Thursday, May 12, 2011

decreting vs accreting curves in a YCG -- basics

Suppose you hold an asset (say a stock) on borrowed money. Over 1 year,

A) You pay interest on the loan. Interest amount is determined by your credit rating and the prevailing risk-free rate (but more commonly Libor). If your credit is excellent, then this interest amount primarily reflects inflation and the gradual diminishing purchasing power of one unit of USD (or whatever currency).

B) The asset in your portfolio also accrues in market-value in USD, due to dividend or coupon income, or you can lend it out on the repo market to earn a fee.

Both of these sums grow with holding duration. A partially offsets B. Net appreciation of the asset is often positive. Note A depends on the borrower and B depends on the asset.

I believe most professional traders (buy-side or sell-side) do most trades on borrowed money -- Leverage. They start with $1m, and through credit relationship, can use $10m -- leverage ratio of 10.

Even if you trade using your own $500k, you are still "paying" or forgoing the interest (opportunity cost) you could earn on the $500k.

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