A recent piece by Izabella Kaminska at the FT spurred me to do some reflection on the theory, or concept, of a price.

Anyone with any finance knowledge can tell you that the basis of the discipline is the concept of the 'time value of money.' Financial instruments, the things we all think about, talk about, and trade all day long, all revolve around this phenomenon. The trillions of dollars of paper zipping across the globe in the form of electrons are all just discounted cash flows. But what does it really mean to discount a cash flow?

Indeed, the integrity of the concept of present value, of making a dollar tomorrow equivalent to a dollar today, is tenuous in practice. The theory revolves around the existence of some discounting factor (based off of the fabled 'risk free rate,' whatever that term means) which can make differently-timed cash flows fungible. But this is in stark contrast with the reality of money markets: not everyone gets the same rate! I do not have money markets experience, so cannot speak from the perspective of those seats. But as a macro person, funding costs and liquidity at the front-end are constantly top of mind.

This question has always seemed to irritate finance academics with whom I have discussed it. I don't blame them: it's tough to use theory to address a question which has no theoretical antecedents. No one is deluded enough to believe that no-arbitrage conditions are 100% perfect in the real world, but they have been believed to be loosely good enough. Divergent funding rates, and regulatory limitations on balance sheet capacity can obviously be huge impediments to clean market operation. The non-existence of bilateral arbitrage conditions can lead to situations such as we are seeing, where apparently 'wrong' pricing can persist. This is a bit like markets slapping theory in the face and reminding our anthropomorphized 'theory' who is really in charge.

As far as I can tell from practical experience and observation, this is a frontier in finance theory, and I am happy to see the increased attention it is garnering. At the very least, as a market participant you owe it to yourself to consider this question of present value ambiguity. After all, it's tough to explain things like negative swap spreads or the non-existence of covered interest parity, otherwise.

If the purpose of financial markets is efficient allocation of investment capital, what does the existence of several different 'correct' prices imply about allocation across industries and geographies? How will this affect WACC calculations and corporate finance decisions? Will there be a new wave of finance theory which unleashes radically more efficient capital markets? (Probably not). History gives us a 'push' and a 'pull' factor in discerning the impact a priori of multiple correct prices. Firstly, the status quo is highly sticky: humans are inert in their behavior as a social group. Secondly, it is the unknown unknowns which matter: no one could have predicted Markowitz optimization or Black-Scholes pricing until clever folks actually worked the ideas out themselves. So, we will just have to wait and see what comes of this apparent erosion of the law of one price.

Reading this over, I added little of substance to Izabella's piece. But hopefully this will have drawn your attention to this relatively new topic, and spur some reflection. As always, I enjoy hearing your thoughts.