What is the lowest common ground for the pricing of a debt instrument?
Currently we utilize the formula Risk Free Rate + Expected Inflation + Default Risk Premium + Liquidity Premium + Maturity Premium = the Interest Rate you pay. In this format we all must FORCAST what inflation is GOING to be during the life/holding period of the instrument in question. The modeling of what the inflation adjusted rate will be on any given future day is a ‘Monte Carlo’ study of immense dimension.
Presently the parties have chosen a capital formation method that is non-cooperative.
The parties to the transaction are each attempting to be a better forecaster than the other side of the transaction.
Each is aware of some: but not all; and may not understand, the forces the transaction is experiencing, will experience and when they will experience those forces. * I am reminded of the old saying, I do not have to be faster than the bear, only faster than you.
The existing form of the transaction may be in a fixed-nominal, variable-nominal, or a variable-real format. Those that attempt to utilize the Treasury Infation-indexed Security (TIIS or TIPS) format face the difficult decision of experiencing phantom income tax or accretion that inflicts weaknesses into the balance sheet and accompanying financial ratios unless they are a tax-exempt structure or can print money.
This is where blockchain contributes in this discussion. The ability to have a multiple computer universe enables for a wider and more secure distribution of the attributes of capitalism and economic ensuing vitality with the optional use of a component being any medium of exchange.
Challenges currently exist; for we continue to know the price of everything, but the future real value of nothing. Those challenges can go away. Let us set the terms of the transaction in an inflation-adjusted, real interest rate.
How does one transact in a Constant Purchasing Power format, without the additional costs and variances associated with the use of derivatives?
Proposed: Start with the real, purchasing power desired and then convert to nominal.
R(n) = ((1 + i(n)) – 1) / (1 +c(n))) defined as the quotient less one of one plus the nominal rate over the quantity one plus the agreed upon known inflation measure.
By going from the real rate to the nominal we have the corresponding calculated nominal rate of interest i(n) = c(n) +r(n) + c(n) x r(n) where r (n) is the contractual fixed, real rate. This calculation picks up the cross-product term c(n) x r(n) from the calculation r(n) = (1 + r(n)(1 + c(n)).
The less precise others work with is x# = i(n) + c(n). Is this not accepting risk because it ignores the cross-product term? The effect of this can have a significant cumulative effect over the life of a transaction. In summary, use a fixed real rate, with the corresponding nominal being variable. Don’t take the nominal as fixed and calculate a corresponding real rate that is variable.
What did I just say? If the borrower and lender will agree to the contractual terms of:
1) what inflation-adjusted (Real) rate of return will be paid or received
2) what the measure of inflation utilized will be and from what known source
3) the frequency of the reset of the inflation component will be agreed upon –
then the equivalent nominal rate/payment amount can be found then paid and received.
And payment can be in the form of any agreed upon medium of exchange, be it a currency, commodity, or a cryptocurrency.
We now have the ability to calculate/pay and receive an inflation adjusted amount, with the payment made and received in the equivalent nominal amounts necessary.
For nations and their political subdivisions, corporations and individuals, the lowest cost of capital is found. No more paying for inflation expectations.
For investors; be they individuals, endowments, retirement accounts, et al, the ability to have an asset class that delivers a KNOWN/STABLE purchasing power return/lifestyle is added to the diversified portfolio.
What is being contributed? 1) The embedding of a fixed, stable component to capital formation. 2) Borrowers will have found the lowest cost of capital without the need for additional risk management tools and the associated costs. 3) The borrower will experience beneficial cash flow with the benefits of an improved income statement, balance sheet, credit rating and for those with an equity component - an increase in share price. 4) The lender will have an asset with lower variability and volatility combined with less default risk on their books enabling a beneficial shift in the lenders efficient frontier and cost structure. 5) The Blockchain, or multiple computer connection, delivers security and lower operational expenses.
* The lender could be a financial institution, endowment, annuity, pension, life company or an individual.
** Research shows an amortizing structure delivers numerous financial ratio benefits for all parties in the transaction.
Today the global economic marketplace has at its disposal the tools to expand and improve the methods and instruments for capital formation.
Questions that I hope this has brought to mind… Withoutthe additional costs associated with the instruments that start in nominal and ‘link up’ to an inflation adjusted rate/payment that are presently available…. How can retirement be fortified for I am concerned I will lose my life style in retirement? Is a life or annuity policy that pays a constant purchasing power life style, without hedging expenses possible? Could a Real futures contract be offered? Will a company have a stronger balance sheet because of this method? Will the firm be able to offer an expanded range of products? A not-for-profit has future Real commitments, will an allocation to an asset class paying higher stable and known Real rates than TIPS enable us to shift the portfolio’s efficient frontier? Could a political subdivision benefit from a lower cost of funding, offsetting some of the limit on SALT deductibility?