Equity and Equity Risk Premium
Equity refers to a security with an indefinite size and timing of dividends. Moreover, these dividends may stop in the event of bankruptcy. This makes equities riskier than debt. Equities, therefore, require an additional risk premium. More precisely, investors who…
Business Cycle and Earnings Growth Expectations
Earnings and business cycles have a very close relationship. Investors should, therefore, have a good understanding of the business cycle to make projections of earnings. Even then, it is worth noting that the effect of the business cycle on the…
Credit Quality
Credit spreads vary across industrial sectors. When credit spreads are narrowing relative to government bonds, the spreads between higher- and lower-rated corporate bond categories also narrow. During these times, although corporate bonds generally outperform government bonds, lower-rated corporate bonds tend…
Credit Spreads and Credit-sensitive Fixed-Income Instruments
A credit spread is the difference in yield between a corporate bond and a government bond of equal maturity. Investors require the spread as a modality to compensate for the additional credit risk relative to that of government bonds. Besides…
Factors Affecting Yield Spreads
The current value of a real default-free bond (inflation-adjusted) is given by: $$ P_0=\sum_{t=1}^{n}\frac{CF_t}{\left[1+R\right]^t} $$ For a default-free nominal coupon-paying bond (non-inflation adjusted), we have: $$ P_0=\sum_{t=1}^{n}\frac{CF_t}{\left[1+R+\theta+\pi\right]^t} $$ The difference between the yield on non-inflation adjusted (nominal) and inflation-indexed bonds…
Business Cycle
Short-term Interest Rates and the Business Cycle Short-dated nominal zero-coupon government bonds have yields closely related to the central bank’s policy rate. Additionally, the uncertainty of inflation over the very short-term investment horizon, typically three months, is negligible. Therefore, the…
Growth Rate of the Economy
Real Default-free Interest Rates Consider an investor investing in a default-free bond. Further, assume that there is no inflation. The investor would still be entitled to compensation for not consuming today. This compensation is the opportunity cost of consuming today….
Expectations and Market Valuation
The return on any asset is determined by the expectation of future discount rate fluctuations. If interest rates are expected to fall, short-term investments will be less attractive while long-term investments will get more attractive. Longer-term bonds will continue to…
Market Values
The market value of any asset is the sum of the present value of cash flows expected to be generated by the asset. Several factors determine the expected values of these cash flows. Some of these factors include the discount…
Risk Measures and Capital Allocation
Capital allocation is critical to a firm’s market risk management. It involves setting limits on all activities and giving priority, in resource allocation, to areas expecting the greatest reward. When wisely allocating capital, a company ensures that all its risk…
