging your credit score in Chapter 20, but suffice it to say, you’ve got to start guarding that thing like it’s the president! Your credit score is a rating of how “safe” you appear to be to a potential lender (i.e., how likely you are to pay off the money that you borrow). The higher your score, the safer you are. The safer you are, the more friendly your interest rate and repayment terms are going to be.
In fact, two people with different credit scores will be required to pay a noticeably different monthly payment on the same loan. The following table contains six different credit scores along with what the corresponding mortgage ends up costing them. For this example, I’ve used a 30-year fixed-rate mortgage on $250,000. As you can see, the failure to show tender loving care to your credit score results in some major money disappearing from your life. In fact, the difference in total interest paid between the best credit score and worst is over $200,000. This is money that could be used to pay off your other debt and save for your other goals. Heck, that’s enough money to buy a second home!
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Friday, June 12th, 2009
The fourth source of poor economic performance may derive from failures, often based on ignorance, in the management of risk. It involves concepts equally as sophisticated and complex as the economic concept of value.
Bernstein begins his book on risk with the provocative question, “Why is the mastery of risk such a uniquely modern concept?” He views risk as the concept that defines the boundary between modern times and the past.8 Prosperity, like risk management, is a new thing. So is it just a coincidence that wealth creation began about the time that the tools to manage risk began to take form?
It is an intriguing hypothesis, but it is clouded by the fact that many other types of progress accelerated at the same time. Nevertheless, a likely suspect for past economic stagnation might have been a general failure to manage risk. Clearly, there was no way prior to 1500, or likely prior to 1750, to develop scientific risk-management techniques. The mathematical tools were not there, the concept of probability was just evolving, and the notion of statistical sampling had not been developed. Risk management was still heavily tied into theology—pray for rain.
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Saturday, May 23rd, 2009
From a valuation viewpoint, the most important thing about risk in business is that there are two kinds, and they can work in opposite directions. One type of risk is unique (sometimes called private1 risk). It is risk that is unique to your particular situation and is partially subject to your control. Unique risks can usually be expressed in terms of probabilities. Examples of unique risk are the probability that our R&D project will fail, that we will drill a dry hole, or that the bank in which our savings are deposited will close its doors.
The other form of risk is market (or systematic risk), which is your exposure to volatility that you cannot control in your current situation. Examples of market risk are the probability that interest rates will increase, that the price of natural gas will rise, that electric power will be deregulated, or that health care will be partially nationalized. An electric utility would be concerned about the first three of these market risks, while a pharmaceutical firm would be concerned about the first and the fourth.
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Thursday, April 23rd, 2009
Value influencing property characteristics can be property-specific or market-wide: the former refers to the spatial, physical and legal attributes of the property itself and the latter refers to the characteristics of the market as a whole or the market sector in which the property operates. Fundamentally, the market value of a property reflects its capacity to fulfil a function. If the property is a shop, for example, then its value will be determined by factors such as trading position, length of frontage, accessibility, planning restrictions and tenure. We shall see later how it is important to be able to quantify financially these value factors as part of the valuation processs (comparison adjustment). This is not an easy task and provides substance to the argument that valuation is as much an art as it is a science.
There are two levels of property value analysis: property-specific and market overview. The value of a property is largely determined by its competitive position in the market in which it operates. Therefore, both property-specific and market-wide factors must be considered to delineate the market by investigating property type features such as (single or multiple) occupancy, use, construction types, design, amenities, geographical extent, available substitutes and complementary land uses.
The built environment cannot be treated like a clinical laboratory and in practice variations in valuations will occur. Rates of inflation will alter, market conditions will change the expected rates of return and unforeseen events will happen. The calculations performed in valuations assume ceteris paribus.
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