Following the publication of Asleep at the Wheel and the launch of this blog Kevin and I have received a steady stream of mail objecting to our claims (and the claims of the PRA) about the valuation of the no negative equity guarantee. There is one idea that dominates, namely that asset growth assumptions should in some way affect the value of a deferment or forward contract, contrary to what we claim. Don’t Kevin and I invest in UK property? Is UK property as a valid asset to hold in a diversified portfolio as an investor? Etc etc.
Now I have already addressed this fallacy in an earlier post. But let’s go through it ‘one more time’, hopefully for the last time.
Consider two contracts A and B. The first gives you immediate possession of an income bearing asset. The second gives you possession in year’s time, with loss of any income that would have been received for that year. Given the market price of A is 100, what will I pay, i.e. settle now, for B? Note the question is about the price of B now, not its price in a year’s time. The price of both contracts will change with the market, and in a year’s time they will be the same, as deferred possession turns into actual possession.
Since I get the growth in both cases, my rational choice for B would be to pay the price of A less the income I will lose by not possessing the asset for the deferment period. This is true even if I am a super-bull about UK property. I can either purchase A, and receive the net income from the property plus the growth, or purchase B, and receive a higher growth rate which includes compensation for the loss of income. It’s the same.
Note that a super-bear might choose to sell me a deferment contract, hoping that property will fall enough for them to buy the asset at the deferment date and deliver to me with a handsome profit. They will agree with me on the price of the contract, and the fact that bulls and bears agree on the pricing shows how growth is irrelevant.
Hopefully I don’t need to say this again, and I live in hope.