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NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR JUST UNUSUAL? March 2016 Aswath Damodaran Aswath Damodaran 1

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Page 1: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

NEGATIVEINTERESTRATES:IMPOSSIBLE,IRRATIONALORJUSTUNUSUAL?March2016AswathDamodaran

Aswath Damodaran 1

Page 2: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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NegativeInterestRateCurrencies:CentralBankandMarketRates

Aswath Damodaran

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Page 3: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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10-yearGovernmentBondRates:ByCurrency(March9,2016)

Aswath Damodaran

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Page 4: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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InterestRates101:AnIntrinsicInterestRate

Aswath Damodaran

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Page 5: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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InterestRates101:AMarketSetRate

Aswath Damodaran

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Page 6: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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IntrinsicversusMarket-setInterestRates–ConvergenceandDivergence

Aswath Damodaran

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Page 7: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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TheCentralBank’sInterestRatePlays

Aswath Damodaran

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Page 8: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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NegativeInterestRates

¨ Theconventionalviewofnominalinterestratesisthattheycannotbenegative,sinceyouhavetheoptiontoholdcash(ratherthansaveitatnegativerates).

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

¨ Ifyouintroducecoststoholdingandusingcash,nominalinterestratescanbenegative,albeitwithalowerbound,sinceatsomeinterestrate,itwillbelessexpensivetoholdcash.

Aswath Damodaran

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Page 9: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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TheEffectofInterestRatesonStockandBondPrices

Aswath Damodaran

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Page 10: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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InterestRatesandtheRealEconomy

Aswath Damodaran

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Page 11: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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TheHubristicBanker

Aswath Damodaran

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Page 12: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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TheRealWorldBanker

Aswath Damodaran

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Page 13: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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ERPandRiskFreeRates

Aswath Damodaran

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Page 14: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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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.

Aswath Damodaran

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Page 15: NEGATIVE INTEREST RATES: IMPOSSIBLE, IRRATIONAL OR …people.stern.nyu.edu/adamodar/pdfiles/blog/NegativeIntRates.pdf · Dealing with negative interest rates 1. Switch currencies:

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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.

Aswath Damodaran

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