The third key point and second corollary is to understand inflation. Most outstanding bonds are termed nominal bonds, since their payments are fixed in nominal terms and not in real terms – that is, what they can buy. For example, if you buy a 6 percent five-year U.S. Treasury, the U.S. government will pay you $30 every six months for five years and then give you your $1,000 back at maturity. These payments are fixed contractual obligations of the U.S. government, regardless of what happens to inflation.
If inflation increases and then stays at 6 percent, the real return on this bond is zero: 6 percent nominal interest has been completely offset by 6 percent inflation. In this case, the investor is no better off having invested in this bond than having simply spent their money immediately: Their purchasing power was the same when they bought the bond as it was at the end of the five years. In contrast, if inflation dropped and then stayed at 0 percent, the real return would be 6 percent, and at the end of the five years, the investor’s real purchasing power has increased: They can buy more at the end of the five-year period than they could have at the beginning.
Understanding how inflation affects nominal interest rates is very important. The fact that nominal interest rates on long-term U.S. securities are now under 5 percent, compared to the +10 percent levels of ten years ago is due to the lower current inflation rates. However, in contrast to ten years ago, we now have what are called real return bonds (in Canada) or inflation-indexed treasury securities (in the United States). With these bonds, the interest rates are fixed in real terms, and the principal of the bond increases with inflation. In this way, investors are protected from inflation, as every year they earn their fixed rate on a principal amount that increases with inflation.
These inflation-indexed bonds are new securities in the United States, but have existed in Canada, the United Kingdom, and other countries for many years. They are extremely useful for two reasons: First, they remove one of the major concerns of retirees, which is that inflation will reduce the real value of their wealth and render their golden years ones of poverty. More important for our purposes is that they reveal more information about market expectations. The difference between the interest rate on the nominal and real return bonds is another break-even rate, in this case a break-even inflation rate.
For example, suppose that long-term U.S. government securities offered a 5 percent yield and the real return bond for the same maturity is 2.5 percent. The difference between them, 2.5 percent, is one proxy for the market’s inflation forecast. If you felt inflation was going to average only 1 percent over the long term, then it would make sense to buy the 5 percent nominal bond. In that case the real return of 4 percent (5 percent nominal rate minus 1 percent inflation) beats the 2.5 percent real return bond. On the other hand, if you felt inflation was going to average, say, 4 percent, then the inflation indexed bond makes sense, since the real return on the nominal bond is then only 1 percent (5 percent minus 4 percent inflation). In either case you should compare your own inflation forecast with that of the market; that is, listen to the market.
April 11th, 2009 in
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The second key point and the first corollary to market efficiency is to understand the term structure of interest rates – to understand that interest rates differ according to different maturities, so the interest rate on treasury bills is different from the interest rate on 10-year bonds and the interest rate on 30-year treasuries. So we can look at the term structure of interest rates and work out where the market expects interest rates to go.
We can do this by working out what are called break-even, or forward, rates. For example, suppose the rate on a one-year government bond was 5 percent and that on a two-year bond 6 percent. Since on the two-year bond you will earn 1 percent more than on the one-year bond, to break even the investor has to catch up by reinvesting the proceeds from the one-year bond at a 1 percent higher rate next year, that is, at 7 percent. In this case, earning 5 percent from the one-year bond and then expecting to earn 7 percent from reinvesting in a one year bond next year will earn the same return as investing for 6 percent for two years.
By performing similar break-even calculations for bonds with maturity dates for three, four, five years, and so on, it is possible to calculate the break-even rates for all future time periods. The theorem of unbiased expectations then allows us to use this as the market’s forecast of future interest rates.
I am often asked how you judge the quality of a forecast. The answer is you have to compare it to something, and the obvious answer is to compare it with this market forecast. Suppose, for example, you’re convinced that market interest rates are going up. Does this mean you should invest in one-year bonds at 5 percent and wait for interest rates to go up just as you forecast? The answer is no. As I just showed by calculating the breakeven rate of 7 percent, we have a benchmark to judge the forecast against. If you think interest rates are going up to 8 percent, then invest for one year, and if you are right, you can rollover at this higher rate and be ahead of the return on the two-year bond. On the other hand if you think interest rates are only going up to 6 percent, then buy the two-year bond: Obviously two years at 6 percent is better than a year at 5 percent and then a year at 6 percent.
These break-even rates also allow us to judge how good economic forecasters are. It is not enough to estimate that one- year interest rates will go up from 5 percent to 7 percent; that forecast is free and in every newspaper. A forecaster has to add value by beating this free forecast, which in practice turns out to be very difficult. Once these break-even rates are calculated, the investor can determine whether to buy long- or short-term government bonds and to question whether their views are correct; either way they should listen to the market.
April 10th, 2009 in
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There are many fundamental propositions in finance, but some are simply corollaries; that is, they follow directly from others. I will take as the fundamental that markets are in some sense “efficient” or “rational” and examine what this means for different areas of finance. We have to remember that most of finance revolves around financial markets and that these markets reflect the actions of many market participants – both buying and selling securities. In some sense it inevitably follows that market prices reflect the information of all of these participants in the market, so in a general sense these prices should be trusted. For example, one of the basic phrases in finance that summarize this idea is “Listen to the market.” Even if you don’t agree with it, market prices still provide information, and you should know what that information is.
Academics have developed a huge literature around the concept of market efficiency, which at its weakest assumes that all publicly available information is already reflected in security prices. Consequently, there is no value to buying shares based on past share price movements (momentum trading) or doing fundamental financial analysis using the firm’s financial statements. I’m not convinced that markets are as efficient with information as financial theory indicates for two reasons.
First, we have securities commissions, who constantly prosecute people for manipulation of security prices. If the markets were as efficient as some advocate, then it would not be possible to manipulate prices, so the mere existence of the SEC is a sobering reminder of potential market inefficiencies. Second, Enron and WorldCom have reminded us that financial statements can be misleading and that the auditors are not always to be trusted. The auditors are supposed to be the gatekeepers who make sure all material information is divulged to the markets. The “disappearance” of Arthur Andersen and the allegation that Andersen actively colluded to help Enron misstate their financial statements (by the use of special purpose vehicles) have heightened everyone’s awareness of the importance of transparency: All material information has to be divulged in a timely and informative manner.
However, the fact that the validity of market efficiency has been questioned should not blind us to its implications. In markets where all material information has been divulged and there is no inside information, market prices are more informative than in markets where the opposite is true. Consequently, I will first deal with four implications of market efficiency where the assumption that all available information is reflected in market prices is robust.
One obvious area where the capital market is likely to possess all available information is in the pricing of fixed income securities, particularly government securities. In most modern economies the central bank is legally as well as functionally separated from the government’s Treasury, that is, the branch that manages the government’s issue of securities. Consequently there is very little “inside information” as to where interest rates are likely to go. In fact, every statement of the Governor of the Federal Reserve System is scrutinized in detail to see whether there is some indication of what the Fed is likely to do. In the face of such intense scrutiny, it is difficult to believe anyone has inside information as to the path of future interest rates.
April 9th, 2009 in
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