Model Insights: Market-consistent valuation of ultra long-term cash flows
Document ID: 2008-1085
Published on: 16th October 2008
Author: John Hibbert
Surely, there is no more fundamental task in financial management than placing a value on a certain future cash flow? Yet this basic task turns out to present a major challenge to economists and financial analysts and continues to be the subject of a debate among accountants, regulators, actuaries and firms’ CFOs. In the attached note we will explain what can make this simple question so difficult to answer as well as highlighting some of our own work which is aimed at helping to build a consensus on what a reasonable set of answers could look like.
The path of extrapolated yield curves and the consequent volatility of ultra long-term discount bonds and known cash flows depends directly on the view taken on how variations in interest rate term premia are transmitted through the yield curve. There are two schools of thought. Firstly, those who believe (implicitly or explicitly – it doesn’t matter) that risk premium changes observed at short maturities are propagated throughout the entire term structure. This extreme view generates huge volatility in ultra long-term discount bond and cash flow values. Secondly, an alternative view (with which we agree) that the variability in risk premia declines with term. This is a view motivated by economic thinking and observation of the behaviour of forward rates at shorter maturities, albeit distorted by measurement errors. Those who choose the apparently innocuous approach of extrapolating with constant forward rates will soon discover what a strong and influential decision it is. Think hard before you do it.
