Understanding how rational investors evaluate cash flows
Real Risk-Free Interest Rate
This is the rate against which all investments are compared. It is the rate of return that an investor can achieve without any risks in a world where there is no inflation. Although it is not truly “risk-free,” government bonds are typically used as a practical benchmark to calculate the risk-free interest rate.
Inflation Premium
This is the premium added to the investment to adjust it according to market expectations for future inflation. For example, the required inflation premium for a one-year corporate bond may be much lower than that for a 30-year bond from the same company because investors believe that inflation will be low in the short term but will increase in the future due to trade and budget deficits in previous years.
Liquidity Premium
Some investments do not trade frequently, which poses a risk to the investor. Investments that trade sparingly, like securities of family-controlled companies, require a liquidity premium. This means that investors will not pay the full value of the assets if there is a real chance they will not be able to sell the bond in a short time due to a scarcity of buyers.
The liquidity premium is expected to compensate investors for this potential loss. The size of the liquidity premium depends on the investor’s perception of how active the specific market is.
Note: Liquidity risk is considered less for investors who trade stocks and other securities. Investors may even be willing to pay higher amounts for these securities compared to their lower liquidity alternatives.
Default Risk Premium
Do investors believe that the company will default on its obligations or go bankrupt? Often, when signs of danger appear, the company’s stock or bonds will collapse as investors demand a default risk premium.
Note: A security’s price collapse can be opportunities. If someone buys assets trading at a significant discount due to an unreasonable default risk premium, they can make a lot of money.
Many asset management firms will look for these opportunities. Kmart provided an example of this in the early 2000s. Before the retailer declared bankruptcy in 2002, distressed debt investors purchased a massive amount of its debt. When the company was reorganized in bankruptcy court, debt holders were given a stake in the new company.
For example, one investor, Edward Lampert, gained a controlling interest in Kmart’s stock by purchasing the debt and was able to use this control to improve the company’s financials and pull Kmart out of bankruptcy. However, despite orchestrating a merger between Kmart and Sears, the lack of capital investment in struggling companies led to declining sales and revenues, ultimately resulting in Sears’ bankruptcy.
Maturity Premium
The longer the maturity of a corporate bond in the future, the more its price will fluctuate when interest rates change. This is due to the maturity premium, also known as interest rate risk.
Here is a simplified example to illustrate the idea. Imagine you have a $10,000 bond with a 7% yield when issued, which will mature in 30 years. You will receive $700 annually as interest. In 30 years, you will receive the original $10,000. If you were to sell your bond the next day, you are likely to receive the same amount since the interest rate of 7% will not change overnight.
However, interest rates change. Imagine if interest rates rise to 9% a year after you bought the bond. You want to sell your bond, but no investor will accept your 7% bond because they can go to the open market and buy a new bond that offers a 9% yield. They will only pay you a lower price for your bond, not the full $10,000, to increase their yield to 9%.
Subject to
The longer maturities carry greater risks than capital gains or losses because there is more time for the interest rate environment to change. If interest rates decline, the bondholder will be able to sell their position at a much higher price. If prices rise further, the bond will be worth less.
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Source: https://www.thebalancemoney.com/components-of-investors-required-rate-of-return-357619
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