The Fine Art of Determining Securities Prices
May 7, 2007
The notion of "price" is a deceptively simple one in today's financial environment. Different uses-auditing, risk management and trading-can dictate different price calculation methodologies. It's particularly tricky given today's vast array of investment vehicles and when the price simply doesn't exist in the normally accepted places where it's expected to be found.
It's time the financial industry's vocabulary and approach to risk management became a little more extensive and a lot more precise.
Seasoned financial professionals typically define price as what you see in the stock price tables, the cost to buy or sell a financial product or whatever a financial instrument is worth. But what if the reported price is wrong? What if the price is real, but is for a thinly traded instrument? Has the price been affected by a recent announcement or adverse credit event?
Before addressing these issues more carefully, let's consider a working definition for something rather fundamental-a meaningful closing price.
As a starting point, perhaps we can say a good closing price can be found where a spot sale and purchase occurred in an open market environment, in a round-lot size of a meaningful volume, and within 60 minutes of the market's close. A spot sale and purchase is a transaction of the asset for cash on a current settlement basis, that is, not a forward transaction where the asset is exchanged for cash at some future date requiring a cost-of-carry element to value the trade. These defined parameters help to make the discussion of price an easier one.
An open market environment provides a context where the trade is visible for any and all to see. The size of round lots provides meaningful volume. If we are interested in as pure a price as possible, then we would want to consider an appropriate transaction size. What is appropriate, however, can be a matter of interpretation with differences across markets and product types.
As is perhaps apparent at this juncture, our working definition of what constitutes a "perfect price" is an ideal. Indeed, the vast majority of fixed income instruments do not trade daily, let alone at or near the market close. Start layering in other hard-to-value considerations-like optionality, credit issues, restrictive covenants, privately placed securities and custom or "bespoke" instruments-and things really start to get interesting.
But there are some tools investors in these instruments can consider: modeling prices when perfect prices don't exist; types of prices available; regulatory considerations; and internal audit and risk management concerns. When market prices are not readily available for a security, quantitative models can help provide context for thinking about price and value.
As market prices reflect where humans have chosen to engage in a buy or sell, and as human sentiments embody their own experiences, expectations and all else that goes into making investment decisions, there are severe limitations on what a model valuation can capture. Nevertheless, models can offer some form of consistency across market moods and sentiments.
One consideration for anyone using models, however, is that every model and equation requires inputs that themselves embody assumptions that may or may not reflect real-world phenomena. Take as a basic example a two-year Treasury note. There are five future cash flows in the instrument that are paid out over its life, and some kind of assumption is required for a yield at which those cash flows will be discounted to arrive at a present value or price. The market convention is to discount all the cash flows at a single yield, namely the security's yield-to-maturity.
This is tantamount to asserting that the yield curve remains unchanged from six months to two years, a rare occurrence in the more than 100 years that the U.S. Treasury note has had a yield curve. What this helps to illustrate is twofold: that pricing conventions can be misguided, and that even the most commonly applied market practices have unrecognized assumptions embedded within them.
If an investor were to limit his or her choice of investments to only those vehicles whose valuations were devoid of assumptions, there would be precious little within their portfolio. Assumptions are implicitly and explicitly being made with every investment choice. The questions that do deserve special time and consideration are: Are the implicit and explicit assumptions known and understood? Are they being modeled in a meaningful way and viewed in an appropriate portfolio context?
So where does this leave us? To be sure, market participants are arguing for consistency when valuing complex securities that ensures the building blocks used to construct an optionality feature of an instrument or credit aspect are consistent with an overall approach to financial engineering. If the pieces are individually modeled and constructed in a consistent way, then the sum of the parts should be meaningful as well.
(c) 2007 Money Management Executive and SourceMedia, Inc. All Rights Reserved.