Lesson 16 of 25 · 7 min
How a policy rate reaches an equity valuation
The chain has four links and the last one is a division, which is how one point at the short end takes a quarter off a share price.
The route from a policy decision to a share price is not mysterious, but it has more links than most descriptions admit and the final link is a division rather than a subtraction. That is where the size comes from.
The links run in order. A policy decision moves the overnight market. The overnight market and the expected path of it move the whole curve, diluted at the long end by the arithmetic of lesson 12. The long risk-free rate plus an equity risk premium gives the return investors require to hold shares at all. And that required return sits underneath a stream of future cash flows, dividing them.
There is a second channel that operates at the same time, which is why the risk premium is not a constant. A tightening slows nominal cash flows and raises the compensation investors demand for uncertainty about them. So the required return usually rises by more than the risk-free rate did.
Put numbers on it. A stream of $100 next year growing at 3.4 percent forever, discounted at a required return of 7.9 percent, is worth 100 ÷ 0.045 = $2,222.22. A tightening adds 1.20 points to the long risk-free rate and 0.50 to the risk premium, taking the required return to 9.6 percent: 100 ÷ 0.062 = $1,612.90. A fall of 27.42 percent, from 1.70 points added to a denominator.
Land it on a facility. A $1,612,000 pledged portfolio becomes $1,170,000, a loss of $442,000. At a 63 percent blended advance rate the lending value falls from $1,015,560 to $737,100, so $278,460 of borrowing capacity disappeared. No notice was issued, because nothing was decided about the borrower — a discount rate moved.
Key terms
- Equity risk premium
- The extra return demanded for holding shares rather than a risk-free asset. It tends to widen in the same conditions that raise the risk-free rate.
- Transmission chain
- The ordered set of markets a policy decision passes through before it reaches an asset price. Each link can amplify or damp.
- Denominator effect
- The disproportion that arises when a small addition is made to a small divisor. Adding 1.70 to 7.90 removed more than a quarter of the value.
Worked example
Four links and a division
A stream of $100 next year growing 3.4 percent forever, behind a $1,612,000 pledged portfolio at a 63 percent blended advance rate. Illustrative.
- Required return before
- 7.9%
- Long risk-free rate rises
- +1.20 points
- Equity risk premium widens
- +0.50 points
- Value after
- $1,612.90
- Portfolio after
- $1,170,000
- Lending value, before and after
- $1,015,560 and $737,100
Value 100 ÷ 0.045 = $2,222.22.
Required return becomes 9.6 percent.
100 ÷ 0.062. A fall of 27.42 percent.
A loss of $442,000.
$278,460 of capacity gone.
A 1.20-point move at the long end, amplified by a widening premium and then divided into a growing stream, removed $278,460 of borrowing capacity from a facility nobody made a decision about.
Check yourself
An asset's required return is 8.30 percent against cash flow growth of 3.10 percent. A tightening adds 0.90 to the required return with growth unchanged. What happens to a $3,180,000 portfolio valued this way?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.