## Wednesday, August 06, 2008

### The risk is volatility

In financial theory, volatility of an asset class is considered as a proxy for its investment riskiness. The risk is captured in the discount rate. So, to value on asset, the formula is

V = Sum of {C(i)/(1+r)^i}, i = 1 to infinity, where

V is the value of the asset,
i is the year,
C(i) is the cash flow in year i,
and r is the discount rate, calculated as

r = r(f) + Beta * {r(m) - r(f)}, where
r(f) is risk-free rate,
Beta is associated with volatility,
and r(m) is the market return

This way, rising volatility increases discount rate, reducing the value of asset.

However, it ignores the impact volatility has on cash flows - the numerator of the equation above. The incidents of the last few months makes me believe that volatility impacts not only the denominator by increasing discount rate, but also the numerator by impacting cash flows.

Take the instance of Indian IT companies. Last year they were hit because rupee appreciated suddenly. They took on derivative positions, in some cases excessively. So, this year, they are getting jacked when rupee is depreciating. Last year, Indian importers didn't take forward cover, thinking rupee will appreciate forever. This year, they are getting hit.

The point is - volatility makes decision making difficult. If oil price rises to \$145, should an airline hedge or not? Should a steel maker plan to massively expand capacity today or not - when there are some tentative signs that China is slowing? If people say that they will not make a decision till volatility subsides, that itself hurts overall growth. One man's savings is other man's income.

So, more than oil prices etc, I think it is volatility itself that will restrain global growth. The animal spirits are sagging - India and China had their share in the last few months and now it is Brazil's and Russia's turn - and they are essential for any boom to continue.