Chat with us, powered by LiveChat costofcapital.pdf - Credence Writers
+1(978)310-4246 [email protected]

3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times 1/4

Uncertainty created in the wake of the pandemic has been reflected in stock markets with a rise in volatility © AP

Michael Mauboussin FEBRUARY 9 2021

The writer is a researcher at Morgan Stanley Investment Management

The year 2020 will forever be associated with Covid-19 and the ills it caused to peopleand economies around the world.

The outbreak of the pandemic led to the greatest contraction in global economicactivity in decades and a precipitous fall in stock markets. More surprising to mostwas the extent of the sharp rally from March lows.

The interplay of two forces that drive valuations, the cost of capital and the volatilityof markets, might explain some of that counterintuitive behaviour.

The cost of capital represents the return investors demand for owning a security andtherefore determines a company’s cost of debt and equity funding. Volatility inmarkets captures uncertainty about the future.

Opinion Markets Insight

How the parting of two market forces helped spur the equity rally


Volatility boosts value of companies with options to invest in future projects

please summarize the below in 7-8 sentences.


3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times 2/4

Quite sensibly, the cost of capital and volatility almost always move in lockstepbecause investors require a higher expected return when the world looks riskier. Butin 2020, the cost of capital and volatility went in opposite directions.

When the price of many stocks and bonds plunged, central bankers referred to aplaybook created during the 2008 financial crisis. Prescribed actions includedlowering interest rates, purchasing securities on the open market, lending tobusinesses on favourable terms and providing households with money to ease theirburdens.

These actions had the effect of lowering the cost of capital. The cost of equitycomponent of this is commonly calculated as the sum of a risk-free rate of return andthe equity risk premium (the extra return investors require for owning stocks).

The yield on the US 10-year Treasury note is a proxy for the risk-free rate and wentfrom 1.9 per cent at the beginning of 2020 to 0.9 per cent at the end. AswathDamodaran, a professor and valuation expert, estimates that the equity risk premiumdropped from 5.2 to 4.7 per cent over the same period as the rebound in stock pricesimplied lower future returns. The yields on corporate bonds followed a similartrajectory.

3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times 3/4

These figures imply that the cost of equitydeclined from 7.1 to 5.6 per cent during theyear. When used in valuation calculations,this boosts the current worth of expectedfuture earnings of companies as the futureincome stream is discounted at a lower rate.

Companies therefore received a richervaluation on greater current or prospectiveearnings. Companies that gained from trends

arising from the pandemic, such as those that enabled working from home,particularly benefited.

However, while the actions of the central banks relieved financial pain, they did littleto dissipate uncertainty. Open questions include the timing and strength of theeconomic recovery, which businesses will be the ultimate winners and losers, and thedegree to which consumer behaviour has changed permanently. 

The uncertainty has been reflected in stock markets with a rise in volatility. This iscaptured by the Cboe volatility index, or Vix. The Vix started 2020 at about 14 butaveraged 30 for the full year. The ratio of the Vix to the cost of equity averaged aroundtwo from 2016-2019 but soared to five in 2020. This matters because volatility is aprimary driver of option value.

An option is the right, but not the obligation, to do something. Financial options havebeen around for a very long time. In recent decades, economists have also developedthe concept of real options. These represent the value of a company’s right to makereal investments in projects such as expansion into a new line of business. 

While the actions of thecentral banks relievedfinancial pain, they didlittle to dissipateuncertainty

3/2/2021 How the parting of two market forces helped spur the equity rally | Financial Times 4/4

Copyright The Financial Times Limited 2021. All rights reserved.

High volatility means the potential worth of projects falls in a wide range. There’s noobligation to act on an option if value is low, but there is a right to act if value is high.Certain businesses are rich with real options. Think of Amazon 20 years ago.

In 2020, companies with real options had a valuation boost for their currentoperations because of a fall in the cost of capital and a gain in their real optionsbecause of an increase in volatility. These observations are also consistent with theperformance of convertible bonds, securities that combine a stream of cash flows andan option to convert into equity. The Bloomberg Barclays US Convertibles LiquidBond Index rose 54 per cent in 2020. 

This might help explain some of the large stock price movements in the past year,particularly in the tech sector. The cost of capital and volatility are likely to convergeas we pass through this episode. But the pandemic caused actions and reactions withremarkable implications for valuation.

error: Content is protected !!