Valuers price risk all the time.
Two main ways that we price risk is through discount rates and cash flows.The cash flows are either promised or somewhat risk adjusted, but most critically market risk is baked into the discount rates. Essentially, we use discount rates to convert tomorrow’s dollars into the dollars of today and accordingly, we need to allow for both the time value of money and the market price of risk.
Of course, many of us think about the price of risk as we invest, but when we value, this estimate is crucial.
This risk price also has real economic effects; the higher the price of risk, the less is invested in higher risk activities like innovation.Accordingly, we all benefit from understanding how risk is priced, and making sure that it is priced efficiently over time.
There are three main ways in which valuers think about the price of risk.
Credit risk
The easiest way to conceive of the price of risk is in borrowing rates.Borrowing rates are used to convert future promised payments into the present value of a debt today, and accordingly are used by valuers in pricing debt securities.
These borrowing rates are composed of a reference rate (usually an interbank rate) plus a credit spread.Credit spreads are an estimate likely default risk, the loss given default and the uncertainty of these loss outcomes across the various classes of credit.
By using the price of traded bonds, and a known reference rate, these credit spreads can be observed from traded bonds over time.
The chart below, sourced from the RBA website, shows how implied credit spreads have moved for BBB rated debt (the most common rating for corporate debt of debt) and AA rated debt (very high-quality corporate debt) together with the reference rate.
Source: RBA Website
This chart shows that there are long periods of considerable stability, interrupted by substantial peaks, reflecting in, most recent times, the GFC and the recent COVID crisis.
Option risk
In option markets, the way risk is accounted for differs considerably.Effectively the price of the underlying security is taken from an active market, and the allowance for expected returns is made through a “risk-neutral” adjustment (in simple terms the price tomorrow will be the same today, except for the time value of money, rather than a higher expected price with more risk).Because the option provides for a choice on the part of the option holder, the uncertainty around expected returns therefore becomes the critical variable.
This uncertainty is captured through the risk measure volatility, which is an expression of anticipated variability in price over time.The other factors are easily input to the Black-Scholes option model for an exchange traded option, so market estimates for volatility can be readily observed, by using the standard formula, the other easily obtained variables (time to expiry, strike price, current price and dividends expected)and back solving for implied volatility in the options.
There is a market index established by the Chicago board of exchange, which captures the implied volatility (calculated in the way described above) of a basket of all options on the S&P500.
This is called the volatility index or VIX. The VIX is known by many names, including most memorably the “Fear Index”, but it does indicate the degree of uncertainty that's built into market prices.Some say that this even provides an indirect measure of the systematic risk in a market at a given time, but valuers use it to calculate the value of derivative securities, where, generally speaking, more risk equals more value.
You can see the chart below, which charts the VIX over several years - the VIX is not a constant, it changes day by day.
Source: Google
One thing stands out.As you can see, the VIX measure of risk exhibits much the same behaviour as credit spreads; there's a relative stability over a long period of time, interspersed with substantial peaks.
Equity risk
Equity risk is typically captured by business valuers by using the capital asset pricing model (CAPM) or its close relatives.
Essentially, this requires the estimate of reasonably expected cash flows, discounted by a weighted average cost of capital.For our purposes in this article, the CAPM, has three factors, a base rate, a Market risk premium, and a measure of correlation with the market (Beta).
Some practitioners default to using spot long term base rates as indicated by government bond rates, together with long term realised premiums of share markets over bonds for estimates of the market risk premium.These practitioners have found the market perturbations over the last 10 or 15 years, together with extensive use of quantitative easing policies, have played havoc with their traditional approach.
Accordingly, more sophisticated approaches have been developed.For example, at PwC Australia, we triangulate an implied cost of capital (discussed more below), a long term cost of capital using equilibrium base rates put out by the RBA and other market estimates of the cost of capital to formulate our considered view on the cost of capital each quarter.On occasion, we have had to make separate allowance for market disturbances like COVID in the second quarter of 2020.
However, the most live estimate of market risk is contained within the implied market risk premium, which takes broker estimates and backsolves for market risk premium (assuming a beta of 1 for the whole market).This approach was pioneered by Aswath Damodaran, but a few others including the website, where the below chart was sourced, do the same.
Source: http://www.market-risk-premia.com/au.html
We perform our own internal analysis, which differs in overall magnitude to the above estimate, but directionally is mostly consistent.
Taking this public analysis, it is pretty clear that similar trends that were exhibited in the credit spreads and volatility measures of risk. In that there are long periods of stability, but occasionally very large peaks.
Takeaways
As we have discussed, the price of risk is a critical variable in valuing securities.
Several markets provide real time estimates of risk pricing, but in different ways.In this article, we have seen the different ways that debt, derivative and equity markets imply risk pricing that can be used across comparable assets.
As you can see, the price of risk, when observed in the three ways discussed in this article exhibit very similar behaviour.The price of risk tends to be relatively stable over long periods but is prone to significant increases in times of uncertainty, but relatively quickly reverts to the mean.
For valuers, who are largely tasked with estimating hypothetical market prices at a given time, a long-term view considering mean reversion is problematic in times of high uncertainty, so a weather eye needs to be on all three measures of risk.
For investors, betting on risk returning to normal levels in periods of high uncertainty might present an opportunity for excess returns.However, those seeking to capture these excess returns should bear in mind Keynes legendary quote “markets can remain irrational longer than you can remain solvent”, as a cautionary note to manage their liquidity carefully in making such investments.
-------------------------------------------------------------------------------------------------------------Richard Stewart OAM is a Corporate Value Advisory partner with PwC.He has been with them for 35 years in Australia, Europe and the USA, doing his first valuation in 1992. He has helped his clients achieve great outcomes using his value skills in the context of major decisions, M&A, disputes and regulatory matters.His clients span both the globe and the industry spectrum.He holds a BEc, MBA, FCA, FCPA, SFFin, FAICD and is an accredited Business Valuation Specialist with CAANZ.He has written two books, Strategic Value, and Hitting Pay Dirt, and is an Adjunct Professor at UTS. The opinions in this article are his own and not necessarily PwC's.
