Copy of LinkedIN post, 2021
Currently the “facts” are deemed to be … The structure that delivers the best risk-management outcomes, the maximation of earnings potential and most efficient frontier for all participants is based on the following capital formation method.
Firm A lends in a Fixed or Variable nominal rate, in a marketable currency to Firm B. Firm A has determined it is exposed to a greater amount for a single entity that is comfortable with. So, it accepts the cost of a credit default swap from Firm C. Firm A then performs a currency swap with Firm D. Firm A, uncomfortable with the duration mismatch of its liabilities and assets enters an interest rate swap (a derivative transaction) with Firm E.
Firm A now believes it has protected itself from credit, ‘nominal’ interest rate and currency risks. Note that it is still accepting ‘real’ rate of return risks. It has now three counterparty risks to manage. Key here is the artificially inflated nominal interest rate that the original borrower is exposed to, along with the potential mismatch of its funding duration to the economic life cycle of its project AND/OR Firm A is accepting a lower ‘nominal’ and ‘real’ rate of return with a complex structure that may or may not have acceptable correlations.
Does firm A now purchase a credit derivative from Firm F against one, some or all these counterparty risk?
The starting point for ‘nominal’ structures creates complicated, convoluted, weakly correlated and potential ‘real’ return robbing structures that generates variable ‘nominal’ returns combined with compounded and complex risks.
The above is an example of the economic risks of having the starting point in capital formation being based in ‘nominal’ rates.
When starting in ‘real,’ calculating the equivalent number of nominal units for the accounting/taxation/regulation: with the return of a ‘principal’ in purchasing power being exempt from the O.I.D. taxation present in the current T.I.I.S. and Linkers’ programs delivers the most efficient method for all market participants. Benefits for all participants includes, but is not limited to improved cash flows, income statements and balance sheets – thereby delivering improved credit scoring and an upward bias to the market value of the entities.
We are all economists. All searching for the highest ‘real’ rate of return, lowest volatility and variability, lowest cost of execution combined with the highest correlation of our known real payments to our expected real incomes.
Starting in constant purchasing power is a solution to be explored. Let us allow the facts to speak for themselves.
My economic prognostication is … borrowers, lenders, regulators and credit evaluators will be aware of a new set of facts.