Streetwise Professor

November 2, 2008

The Market Price of Risk, More Generally

Filed under: Derivatives,Economics,Energy,Politics,Russia — The Professor @ 6:31 pm

I wrote an extended reply to DR’s comment regarding sovereign debt credit spreads, but (a) I had been planning on writing something regarding the price of risk more generally, and (b) the subject is of broad importance, so I’ll expand upon those thoughts in this post.

Credit spreads are essentially a price. Given a set of promised cash flows, the higher the credit spread, the lower the market price of those cash flows. Thus, if you had Russian and Brazilian debt with the same promised cash flows, a higher spread for Russia implies that the Russian debt sells for less.

This can occur for two reasons, the first of which gets the most attention, the second of which is the focus of this post.

The first reason relates to the size of cash flows. On debt instruments, realized cash flows differ from promised cash flows due to defaults. Therefore, the lower price of Russian debt could arise because market participants estimate that Russia is more likely to default than Brazil, and/or, in the event of a default, bond holders will receive fewer cents on the promised dollar from Russian bonds than Brazilian bonds.

The second reason, which is somewhat harder to grasp, is that market participants can apply different discount rates to different securities. In particular, finance theory tells us that you should discount riskier cash flows more heavily than less risky ones. All else equal, greater risk leads to greater discounting to lower price, which leads to higher spreads. Thus, Russian spreads could exceed Brazilian spreads because market participants discount Russian cash flows more heavily due to greater risk.

This raises the question: What is risk? Finance theory tells us that risks that are diversifiable should not be priced, that is, they should not affect the discount rate. This is because if the risk is diversifiable (also known as “idiosyncratic”) investors can eliminate it by holding highly diversified portfolios.

A diversifiable risk is one that affects one investment and that investment alone, and which is uncorrelated with the risks on other investments. For instance, the possibility that a particular company achieves a technical breakthrough is diversifiable, as is the risk that a particular company is hit by a product liability suit, or has a particularly good or bad management. Diversification eliminates these risks because in large portfolios, the law of large numbers means that the bad luck in one company is likely to be offset by good luck in others.

A systematic risk is one that cannot be diversified away. Typically, it is a risk that is driven by overall economic activity, that is, by the state of the overall economy. The overall economy affects all investments to some degree or another, and can’t be diversified away. We have many companies and countries, but only one economy.

Different assets have different sensitivities to overall economic activity. “Cyclicals” is an investment buzzword for companies that perform very well when the economy does well, but do very poorly when the economy is in recession. Some stocks (e.g., healthcare) are often considered to be non-cyclical because the demand for the services of these companies is not as sensitive to overall economic activity as are industries more dependent on discretionary income, such as automobiles and housing.

In brief, investments with performance that is highly dependent on overall economic activity tend to be discounted more heavily. People want investments that pay off when times are bad, and are willing to give up payoffs when times are good. Investments that are highly dependent on the overall economy are sunshine friends–they do well when you don’t need them as much (as your other investments are also paying off), but do poorly when you really do need them to pay (because all your other investments are doing poorly then too.)

Oil provides a very interesting illustration, and a link to the discussion of Russian credit spreads.

Historically, oil has had negative systematic risk. That is, oil prices tended to go up when the economy was doing badly, and go down when the economy was doing well. That meant that if you bought oil, it would pay off handsomely when you really need good payoffs–when your other investments are doing badly.

One explanation for this negative systematic risk is as follows. Supply shocks have historically been an important source of major oil price movements (think of the 1973 and 1979 oil shocks, the supply glut of 1986, and Gulf War I). Unexpected reductions (increases) in oil output raised oil prices and hurt the overall economy. The decline in the overall economy led to stock price declines. Thus, if supply shocks are major drivers of oil prices, you would expect a negative association between stock price and oil price movements.

Things are different now. At present, demand shocks are the major drivers of oil prices. Anticipations of a recession, and likely a severe, worldwide recession, have led to reductions in the expected demand for oil. This is why oil prices have declined of late. Moreover, the anticipation of a recession has caused stock prices to tank too.

Nowdays, the prices of oil and stocks tend to move in the same direction, and exhibit a relatively high correlation. You tell me what happens to the price of oil, and I can tell you (at least directionally, and with some precision as to magnitude) what has happened to the S&P or the FTSE. The price of oil is now a hostage to overall economic activity, as is the stock market. As a result, oil has gone from exhibiting low or negative systematic risk, to exhibiting high and positive systematic risk.

This can help explain Russia’s particularly high credit spreads relative to other BRIC countries, and why Russia has a higher credit spread that Iceland, even (though not as high as basket cases Pakistan, Argentina, and Ukraine.) It also contributes to the oft-noted fact that Russian stocks appear very “cheap” (as measured by price/earnings ratios, for instance) compared to other stocks.

The Russian economy is highly dependent on oil. In particular, government revenues are highly dependent on oil prices. Since oil has significant systematic risk, this means that securities (debt and equity) that are tied to the Russian economy have high systematic risk.

Moreover, the political factor risk factor plays here. It is becoming increasingly clear that the government is willing to spend a lot of money to cover the foreign currency borrowings of Russian companies. The largest borrowers, moreover, are energy companies. Their need for help will be greater, the lower the price of oil. Hence, the lower the price of oil, the faster Russia will burn through its reserves, the weaker its financial position will be, and the higher the likelihood of a default (de jure or de facto, a la 1998).

In essence, due to the close tie between oil prices and its economic fortunes, it makes sense that Russian spreads are very high. The country faces a triple-whammy. (That’s the technical finance term for it.)

First, default is more likely, and recovery rates are lower, the lower the price of oil. If oil prices remain low, Russia is more likely to blow through its reserves bailing out favored firms and defending the ruble. Furthermore, with low oil prices, government finances erode. All of these factors raise the likelihood of default on government debt. Thus, the probability of default is higher, and the recovery conditional on a default lower, the lower the price of oil.

Second, due to the high systematic risk associated with oil prices, cash flows highly dependent on oil prices are discounted more heavily. This includes government debt, private debt, and the equity of Russian companies, especially those in the energy sector, but not limited to that sector (e.g., consumer goods producers and retailers and construction firms are also vulnerable due to the link between their sales in Russia and the price of oil.) Russian investments, including government debt, are likely to do very badly when oil prices are low. Since the price of oil is likely to be low when overall economic activity is low, this poor performance is especially costly to investors, leading them to discount Russian investments more heavily.

Third, the factor I mentioned in The Price of Political Risk, namely the greater susceptibility of the Russian state to disorder when oil prices are low, exacerbates these problems. The low oil price stresses the weak institutions, and which contributes to pressures to spend reserves. It also increases the probability of popular unrest, government infighting, clan warfare, and in the extreme, political chaos and collapse.

So, the facts that (a) the Russian economy, and perhaps more importantly, its public finance and the demands on its public purse, are heavily dependent on the price of oil, and (b) in current market conditions oil-sensitive investments bear substantial systematic risk, imply (c) investments in Russian government or private debt, or Russian equity, have been especially hard hit by the credit crisis. Moreover, (a) and (b) imply that Russian investments will exhibit exceptional sensitivity to oil prices. So much for an island of stability and tranquility.

If you’ve been following the markets lately, you’ll observe that Russian stocks and US and European markets have been moving in the same direction (up on the same days; down on the same days), but that the movements in Russian stocks have been far more violent. (One consequence of this is that since markets overall are down in recent weeks, Russian markets have fallen more.) This is consistent with the foregoing that suggests that due to the oil price connection, Russia exhibits very high systematic risk. Moreover, the very low P/E ratios of Russian stocks are also consistent with this analysis.

Although the Russian market experience is a particularly interesting, this analysis demonstrates a very important point that is missed too often. It has application, for instance, to the ongoing financial crisis and the collapse of mortgage securities prices. This very interesting paper by Coval, Jurek, and Stafford argues that CDOs (and other tranched securities) exhibit very high systematic risk by the very nature of their structure. CDOs invest in multiple instruments, and therefore are highly diversified. What’s left is all systematic risk. What’s more, per C-J-S, this systematic risk is very high because of (a) the fact that the underlying investments are very sensitive to overall economic activity, and (b) the optionality (and hence embedded leverage) in the structure of the instruments.

For instance, the highest tranches of CDOs are likely to payoff when the economy does well. Defaults occur when the economy is doing badly. Thus, low payoffs on these instruments occur when the value of consumption is greatest. This means substantial systematic risk.

C-J-S note that rating agencies only modeled default probabilities and recoveries when rating these instruments, and did not take into account their high systematic risk. The investment grade credit ratings were therefore a very misleading indicator of the risk of capital gain or loss on these instruments.

In sum, finance theory tells us that systematic risk matters. Different instruments have different systematic risks. Russia’s dependence on oil prices and the structure of CDOs both create substantial systematic risks that the market discounts heavily.

As C-J-S note, too often people focus only on the cash flow projections, and pay too little attention to the discounting. (That’s what the rating agencies did in the CDO market.) Seemingly anomalous pricing may well reflect specific systematic risk characteristics of the instrument being priced. (Ignoring this is why arguably why Bernanke thinks that CDOs on bank balance sheets should be worth a lot more. His public statements have seemed to focus on the cash flow projections, rather than the discounting assumptions.) Thus, when evaluating the pricing of a particular instrument, you need to ask: in what states of the world are the cash flows going to be low? Are they going to be especially low during those periods when the cash flows on most other investments are low too? If the answer to that question is “yes”–you need to discount heavily.

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