“A slow sort of country!” said the Queen. “Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!”
According to Wikipedia, the Red Queen effect, i.e. the need to run in order to stand still, has been used to explain all sorts of scientific and philosophical ideas. No one, as far as I know, has used it to explain equity release mortgage valuation.
But consider this. As we know now, the value of an equity release mortgage is driven by the value of a deferment contract, namely the cost of paying now to receive an income producing asset in the future. The value is thus discounted from spot by the deferment rate q.
Deferment (market value) = S exp(-q x t)
What will be the value of the contract in a year’s time? Two things will happen. First, the value will go up or down depending on the growth in S. Second, because there is one year less to expiry, it will go up by the rate q, which in effect is the compensation for not receiving a real net rental from present ownership of the asset. Assuming q of 2.5%, the contract will grow in value by 2.5% plus or minus the asset growth.
But what if the contract has been priced using ‘real world’ methods? The contract value is this
Deferment (real world value) = S exp( (f-r) x t)
where f is the forecast growth rate estimated by the actuaries, and r is the risk free rate. Assuming 4.5% forecast growth, and risk free of 2%, the contract will grow in value by asset growth minus 2.5%.
This is why real world valuation would not really a good idea for shareholders of companies investing in deferment contracts valued this way. The asset has to grow in value every year just for them to make no money at all. In real world valuation, you see, it takes all the running you can do, to keep in the same place.
A fast sort of world eh?