A GREEK TRAGEDY – Ananke the Goddess of Inevitability, or Risk Premium and Greece Default.

Normally we refer to “risk premium” as the different in the interest paid
by a risky asset versus the interest paid by a risk-free asset; then when
we talk about the risk premium of a specific country, we are normally
referring to the additional interest paid by the debt of a government of
that country, in comparison to the interest paid by the government debt of
a “benchmark country” with a reputation for having a very reliable
financial strength and therefore, for which the possibility of default is
minimum or nonexistent. More specifically, Greece debt would be the “risky
asset”, German bonds are seen as the risk-free benchmark in the Eurozone,
and the difference in return between them is the risk premium paid by
Greece, this is as simple as it gets.

Now, what does the risk premium of a country says when such a country is
likely to be facing a default scenario, and by default I refer to any form
of “voluntary” or non-voluntary change in the terms of the outstanding
debt, such as a haircut in the capital or an extension in the terms of
payment, either way producing a change in the cash-flow of mentioned debt.

Let’s start by how the yield of a bond is calculated, and basically we will
find out the yield of any bond by comparing its cash-flow to its current
price, the rate that produces a present value, for a given cash-flow, equal
to its market value would be the yield of such a bond. And this will be
always correct, unless the market is already expecting some kind of
default, voluntary or compulsory debt restructuring, which will produce a
change in the cash-flow. In such a scenario, the market value of a bond
would be the present value of the new cash-flow expected by the market, and
since this expected cash-flow would be smaller in value and/or longer in
time, the expected yield when someone buys a bond that is expected to enter
in default, is necessary lower than the yield calculated based in the
original cash-flow of the bond; consequently the risk premium of a country
facing default is overestimated.

But what is the relevance of all this, and most importantly, what is the
use of it. Well, there are some important applications and conclusions
based on this concept.

First of all, we can take a look at the yield of the debt of countries that
actually defaulted, prior to their default, and see what was the
risk-premium they had. If we compare that risk-premium with current
Greece’s risk-premium, we could have a good indication of whether the
market is already expecting some sort of default. Secondly, we can see what
the historic risk-premium post default was, and that would also be a good
indication of what would happen with Greece’s risk-premium after a default,
then we can use this new risk-premium to have an indication of the new
yield of its debt post default, and since we know the current market value
of Greece’s debt, we can predict possible cash-flows that would be
consistent with current prices, and therefore to have an idea of what kind
of haircut or extension the market is expecting.

Today we have two strong antagonistic positions, on one side people sustain
that any kind of default has to be avoided and therefore, they are willing
to dedicate large amounts of resources into rescue packages for Greece in
order to avoid its default; on the other side we have people that sustain
that a default is unavoidable and therefore, to keep dedicating resources
into rescue packages for Greece is a waste of time and money and it’s not
helping to solve Greece problems.

If the market is already expecting some sort of default, the longer we
postpone it, the more expensive will be for Greece’s government to raise
fresh funds, since they would be raised at a yield that indicates that
current situation is not sustainable and a default is expected, rather than
to a lower yield in a post default scenario. In this case, the best course
of action is to put together a debt restructuring plan in such a way that
would be consistent with market expectations and Greece financial
situation; this would eliminate the uncertainty in the market and therefore
it will allow Greece to start improving its economic situation instead of
extending the current scenario of struggle and political unrest that we
have been seen for quite some time.

But what is "Wealth" after all?

This is the typical kind of question for which the answer seems to be so obvious that we never bother to ask.

First of all lets clarify what is not "WEALTH", and even though it could sound disturbing, wealth is not money, is not the balance in our account or the total assets in our portfolio. All those things are ways we have to measure save or manage our wealth, but are not wealth.

In a very straight forward definition, wealth are goods and services. When we produce a good or we provide a service, we are creating Wealth; When we purchase a good or we hire a service, we are consuming our wealth; and the more goods we can acquire or the more services we can consume,the wealthier we are.

It is such a basic and elemental concept that it may seem pointless to clarify it, but as they say "the devil is in the details" and if we overlook this concept, we may end up overlooking some more important and relevant factors, and that is why I took the time to explain it.

As an example, the same amount of money has a very different purchase power depending in the geographic region you are spending it, and therefore you would be more or less wealthier depending where you are planing to  spend your money. Similarly, the same good we produce or service we provide, would represent more or less money for us, depending the geographic region in which we are selling it.

A simple application for an individual of this concept would be to go to the university in a country where you could get a high quality education at a very reasonable price, then move to work in a country where you can maximize your income during your professional life, and lately retire and move to a country where you could get the most for each dollar spent. Of course there are many other personal factors to consider in order to take such decisions, but if someone want to focus in maximizing his or her wealth, it definitely will be something to consider.

The same concept is applied for a company when deciding to outsource part of its operations to a foreign country, where the cost of labor is cheaper; or with exactly the same reasoning, when a worker decides to move to a foreign country where the cost of labor is higher.

As we can see, the concept of wealth is a very intuitive one but it is also a very important concept to understand and to have a clear understanding of it.

Hugo Novaro

Welcome!

Hello, I'm just starting my blog and probably the first think you would be wondering is what this blog is, or will be, about.

The answer is in the title of the blog, that happen to be a question; let me explain it. I'm an investment professional, and as such, I am highly interested in subjects related to economics and wealth management, therefore the question made in the title of this blog, will allow me to address several economic and investment matters, from the individual point of view and also from a more global perspective.

I came up with this question a few years ago when I was analyzing some economic events, I started to develop a line of thought and then the best way I found to summarize the complete idea was the question "How Much Wealth Can We Afford?"

I the following posts I will start to explain with more detail my ideas, and at the same time I will discuss current events related to the subject.

Thanks for visiting my blog,

Hugo Novaro