What Is Risk-Free Rate?

Let's begin with RISK-FREE RATE 101 class. (Prerequisites: Default-free, Treasury, Safe, Secured)

2 years in the business school and reading all those books of CFA program curriculum. The most repeated term has been- Risk-Free Rate (Rf). It is considered as yield of US Treasury securities. US Government is (was?) considered as default-free thought it fought hard to prevent default recently. Whenever global economy melts or shakes, investors look for Treasury securities. They have been known as the safest investment since there is no volatility or risk included. We employ many risk-return tools (for example, Sharpe Ratio) to calculate excess return achieved by investing in particular assets. This excess return is calculated by considering risk-free rate as benchmark. Many countries with political instability and higher inflation rates do not have their risk-free rates. They add their inflation rate to US risk-free rate to get the benchmark rate for their country. And thus long-term bond yields and so on. This is what the biggest economy stands for.

But in the recent turmoil, I am not able to believe completely that we should still use Treasury yields as risk-free rate or not? I do not want to discuss why S&P has recently downgraded US credit ratings to AA+ from AAA. It may be reversed or may be not. S&P might be wrong in deriving this verdict or they might be late in doing this. I do not know the facts. But few things I surely know that there are few problems in Washington DC. There are serious fiscal challenges we have been facing. Looking at the current scenarios, US may not deserve AAA. But when country has to put efforts to prevent default which US did last week, their risk-free rate should not be considered as default-free rate or benchmark rate. Why can't we change that? Why can't we use risk-free rates from countries like UK, Germany and Canada who still have AAA?

I am not sure about literature we used in the business school, but CFA institute updates its books every year based on recent market conditions. I will not be surprised if I see Canadian rates as risk-free rate in those books next year...

Chipotle: Expectations vs Fundamentals...

I never thought that "burritos" would bring me out from hibernation (it has been nearly more than 3 weeks since I wrote the last blog). I love their food. Many of us do. It is Chipotle Mexican Grill, Inc (ticker: CMG). Short, simple and affordable- 3 words help it rule its peers. An inspirational success and growth story. Following chart  says it all:

Phenomenal growth. Handsome return to investors. Stock was worth $38 on November 20, 2008. Stock is worth $330 today. Do I need to show return figures? Company's business model is fundamentally strong. They target fast food consumers who want to spend $5-$10 on their meals. It has nicely managed the global food inflation. Its store operate in all metropolitan area of the US and try to provide affordable options in such areas. Conclusion: Sweet & Sound!

Yesterday, they announced their second quarter earnings. Earnings were pretty good despite of rough outlook of the global economy. All numbers were decent and higher than last quarter. But I heard the voice.... "Clear Disappointment". I am still trying to figure out why I was supposed to hear that. Reason was--- they missed analysts' estimates. What bothers me is they missed it by dozen cents. Negative earnings surprise. I understand that analysts on the street perform all fundamental analysis and provide their estimates. But I still consider a phrase "Failing to meet expectations" which may make another phrase "Clear Disappointment". If we compare all the numbers with its peers and industry overall, they are still the leader. There is nothing wrong happening with its revenue generating model. It is partially because of too much expectations, isn't it?

Based on Chipotle's news, I wonder what happens in the market if mammoth Apple Inc misses its estimates. Worse. Worst. Why? They never respect analysts' estimates and always believe it positive earnings surprise!! Yesterday, they announced those bottom line numbers 25% greater than estimates. And that sends the story to investors for their EXPECTATIONS from Apple in the next quarter...

How long can you put on your 3D glasses?

When I graduated from high school, I and one of my friends went for IMAX 3D "show". I did not write "movie" because it was a 30 minutes educational/ informative documentary which we always find here in museums. It was expensive. And rare! Times have changed. Now every Friday, we get at least one movie in 3D to spend our wealth on.

Before 3-4 years, when releasing movies in 3D was not as normal as it is now, it started to change the definition of movie watching on the big screens. Stumbling Regal Entertainment Group & AMC Theatres during the painful recession got some room to breathe. Rapid rise of 3D movies boost the earnings for Regal Group, RealD and the hopes for an IPO for AMC. Entertainment sector was almost back on the track with the 3D hits like Toy Story 3, Avatar, Transformers and Harry Potter. Then AMC postponed their IPO plans. Why?

• 3D Burnout- Excess leads to an destruction. Well said! Burnout is the term often used during mortgage refinancing phase for prepayments. When rates are low, you refinance the loan by prepayments. After few years, when rates become lower again, you have nothing much left to refinance. Same applies here. 3D movies and its craze cannot be placed in the category of sustainable items.
• Online movie providers- Ah! Internet is killing everyone. Surge in the paid subscription based online movie providers like Netflix, Amazon, YouTube have clearly staged their competition with these entertainment giants.
• 3D TVs- Dance until music stops. And that is the reason why we can see the brand new isle of 3D TVs at Best Buy or Wal-Mart stores. 

RealD does many innovative things. It recently launches "Wimbledon 3D" for 2011 Grand Slam. Beautiful. Wimbledon 2011 is still in progress, but still RealD stock is suffering today. Why? It is because of less than expected, not poor, box-office performance of Cars 2 which also released in 3D during last weekend. It is a lovely example of positive correlation, isn't it?

Let's see how long we are able to witness the entertainment industry's fight against sustainability and volatility.

A documentary explains "The Capture Hypothesis"

We have avoided disaster and we are recovering... But the men and institutions that caused the crisis are still in power... and that needs to change. They (mammoth banks) will tell us that we need them, and that what they do is too complicated for us to understand. They will tell us it wont happen again... It wont be easy, but some things are worth fighting for.

Finally, I got some time to watch last year's academy award winning documentary, "Inside Job". And what a masterpiece it was! Perhaps, it is the finest documentary I have seen in my life. Neat and straight. It is based on the catastrophic financial crisis from which we are still trying to recover. Last year, I read a book by Suzanne McGee, "Chasing Goldman Sachs: How the masters of the universe melted Wall Street down... and why they will take us to the brink again." The reasons why I like this book and this documentary are the timing, my education and my area of interest. I was about to graduate from business school in  the midst of this crisis. And I was exposed directly or indirectly to majority of the events listed in the book and shown in the documentary.

"Inside Job" emphasizes on the critical issues like political influence, lobbying power of Wall St, corruption- collectively "Wall Street Government" and other market changing events like introduction of derivatives in early 90's, housing bubble, ponzi schemes, subprime lending and the rise of structured products like MBS, CDO and credit derivatives like CDS. But the most important thing I have understood through this documentary is an industry regulation theory, "Capture Hypothesis". According to this theory, regulators of different industries are elected/selected from the pool of experienced and influencing candidates from their respective industries only. For example, regulator for environmental issues cannot be selected from the finance & banking industry. And that is the reason why regulators are more biased towards industry rather than consumers. If they do not support the industry, their spot will become endangered. That is what happened with the failure of 3 big Iceland banks. That is what happened with the regulators' decisions(influenced by Henry Paulson and other top executives from number of big banks) of permitting banks' leverage ratio to rise as much as 20:1 and loosening the regulations on derivatives. Eventually, this led to the collapse of Lehman Brothers, AIG, Bear Sterns, Merrill Lynch, Washington Mutual, Wachovia and many others.

When I was in grad school, I had to watch Wall Street, Boiler Room and Rogue Trader. I am sure that B-school finance majors will have to watch documentaries like "Inside Job" down the roads since ethics and finance and banking and investment are all coherent with one another.

"New Normal"... Hope or Frustration?

Like every morning, I settled at my desk, logged in to my computer (Bloomberg Terminal) and read news. And saw a news story elaborating few economists' warning on unemployment rate in the US. Since the downturn started, we have been listening to and looking at all fiscal efforts to combat higher unemployment rate which is the key impediment to achieve economic growth. We have managed to drop it down to 9% and started to believe that within 3-4 years, it may be at its normal level. What is this "Normal Level"? Is it decided by the congress or economists or something else? Unexpected and turtle speed recovery in developed economies has certainly shifted those economic graphs.

Current unemployment rate is seen as "New Normal" by few economists. If that turns out to be true, then 8-9% rate will stay in normal business cycle. It may climb to 13% or 15% or 18%, if another downturn arrives. But no more hopes for those 5% or 7%?

Similar things follow in the case of US Debt Ceiling and US Credit Ratings. If we consider "New Normal" in debt ceiling, then new ceiling will allow the Government to borrow more than they are doing now. More public debt. Higher debt to GDP ratio. We know the consequences. I still remember one of the story on US credit ratings published couple of years ago. It said "If US credit rating is downgraded to AA from AAA, then new AAA will be AA." Doesn't it sound like "New Normal"? Yes, it does. New Normal changes the benchmarks.


Establishing "New Normal" for unemployment rate, debt ceiling and credit rating (... and many more may come) have positive consequences as well. Based on hopes and optimism, they give us room to accelerate recovery and to acquire potential growth opportunities. But that is what we have been doing since last three years. We might have started to realize that perhaps there is no hope. Potential frustration may make us prompt to start everything from scratch... and that can be done by creating new zeros... new benchmarks... new normal.

Inflation, Commodity Futures, Speculating, Hedging... And Coffee.

Few days ago, I read the news uttering about the Americans' reactions on the inflation- especially on higher food prices. And I immediately tweeted that the Americans should not outcry for higher prices when they have no idea about the painful inflation in the emerging markets. I spent 22 years in India and I can understand how cheaper the daily necessities in the US are.

Commodity futures are positively correlated with the inflation and that is the reason why investors choose them as an inflation-hedge in the long-run. Commodity prices are speculator's & hedger's game besides the global demand-supply. If perceived price risk in the future is higher for consumers of commodities, they buy the futures and the net long position sends market towards the contango. And if perceived price risk in the future is higher for producers of commodities, they sell the futures and the net short position pushes market towards the backwardation. Generally, perceived price risk in the future is higher for producers and because of this, commodity markets are in normal backwardation most of the time. But consistent upward pressure in the global inflation in the recent years has pushed the global commodity market in normal contango.

If we talk about the whopping prices of coffee, Starbucks is being considered as one of the culprits who pushed coffee futures in the contagion world. Based on their recent quarterly reports, they have shown noticeable hedging activities especially in coffee futures. Their speculation of higher coffee prices in the future made them take net long positions in the coffee futures. Per recent Financial Times news story, they are fully hedged against their needs until the end of this calendar year in April. And that tells the whole story about the speculation. I do not find any fundamentals.


It is a simple phenomenon. If bigger players like Starbucks keep on buying futures, then demand for futures increases regardless of other fundamental or economic factors. And contango stands out as a bull market with a possible commodity bubble. It is not illegal for corporations to perform hedging activities, but there should be some difference between speculating and hedging. Per my knowledge, whatever Starbucks is doing is speculation and whatever all airlines are doing is hedging.

Stepping Stone for Social Media IPOs...

One of the interviewers asked "If you have money to invest in, which stocks you buy?" And I responded "I would have said Netflix if you had asked me the same question few months ago, but now I like LinkedIn. I am waiting for their IPO." Yes, LinkedIn it is. Investors are waiting for Thursday, May 19, 2011 when LinkedIn is likely to hit NYSE.

When you have faith in a company's operations, culture, financials, policies and strategies; you will see your money being secured while investing in it. It is all about confidence factor, but not about following the herd. One of my friends said that this stock is going to make you wealthy and all variations thereof, never work in long-run. Such sort of investor confidence is provided to LinkedIn. And that is the reason why they have raised the size of their IPO twice after their announcement in January 2011. Per recent announcement of their IPO size, stock will likely to trade between $42-$45 and valuation will be around whopping $4 billions.

Why not? If company believes in their chores and realizes the lustrous confidence of investors, it should ride on it. Personally, I have faith in LinkedIn and that is why I gave that response to an interviewer. LinkedIn is a part of  bullish social media industry, but it may be the only company who is providing the professional networking. Their business model seems clearly different than what Facebook, Twitter and others have. They connect recruiters, companies and job seekers in the unique ways.

Stepping stone. LinkedIn being the first social media company in the US who is going public this week, provides some efficacious groundwork for potential future IPOs of Facebook & Groupon. LinkedIn's valuation is certainly way lower than what Facebook and Groupon are valued at. But their post-IPO stage may deliver few twists in this household industry.

... "what is LinkedIn and why is it so hyped?" I hear such questions from professionals of the industries where vacant jobs are more than number of job seekers. The only key limitation I consider in the business model.