Interesting Times: The Drivers

Une fausse perception de la sensibilité

Interest rates.  It's a common topic of discussion, but why is it so important?  The so called “fed funds rate” is the rate of interest at which depository institutions trade with one another overnight.  If an institution's reserve account is too low, it will borrow from other institutions at the federal funds rate; if it's too high, it will lend at this rate.

The rate is critical to everything finance related and is a crucial tool that the central bank of the United States (the Federal Reserve) uses to stabilize prices (inflation) and control the labor market (employment).  The rate influenced by the Federal Reserve trickles into the rest of the economy by influencing borrowing costs.  This has a grave impact on investment decisions, as the opportunity cost of holding a Treasury Bill (short term debt issued by the United States Government) decreases greatly.  In other words, holding a riskless asset for a guaranteed yield looks much more attractive than holding a basket of stocks for an uncertain one.

Say, for example, you are an investor.  As the astute investor you are, you decide that you are going to base your investment decisions off the Capital Asset Pricing Model (CAPM).  Describing the expected return of a security, the model uses beta (an asset’s sensitivity to some index or benchmark), the risk-free rate (the rate on a Treasury Bill set by the federal funds rate), and the expected return on the market as described below.

E[Ri]  = Rf + β * (E[Rm] - Rf)

Where:
E[Ri] is the expected return of security i

Rf is the riskless rate

β is the asset’s beta or sensitivity to the market/benchmark

E[Rm] is the expected return of the market/benchmark

Without going into the limitations and unrealistic assumptions of the CAPM, we can clearly see that the risk-free rate will have a substantial impact on the overall equation and its derivations.  That’s where the last year or so comes into play.  With the historical rapid increase in rates that we have seen recently, this key component in models has seen quite the whipsaw.  Below are some descriptions of key drivers.

Cost of Capital: Firms have a cost to raise money, either through the debt or equity capital markets.  A rapid change in the risk-free rate will substantially impact firms that need to raise capital, especially those who are not rated at the high end of the credit rating scale.

Discount Rates: A common way to price assets involves discounting future cash flows to what they are currently worth in today’s dollars using the rate set by the Federal Reserve.  The higher this rate, the lower present value a future cash flow has.  Intuitively, this makes sense, as all else equal, you could invest at the risk free rate for that time.

Interest Rate Sensitivity: Fixed-income securities in particular have a sensitivity to a change in interest rates, as the coupon a bond pays and the time it has left until maturity have direct influence on how the price of that bond will change if interest rates move (see more: duration).

Common Equity Valuation: Many DCFs use models such as the Gordon Growth Model or the Dividend Discount Model, both of which have a common key input: the risk-free rate.

Unless you prefer to use circular logic on projecting multiples.

Thanks for reading.
- Mickey