Finance Basics, part 6

Point number six is essentially the same as point number one, that equity markets are efficient in the sense that it is incredibly difficult to make money in the stock market by following simple trading strategies using publicly available information. Financial research has demonstrated many times that simple rules do not deliver superior returns, especially once the transactions costs of constant trading are taken into account. Some rules appear to have some merit and work for a while, and then they stop working and deliver stunning losses. For example, in the late 1990s momentum trading was all the rage, as the stock market was in a long-run bull market. However, none of the momentum rules picked up the peak of the market and stung many investors as the market turned into a three-year bear.

I tend to believe that the equity markets, like the bond market, are efficient in the sense that there is no easy money to be made and that prices are set by many reasonably sophisticated investors constantly searching out relevant information. However, does this mean that, like the bond market, there are corollaries in terms of interesting information we can glean from these prices? Here I think that the answers are not so obvious.

Finance Basics, part 5

The fifth point and fourth implication of market efficiency is to understand credit risk. U.S. government bonds are default-free, since they have a monopoly on the money supply. Despite deregulation in many areas, very few governments have given up their monopoly rights to print money as the legal medium of exchange. However, corporate borrowers have no such access to the money supply. They have to earn the dollars to pay off debt obligations the same as everyone else. Consequently, there is default or credit risk attached to corporate bonds.

We can look at the amount of default risk attached to corporate bonds by looking at the yields, or market interest rates, on lower- quality corporate bonds and comparing them to the yields on U.S. Treasuries. This yield spread reflects the default risk attached to corporations and both the likelihood of the company defaulting and the expected payout should the firm default. By tracking this yield spread through time, we get the market’s indication of the likelihood of corporate bankruptcies.

For example, at the top of the business cycle when the economy is booming, most firms are profitable and can survive; this is just a variation on Ronald Reagan’s “Rising tide raises all boats.” In this case, there is relatively little risk attached to corporate debt, and we tend to see default spreads narrow as investors become convinced that good times will continue. On the other hand, once the economy starts to slow, corporate profitability starts to decline, and competition becomes more acute. In this case, default spreads start to widen as investors sell corporate bonds due to their higher default risk, forcing up the yield or market interest rate on corporate debt. A “flight to quality” always happens during a slowdown, and the severity of its effects can be seen in the default spread.

By understanding how credit risk varies with the business cycle, we can understand how the market rates the probability of a firm’s defaulting on its obligations. By looking at the aggregate data, we get an indication of the short-run severity of a recession or boom. This information is particularly useful when combined with the interest rate data indicating where the market expects interest rates to go. Want to know where we are in the business cycle? Listen to the market.

In terms of what the capital market can tell us, there are clear messages. The term structure of interest rates tells us where interest rates are expected to go. The interest rate difference between real return and nominal bonds tells us where the capital market thinks inflation will go. The forward foreign exchange rate tells us where the foreign exchange rate is likely to go. Finally, the spread between corporate and government bonds tells us where the market thinks default risk is going and gives a good indicator of where we are in the business cycle.

Finance Basics, part 4

The fourth key point and third implication of market efficiency is to understand the implications of investing in foreign markets. As capital markets become more efficient and barriers to international investing come down, more and more investors look to foreign markets as possible investments. Suppose, for example, one-year U.S. Treasuries are at 5 percent, but the government of Canada is selling one-year Canadian dollar bonds with a 6.0 interest rate, which bonds should the investor buy?

It is tempting to say that obviously 6 percent is better than 5 percent, so buy the Canadian government bonds. The problem is that the payoff of those bonds is in Canadian dollars, and a U.S. investor has to be concerned with the U.S. value of the Canadian dollar in a year’s time. If the Canadian dollar depreciates by 5 percent, the extra 1 percent interest is not worth the 5 percent foreign exchange loss. To remove the possibility of foreign exchange gains and losses, the investor could sell the Canadian dollars at a special exchange rate, called the forward rate, thereby locking in a fixed U.S. dollar return. However, as might be expected, the return from such a strategy, known as covered interest arbitrage, gives essentially the same return as investing in U.S. government securities.

That these covered interest arbitrage strategies in different countries all yield the same return indicates that these forward rates are another set of break-even rates. In this case they are break-even future exchange rates. Just as the term structure of interest rates allows us to estimate where the market expects interest rates to go, in the same way, we can look at a term structure of forward rates as indicative of where the market expects foreign exchange rates to go. Similar to the interest rate forecast, these market foreign exchange rate forecasts are free, except for the cost of a newspaper and the time spent looking in the financial pages: Listen to the market.