Dear,
As we discussed last week, we have two main families of assets valuation.
- Historical Value Accounting.
- Fair Value Accounting.
http://sapbank.blogspot.com.es/
The second includes risk and capital consumption, the first doesn’t as there’s no uncertainty in past events.
In a world of limited Capital, estimating risk is a critical activity; incorrect risk estimations will driver wrong valuations and capital waste.
In Corporate Finance we identify three types of Risk (this is just a classification; there’re others).
- Credit Risk.- The Risk that our counterpart don’t fulfill his obligations.
- Market Risk.- The Risk that the value of an asset fluctuates due to market events.
- Operational Risk.- The Risk that of making an operational mistake.
In Credit Risk estimation, we measure the Rating, which is an estimation of the statistical probability that our counterpart is not willing or able of fulfilling his obligations.
Again, we have two methods of estimating the rating.
- We look at the past.
- We look at the future.
We also can ask for an expert opinion (Rating Agency), but whatever methods they use, they will look at the past, at the future or both (mixed methods).
Looking at the past means measuring the past credit events of the counterpart, or other counterparts similar to him (Historization). Looking at the future means “making a bet”.
We’re in the middle of a Systemic Crisis, we’ve enjoyed high growth rates on the last 70 years, but Capital scarcity is making very challenging to keep those rates in the future.
Can we estimate the uncertainty of the future, just by looking at the past events, when we assume that the environment will be radically different?
An alternative is “making a bet” or even better, measuring the bets of many experts. For doing that we can use a Financial Derivative called Credit Default Swap.
Finance Mathematics provide us with a function which determines the value of a CDS according the Rating of its counterpart, the inverse function will determine the Rating according to the value of the CDS. We call it "Implicit Rating".
But the question remains, what is the Value of the CDS?
Let’s assume for a second that Capital Markets are Perfectly Competitive Markets (we know they’re not), under this assumption trade price would be very close (ideally identical) to the value of the asset, and consequently trade price of CDS’s would disclose the Rating of the counterpart.
But we know we’re far from being in a Perfectly Competitive Capital Markets; the real power is concentrated in a small number of Investment Funds, Hedge Funds and Shadow Banking agents. They have the ability of determining the price of the assets and consequently the Rating of the counterparts. On the process, they drive Capital allocation activities, inflating and bursting bubbles according to their interests.
In a world of limited Capital, growing by inflating and bursting bubbles is a big issue. Can we move to the new model if we don’t improve the transparency and efficiency of the Capital Markets?
I don’t think so.
Looking forward to read your opinions.
K. Regards,
Ferran.
As we discussed last week, we have two main families of assets valuation.
- Historical Value Accounting.
- Fair Value Accounting.
http://sapbank.blogspot.com.es/
The second includes risk and capital consumption, the first doesn’t as there’s no uncertainty in past events.
In a world of limited Capital, estimating risk is a critical activity; incorrect risk estimations will driver wrong valuations and capital waste.
In Corporate Finance we identify three types of Risk (this is just a classification; there’re others).
- Credit Risk.- The Risk that our counterpart don’t fulfill his obligations.
- Market Risk.- The Risk that the value of an asset fluctuates due to market events.
- Operational Risk.- The Risk that of making an operational mistake.
In Credit Risk estimation, we measure the Rating, which is an estimation of the statistical probability that our counterpart is not willing or able of fulfilling his obligations.
Again, we have two methods of estimating the rating.
- We look at the past.
- We look at the future.
We also can ask for an expert opinion (Rating Agency), but whatever methods they use, they will look at the past, at the future or both (mixed methods).
Looking at the past means measuring the past credit events of the counterpart, or other counterparts similar to him (Historization). Looking at the future means “making a bet”.
We’re in the middle of a Systemic Crisis, we’ve enjoyed high growth rates on the last 70 years, but Capital scarcity is making very challenging to keep those rates in the future.
Can we estimate the uncertainty of the future, just by looking at the past events, when we assume that the environment will be radically different?
An alternative is “making a bet” or even better, measuring the bets of many experts. For doing that we can use a Financial Derivative called Credit Default Swap.
Finance Mathematics provide us with a function which determines the value of a CDS according the Rating of its counterpart, the inverse function will determine the Rating according to the value of the CDS. We call it "Implicit Rating".
But the question remains, what is the Value of the CDS?
Let’s assume for a second that Capital Markets are Perfectly Competitive Markets (we know they’re not), under this assumption trade price would be very close (ideally identical) to the value of the asset, and consequently trade price of CDS’s would disclose the Rating of the counterpart.
But we know we’re far from being in a Perfectly Competitive Capital Markets; the real power is concentrated in a small number of Investment Funds, Hedge Funds and Shadow Banking agents. They have the ability of determining the price of the assets and consequently the Rating of the counterparts. On the process, they drive Capital allocation activities, inflating and bursting bubbles according to their interests.
In a world of limited Capital, growing by inflating and bursting bubbles is a big issue. Can we move to the new model if we don’t improve the transparency and efficiency of the Capital Markets?
I don’t think so.
Looking forward to read your opinions.
K. Regards,
Ferran.
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