negative interest rates: impossible, irrational or...

NEGATIVEINTERESTRATES:IMPOSSIBLE,IRRATIONALORJUSTUNUSUAL?March2016AswathDamodaran

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NegativeInterestRateCurrencies:CentralBankandMarketRates

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10-yearGovernmentBondRates:ByCurrency(March9,2016)

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InterestRates101:AnIntrinsicInterestRate

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InterestRates101:AMarketSetRate

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IntrinsicversusMarket-setInterestRates–ConvergenceandDivergence

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TheCentralBank’sInterestRatePlays

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NegativeInterestRates

¨ Theconventionalviewofnominalinterestratesisthattheycannotbenegative,sinceyouhavetheoptiontoholdcash(ratherthansaveitatnegativerates).

¨ Thisisbasedonthepresumptionthatholdingandusingcashiscostlessandthatmaynotholdfortworeasons:¤ Storingcashmayrequiresecurity (anditscosts).¤ Usingcashforsome transactionsmaybeexpensive andperhapsinfeasible.

¨ Ifyouintroducecoststoholdingandusingcash,nominalinterestratescanbenegative,albeitwithalowerbound,sinceatsomeinterestrate,itwillbelessexpensivetoholdcash.

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TheEffectofInterestRatesonStockandBondPrices

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InterestRatesandtheRealEconomy

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TheHubristicBanker

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TheRealWorldBanker

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ERPandRiskFreeRates

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Dealingwithnegativeinterestrates

1. Switchcurrencies:Ifthecurrencythatyourcompanyreportsfinancialsinhasanegativeinterestrate,switchtoadifferentcurrency.Caveat:Youcanrun,butyoucannothide.

2. Normalizeriskfreerates:Replacethecurrent(negative)interestratewithanormalriskfreerate,obtainedfromeitherhistoryorfundamentals.Caveat:Normalization isintheeyeofthebeholder.

3. Staywiththenegativeriskfreerate:Usethenegativeriskfreeratebutmakesurethatyourotherassumptions(nominalgrowth,riskpremiums)areconsistentwithadeflationary,no-growtheconomywithhighriskpremiums.

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ImplicationsandConsequences

1. Badnews:Negativeinterestratesareincompatible withahealthyandgrowingeconomy.

2. Insanity,ImpotenceorIrrelevance? Centralbankshaveloweredratesoverandoverinthelastsixyearsandhavenotbeenabletonudgeeconomies outoftheircomas.Buttheykeepdoingit..Theveryfactthattheykeepgoingbacktothislever isasignalofimpotence onthepartofpolicymakers.

3. Unintendedconsequences:Investorswhodesire (andneed)fixedincome fromtheir investments increasinglyhavetolook furtherandfurtherawayfromtheirpreferred domains forthatfixedincome. Thepotentialforscamsandinvestment painisimmense.

4. Digitalcurrencies:Totheextentthatcentralbanksmake itunattractivetosavetheircurrencies, theyarecedinggroundtodigitalcurrencies.

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