In financial modeling, as is well known, one of the most debated variables is the risk free rate. In reality, in fact, nothing is truly risk free. However, usually, we tend to identify the risk free rate with that of safe government bonds (German, for the euro area, American if we think in dollars). However, it remains to be assessed whether the short-term or the medium-long term rate should be considered.
In general, however, it is legitimate to say that the yield of the american ten-year government bond (10yrs US TSY) is not only the risk free asset for the United States, but is also the reference benchmark for all asset classes globally, as the relevance of the american economy at the international level, together with the power of the Fed (the world central bank) inevitably affect the prices of the main asset classes globally.
For this reason, the 10yr US TSY is to be considered the “global discount factor” (to which the risk premium is added) to be used in discounting cash flows (coupons or other cash flows, such as dividends, to depending on whether we are analyzing bonds or equity) of the main asset classes in order to determine their value.
To be more precise, it is its implicit real rate that must be used as a discount factor: the higher it is, the lower the current value of the flows of the asset that you want to evaluate.
But how does the process work?
In times of economic crisis, the Fed usually uses the lever of reducing interest rates and, in doing so, acts on the real rate implicit in the 10yr TSY by lowering it: in other words, the bank communicates the future monetary policy and the market acknowledges it by modifying the future series of rates downwards.
The process breathes in asset prices (bonds and equities rise) and stimulates the economic growth.
Conversely, when inflation goes beyond the set targets, the resulting process is reversed: the Fed communicates the new monetary policy intentions and the market acknowledges them by modifying the future series of rates upwards. This leads to a rise in real rates, increases the discount factor with which financial assets are priced and reduces their value.
Some assets suffer more, others less: this is why we are talking about long and short duration assets.
For convenience, the following is a generic formula for the market value of an asset.
The PV (Present Value) represents the market value and is a function of all C (coupons of a bond or cash flow of a equity stock) discounted over time at the reference rate r (discount factor). With r being equal, the higher C the higher the PV, or the market value of the asset we are analyzing. The lower C, the more an upward movement of r produces a decline in the market value of the asset class (the higher the sensitivity of that asset class to the movement of the real rate). In this case we speak of “long duration asset“.
Conversely, for an asset with higher C, an equal upward movement of r has a minor impact on the price of that asset: we are talking about “short duration asset“.
As is well known, there are long and short duration assets in the bond sector (government and corporate): fixed income securities can in fact be characterized by more or less high durations.
But the same thing also happens in equity: there is in fact a difference in sensitivity not only between equity indices globally, but also at a sector level. For example, in the equity asset class the technology sector is a long duration asset, while the energy sector and basic materials are a short duration asset.
In a phase like the one we are experiencing, with real rates rising sharply, having more short duration assets in the portfolio than long duration assets would certainly have changed performance.
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