PIMCO's power brains often generate really interesting and unique analysis to common questions. The summary and thoughts below were derived from a recent presentation on asset allocation. Discount Rate
Post US downgrade, and recent sovereign debt crisis, what are the implications for the actual figure of the risk-free rate?
What about the equity risk premium? Academics prefer to examine historical spreads to determine this risk premium figure, think it’s around 2-6%. This “premium” increases when investors don’t want risky assets (e.g., 2008), and decreases when investors become risk loving (e.g., 2004-2006).
So what exactly is the appropriate equity risk premium? Is a historical figure appropriate? Does it differ depending on the security being analyzed?
Accordingly, if the risk free rate AND equity risk premium is constantly shifting, it would imply that the discount is constantly fluctuating as well. Any slight shift in the variable “k” in discount cash flow models creates huge ripples in the implied value of a security today. Perhaps we should all re-examine our casual use of “discount rates” when attempting to determine the value of a security.
Leverage
It’s a good time to be a borrower – especially on an after-tax basis. Ohio State had just sold $500MM 100-year “century” bonds at 4.849% coupon.
Risk
All risk within a portfolio can be explained by one of the four factors below, with Equity and Duration explaining about 95% of risk in most portfolios
- Equity
- Duration
- Liquidity
- Foreign Exchange