Dear all.
Happy new year BTW!
I have a question that apparently is very simple but trying to explain it in financial terms seems (at least to me) very complex!
What is the risk of a gift? How do we decide if we will accept it or not?
Imagine somebody give you a gift: a commodity, that can be disposed pretty much at the observable market price (so, [e.g.] worth 10m€ at present value [discounted]).
You receive the gift for free but not now. Will be delivered to you in some time (say 5 years).
Let’s say you’re also able to calculate a VaR of it (given volas and prices, …) of 1m€.
Would you accept?
What consideration would you take?
The struggle I see in making the argument is the following:
If I have to put the 10m€ value into my balance sheet now, so that I could theoretically dispose of it (per example taking an equivalent loan and using it, investing/spending money) I would also have to calculate the Risk of losing the 10m€ value + the interest of the mentioned loan.
In other words, the 10m€ value is not really 10m€ value for me but is rather reduced of the risk of it (let’s say a VaR of 1m€) + the interest of the loan I’ll have to pay back (let’s say: 10m€ minus 1mEur of PaR minus say another 1m€ of interest I’ll have to pay back). So is worth 8m€!
Is this the right thinking?
Am I too aggressive taking out 1m€ VaR or shall I take away just a fraction of it (given that It is not certain that I really loose 1m€)? If so, what would be the right fraction of it? Is it another theoretical loan interest rate?
Essentially, if these arguments are right, I would accept the gift only if the interest I have to pay back for an equivalent loan plus the “charge” (fraction of VaR) of the risk is lower than the present value of the gift.
Thank you all for your support!
Replies
It isn't how I would look at it. I think it is about the gift provider and their risk of default. It isn't a gift until it is in your hands for free in 5 years time.
A counterparty gives you a forward deliverable contract with an observable market price for zero consideration. (My assumption is that they are providing the commodity.) You now have a choice to run the asset or sell the asset.
If you do not sell on the commodity and you decide to run a long forward position then every day you need to compare the original acquisition at nil € to the observable market price and book the difference, increase or decrease. That is how much subsequent profit or loss you made since the benevolent guy came into your life and is not relevant to the original value of the gift. The Var provides you an idea of just how much you may win or lose tomorrow if the markets behave as per your model of them and is also not relevant to the discussion. At the end of the 5 years the counterparty should deliver you the commodity and whatever price the commodity settled at on the last day of trading before your delivery would be the profit you made.
If you sell on the forward deliverable contract the same day for the 10M € observable market value (NPV), you have a balanced trading position. Your 10M € profit is dependent on the gifting counterparty's performance to deliver the commodity in 5 years.
Both outcomes rely on counterparty performance. Say the gifting counterparty does not perform in both cases.
In the first scenario you do not receive the free commodity and therefore you have to write down your free asset to zero. That will be from the preceding day's market price but overall you would have recorded a $10M € profit and then lost it over 5 years so you are back to zero.
In the second scenario you attempted to lock in 10M € of profit by selling immediately the commodity forward and now you need to buy in at market which could be valued anywhere at that point. Therefore your position is plus 10m € less an unknown and unquantifiable cost to you at the outset. This loss is based on the market risks underlying that commodity price and say the market has trebled since the gift then you may be 30M € down. This loss is based on running counterparty and market risk whith the counterparty element being the original 10M €.
Overall value of the gift is between zero and 10M € dependent on your risk appetite of the gift provider and whether you think they will perform. However, if you can achieve a true hedge on counterparty performance risk through insurance then the premium would be the discount to the 10M € and creates your "risk-free" value of the gift....well assuming the insurer pays out and is therefore risk-free! If you cannot obtain a true hedge through insurance, etc then the risk-free value of the gift is zero because everything else is taking on a trading risk.
In a perfect world a lender would look at the forward physical contract and because the commodity market was a perfectly efficient and liquid market they would reduce the amount of money they would lend you today without recourse just by the risk of the counterparty not delivering the contract. In a perfect world that should be the same as the insurance premium above.
In reality the interest rate charged by the bank to you compared to the interest rate used to discount the 5 year forward physical value is another confusion because they are not based on the same factors.
In summary, it comes down to how much value you put on the counterparty defaulting. Now, how you develop an efficient model to convert counterparty risk into € of premium is another story.
Thanks for the reply David.
It isn't a real case, as if it was, definitively the points you mentioned are absolutely worth considering!
It is actually more a case to brainstorm about Risk & value of the gift.
David I. Wilford said:
There are far more considerations here than the question of consideration and accounting treatment. The very first question must be 'who is the gift from and why?'
If the gift is from a client, then there are legal and disclosure issues to consider, possible reputation damage and if everything is above board, the possibility / probability of default of that client before he can fulfill his obligation to you in, say, five years time.
If the 'gift' is a contractual one - under a share bonus scheme, for example - the company performance may influence the share price. Or there may be a minimum consideration built into the gift. In any case, there may be legal impediments with regard to disposal or even the availability of the gift at the end of the period, especially if performance related e.g. the deals that you brought in went sour!
Consequently, the question is actually far more complicated than simply 'how much do I deduct off the current face value of the gift if I am to hedge my position?'