Wednesday, July 3, 2013

Emons, The End of the Risk-Free Rate

Ben Emons, a senior vice president and global portfolio manager at PIMCO, argues that we need to adjust our financial models to reflect, as the book’s title states, The End of the Risk-Free Rate: Investing When Structural Forces Change Government Debt (McGraw-Hill, 2013). Emons’ thesis, if sound, is challenging; it calls for a paradigm shift. For instance, equities are priced off the risk-free rate. But if there is no longer a risk-free rate, if (to look only at the domestic market) U.S. Treasuries now carry an element of risk, and presumably an element of risk that is dynamic, how do you calculate the risk premium that is built into a stock price? Equity pricing models need to be redrawn. And options prices would have to be recalibrated as well; the risk-free rate is, after all, an input to the Black-Scholes model. (A proofreading aside, it is not—as it appears in both the text and the index—the Black-Sholes model.)

Unfortunately, Emons’ book doesn’t serve his thesis especially well. He writes like a bond guy, actually like a Dutch bond guy. Which means that his prose is often incomprehensible. To take but a single sentence—and it’s supposed to be a full sentence (p. 62): “In connection is a ‘sudden stop’ at which foreign capital withdrawals that cannot be offset sufficiently by domestic capital.” I assume that “withdrawals” should read “withdraws,” but I can’t parse “in connection.” The book suffers mightily from the absence of a good copy editor and proofreader.

For those who are willing to soldier on, let me try to summarize the author’s argument for his claim that “the present-day risk-free rate resembles an ‘upside-down’ world.” First, the “risk-free rate can be seen as the sum of two kinds of expectations: an expectation of future inflation and future real GDP growth.” With the so-called risk-free rate now at 0, we can conclude that both expectations have been dampened considerably. “That effect gets momentum in case of ‘flight to safety’ during a crisis situation. Because this flight to safety affects the risk-free rate, it also affects risk premiums for other securities.” In 2012 the equity risk premium reached its highest level since the 1960s, nearly five percent. “Based on historical data on equity risk premiums by Ibbotson, at ultra low levels of risk-free rates, the risk premiums represent an ‘old normal.’ It creates the perception that, for example, stocks are dramatically undervalued. That may not be fully correct because historical models are using a risk-free rate based on the assumption of growth rates from better times.” And so, Emons concludes, we get to the upside-down world where the risk-free rate “is distorted on the one hand by flight to safety and central banks; on the other hand, the risk-free rate is assumed in models to be at old school value when growth was higher.” (pp. 29-30)

This book is ostensibly directed at investors who have to make decisions in this new, uncertain environment. I would narrow its audience to exclude all but relatively sophisticated bond investors, academics, and professional money managers. Retail investors in stocks who are not comfortable with the language of bonds will struggle.

1 comment:

  1. Dear Mrs. Jubin:

    Thank you for reading my book and spending time on reviewing it. I appreciate you point out spelling issues. This is something I have spent diligent time on with the editor.

    I like to make a few points to your critique of the book. Indeed the content of the book has a market technical nature. Although there is always room for improvement, the fact that I am Dutch and English is not my native language, doesn't mean my writing is "incomprehensible" as you say. Editing is an art, and you should know as an experienced reviewer that it is not uncommon typos or spelling issues often show up in books. Although my style of writing is technical, others whom have read the book and have little knowledge of bonds, didn't seem to have an issue following the content.

    Many of the topics I describe are actively discussed in financial markets. These may be for the "retail investor" perhaps somewhat over and above. However, for example a balance of payments crisis, structural unemployment, or restructuring of debt have a major influence on financial markets. This book aims at educating investors what those topics mean in practice.

    Unfortunately you did not address the second part of the book which is a more practical approach to the thesis of the end of the risk free rate. For example I discuss at length the implications for stocks and bonds, and take the reader on a tour across many asset classes. The reader gets a good insight in the return and risks of those assets. In addition, I 'quantify' the embedded risk in the risk free rate in chapter 4 by introducing a basic framework. Such framework could be useful for investors to better gauge what the true risks are of the "risk free rate".

    This book aims at discussing ideas around the concept of "risk free" in markets. The risk free rate is an assumption in models, pricing of securities and even in quantitative easing policies. I don't make investment recommendations but I strongly argue there is no "alternative risk free rate". Often in the media it has been said that with Treasury yields on the rise, the 'safer' alternative could be equities. Obviously that is not true.


    Ben Emons
    Author of The End of the Risk Free Rate