A reader writes questioning my claim in the 7 August BBC interview that Matching Adjustment is fake equity. Compare a gilt and a perpetuity issued by an insurance company, he says. Assume the gilt is highly liquid and can be sold in the secondary market, but the perpetuity is not. Then if the two instruments are priced the same, shouldn’t I choose the gilt every time? And doesn’t this, by implication, suggest that they cannot have the same value?
Not at all. If I hedge a riskless debt with a riskless asset so that the asset cashflows are equal and opposite to the debt cashflows in every possible state of the world, then the expected payout of the hedged position is nil, and so has no value. Hence the value of the asset and the debt must be equal. That is the argument for discounting the debt at the risk free rate (or strictly speaking the rate of return on the perfectly matching asset).
What about the owner of my debt? Won’t he or she value it lower than the gilt if I am only going to pay out at maturity, and if there is no secondary market? Possibly, but that does not justify my discounting the debt at the creditor’s expected rate of return and creating a little slice of equity to pay my bonus now, for I still have to pay the creditor all the money at maturity, not all the money less the future value of my bonus. That would be a breach of contract.
In any case, the argument defeats itself. The creditors (for there are more than one) have paid me £1bn, say, for a contract for future payment that can be perfectly matched by a gilt costing £1bn. Yet the contract is completely illiquid! Why aren’t the creditors paying me less than £1bn, and why aren’t they ‘choosing the gilt every time’? But this is the retail market. There are many creditors, i.e. policyholders, who do not have access to the gilt market. So there are all sorts of reasons why the illiquid asset may have a cost equal to, or even higher than, the liquid one.
Note there is a similar fallacy about company debt. Can I value my debt lower than par, on the grounds that the market for my debt is pricing it below par, and create ‘equity’ that way? No, for the same reason. My contract with the creditors is to pay them at par. What the market is actually doing is looking through the debt to my assets, which it probably regards as weak and below book value.
Would I price my debt lower on the grounds that my assets are too weak to support it? Bank managers around the country say no.