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Session 807 - Basics of Financial Economics
Speakers: Gordon C. Enderle, Chad A. Hueffmeier
Recorder: Susan Lee

This session provided a brief introduction to financial economics.

Law of One Price

This is one of the central tenets of financial economics.  The law of one price states that liabilities and matching assets should have the same market value (also known as economic value).  Here, matching assets means a portfolio of securities with cash flows that match the liabilities in amount, timing and probability of payment.  Thus, a liability should be measured using the discount rate embedded in a matching asset portfolio.

This is a statement regarding liability measurement, not a statement regarding investments.  In particular, a pension plan’s asset allocation should not affect the discount rate used to calculate the pension plan’s liabilities.

Bader Swap

Another important concept of financial economics is that the equity risk premium, once adjusted for risk, is zero.  An illustration of this principle is the “Bader swap” described below.

• Person A owns 15 year zero coupon bonds yielding 5% with market value of $1 million.
• Person B owns shares of an S&P 500 index fund with market value of $1 million.
• The swap: at the end of 15 years, Person A will pay Person B the entire return on the bonds and Person B will pay Person A the entire return on the S&P index (positive or negative).

Who has the better deal?  Assume equity returns have an expected return of 8%.  In this case, the use of stochastic simulations shows Person A wins more often than not.  Also, the traditional actuarial practice uses only the expected return of 8% to determine that Person A has the better deal.  However, the traditional actuarial practice does not in any way take into account the risk (the variance) associated with equities.

Financial economics argues that actually neither person has a better deal.  Swaps happen all the time in financial markets.  The market price for the swap between Person A and Person B must be zero because otherwise Person B could make money without taking on any risk by borrowing $1 million at time 0 and investing it in an S&P 500 index fund.  The fact that the market value (or the economic value) of the swap is zero shows neither person has a better deal.  (The economic value reflects risk, whereas the traditional actuarial value does not in any way reflect risk.)

Second Order Issues

A further premise of financial economics is that the corporate task is to maximize shareholder value.  Towards this end, higher returns in the pension plan create no first-order economic value for shareholders.  However, second order issues (those that are not directly related to the value of a financial deal, but rather indirectly influence the value) of taxation, surplus ownership, and agency costs do affect shareholders. 

Because tax rates for debt income exceeds tax rates for equity return, investors are better off when plans hold debt and investors hold equity directly.  Shareholders bear risk when the pension plan’s assets are invested in equities but shareholders do not get the entire benefit of excess return.  Agency cost occurs when the management does not act in shareholder’s interest.  Payments to plan vendors are also often included in agency cost.