Global financial markets are essentially mechanisms for buying, selling and transferring risks. When we break these risks all down to their roots, I would argue that there really exist only four actual fundamental risks that are being bought, sold and otherwise transferred. They are:
(1) Enterprise credit risk: the risk that an organization won’t be able to service and pay off its debt obligations,
(2) Enterprise equity risk: the risk that an organization won’t generate enough free cash flow to pay back creditors and have something left over for equity holders over time,
(3) Governmental credit risk: the risk that a government won’t have enough cash to pay its debt obligations at some point in time, and consequently might just print money to do that; and
(4) Macroeconomic risk: the risk that exogenous and/or endogenous economic circumstances slow regional or global economic growth for a period of time. This is somewhat a catch-all that covers geopolitics, natural disasters, raw material scarcity, etc.
The only other risk that deserves attention is one that is, arguably, less fundamental, which I call “timing risk.” I call it timing risk because in the end, fundamental risks will drive security prices (the prices of these risks) to an appropriate economic value. The problem with that is figuring out when “the end” is. Timing risk captures the fact that human emotion and other factors will drive prices away from fundamentals for sometimes very long and painful periods of time.
Smoothly functioning capital markets should be designed to facilitate ease of transfer of these risks among market participants. And, in fact, that is what they do. For this reason, I am a big fan of financial innovations that allow for ease of risk transfer. Such innovations are important and helpful to providing the needed lubrication for the global capital market machine. However, capital market regulators also have the obligation to protect the free functioning of global capital markets – and to ensure that the global capital market machine doesn’t take on too many Rube Goldberg qualities.
With this as a background, my next Intrinsic Value post will deal with one such financial innovation of recent years, the Credit Default Swap. Is the credit default swap lubrication for the capital market machine, or is it the proverbial sand in the gears?