Category: Finance

When spot prices fall relative to futures prices, traders buy the commodity and store it until it is in greater demand. With the reduction in demand and excessive supply, storage is becoming more scarce and becoming more expensive. The more expensive the storage, the lower the spot price needs to fall before traders will buy and store the commodity. Usually, there is some customer that would be willing to buy at a low price but currently, there is no way to store the oil and very few consumers of oil due to the COVID-19 lockdown. Traders with long positions usually close their contracts and buy new contracts with a longer maturity in order to avoid taking physical delivery. With no buyers, these traders needed to unload their contracts at ridiculous prices to avoid being fined for not taking delivery at the expiration of their contracts.

A very reasonable process when confronting policy decisions is to consider the economic impact of those decisions. Recently, the suggestion of 20% unemployment has been repeated by media because Treasury Secretary Mnuchin used that number when briefing Congress. This was not an estimate based on any kind of model or thoughtful analysis as stated by the secretary himself. I am certain that in the next few weeks there will be numerous estimates of economic impact hopefully with better analysis but none of them will be adequate to support policy decisions.

Many firms have access to high-frequency data on credit card transactions from which they can estimate changes in spending. Most economists neither have access nor are familiar with these data sets. They will try to use examples from the Spanish Flu or from more minor events that have occurred in structurally different global economies through time.

One of the confounding factors in forecasts, is that the US has become accustomed to using markets as a signal for policy. While markets do provide useful information, they also incorporate changes in risk preferences and perception which are often confused with event probabilities. An accurate economic forecast must now factor in policy changes resulting from changes in risk perception which may or may not be related to actual events.

The answer to the economic impact question is that there will be heroic assumptions made on the effectiveness of unknown future health policy. Further heroic assumptions will estimate the interaction of unknown future monetary and fiscal policy with health policy. All of this will be based on the (much more likely) assumption that medical professionals will know more about how COVID-19 is transmitted and will development more effective treatments over time.

We should find comfort in the fact that the lack of certainty is not uncommon. When stakes are low, it is easy to fool ourselves into thinking that the world is certain. During times of crisis, we should remember that the world was never as certain as we thought, but that is OK.

As a finance professor, you occasionally get questions like these:

“A friend and I were wondering what your opinion was about the Fed dropping close to 0% interest rates. Additionally, we were wondering on what your opinion was on the markets reaction to everything since.”

My response is below:

Most businesses have a revolving line of credit that they draw down in case of emergencies. Banks need to provide cash when they do this and usually it is an idiosyncratic event. Right now, all businesses are maxing out their credit lines which means banks need a lot of cash. The Fed Funds market is a way to push money out to all banks and then to businesses. The reason this should be different than the Financial Crisis is that the Fed also cut the interest paid on Fed deposits which was why banks did not lend in the aftermath of the last crisis. Now, banks have a greater incentive to lend although they will be looking at risk and still may not lend to risky businesses.

Monetary policy is very useful for managing the banking system. Federal Reserve policy cannot change the consumer’s willingness to spend or ability to spend due to supply chain and distribution disruptions. Additionally, the Fed cannot fix any of the fundamental causes of this crisis. On Friday, the markets were reacting to the president’s announcement on the use of fiscal policy and measures for dealing with COVID-19. Over the weekend, it turned out that many of the president’s statements were not entirely true. The positive market reaction on Friday was reversed today. Until there is some progress on COVID-19 management and a fiscal policy response, markets are expecting a longer and more severe economic reaction.

I hear a lot of opinions on how economic value is created. Some of these opinions are supported by secondhand anecdotal evidence and most of them are used to support various political or social positions. Some of the most absurd theories on value creation even come from wealthy and/or successful people so someone without a business education may be forgiven for believing that this is a philosophical question that can only be answered through a belief in some set of principles. I would like to articulate why there is an objective reality to value creation. It has very little bearing on any political or social position and absolutely nothing to do with faith.

Value is created through the decision making process. This process need not be rational; the only thing that matters is success. As in warfare, winning by skill, preparation, accident, luck, or for the wrong reasons are all sufficient. Unfortunately, in this framework, there is an objective definition of success and it requires two ingredients. The first ingredient is an understanding of the money generated from a new venture and the second is understanding the price of the money necessary to start and maintain the project. Success is defined as a project that generates a rate of return greater than the cost of the money that is required for the project. That is it. Full stop.

While the concept is simple, there is also an objective methodology for calculating success. Future cash flows must be discounted at the cost of capital which is the rate at which you obtain the capital necessary to start and run the business. Oftentimes this rate is uncertain so the best estimate is used and the results are tested to see if changes in this rate affect the decision to go ahead with the project. The internal rate of return is the constant rate at which a series of positive and negative cash flows can be discounted such that the net present value of these cash flow are zero. This can also be described as the discount rate at which the manager is financially indifferent to taking on a new project. If that discount rate is greater than your cost of capital then you undertake the project.

Whether managers know this process or not, this is the only method of creating economic value. Improving on this process requires either lowering your cost of capital by getting money at a lower interest rate or by increasing the present value of the cash flows generated from the project. This can be achieved by reducing the investment in the project, getting the cash flows earlier, or increasing the growth rate in cash flows.