Tuesday 4, January 2022

Interest rates, futures curves, backwardations, waves

Interest rates underpin all of financial modelling. They link cashflows today to cashflows in the future. The “risk free rate” is a key parameter in all derivatives valuation. One of the odd things about the fundamental equation of finance, the Black and Scholes equation, is that it does not involve any commodity-specify discount rate (equivalently, the expected return to holding an asset). As a simple way of understanding this, imagine pricing an ounce of gold to be delivered in a year’s time. This can be predicted by knowing the price of gold today, and the cost of borrowing money for a year. It doesn’t depend on the supply and demand for gold in the future. You can buy the gold now, with borrowed money, and be confident that whatever happens to the market price of gold over the next year you will be able to meet your contractual obligation. Obviously, storing gold is not quite costless, so you may have to factor in a ‘carry cost’ relating to warehousing the stuff.

Anyway, something is not quite right, as oil for delivery in five years time looks far too cheap on this model. Storage for oil is expensive, so maybe the futures price does merely relate to unpredictable storage costs, but futures strips certainly do not behave as expected by this simple model.

Even if we did have a separate interest rate for every commodity, we have the added complication of credit risk. I might offer you a higher price for oil delivery in a year than I do to someone with no track record of delivering oil. This reflects the situation in the economy. Elon Musk can borrow a lot more cheaply than some twenty year old in a dead-end job who has already been made bankrupt. Especially if Elon pledges stock in Tesla to the extent of twice the amount of the loan. The figures are not insignificant: credit card borrowing for poor quality borrowers will cost above 40% per year. If George Soros’s family office borrows, it will be cheap.

Each individual has his own personal discount curve, which presumably depends on his expectations about how long he wants to live, how much he wishes to leave to his dependants etc. A theory that aggregates all this data and comes up with robust predictions is a tall order. No wonder economists suffer from physics envy.

The trouble with markets is that, mostly, money does not flow into gold futures because buyers and sellers have a real need for gold in one year, but don’t want the hassle of buying now and storing. Money flows into gold because investors bet that gold will be cheaper of more expensive in one year than the current forward price. In other words, gold is just a substitute for any other financial asset, and the changing attitudes of investors to different asset classes hugely affects the price. Anticipating these changes in fashion is what all investors are trying to do, which decouples prices from all fundamentals. Investing is difficult; did I already mention that?

What will happen in 2022?

Continuing my theme above, how will fashions switch this year? I don’t know, but I think that the basic understanding that meme stocks, crypto, NFTs, the FAANG, lockdown plays, ESG ETFs etc. may all be now in deep bubble territory. This is Kuppy’s view, which I nearly always agree with. He sets it all out here.

I tried to clone the Tiger Global holdings via unhedged.com. In theory, this can be done here. For some reason or other, I can’t do the export.

He talks about how liquidity can slosh around from one asset class to another, creating huge waves. Maybe it’s coming this year. A lot of gurus are saying so. But, as some wag on Twitter remarked, the only reason so many investors are called ‘gurus’ is that ‘charlatan’ is so difficult to spell.