The interest rate charged on business loans, known as the discount rate, affects stock prices. This is particularly important, given the fast rate increases by the Federal Reserve this year. However, traditional methods of calculating its impact are not sophisticated enough, according to HKUST’s Zhanhui Chen. To address this limitation, the researcher proposes a new model, effective equity duration, that accurately captures the influence of interest rate changes on future cash flow growth and, in turn, stock prices.
Discount rates affect stock prices in two ways: either directly, via the discount-rate channel (stock prices drop when discount rates increase), or indirectly, via the cash-flow channel. As Chen explains, “expected future cash-flow growth often covaries with the discount rate.”
Bankers typically use a measure called the Macaulay curve to assess the relationship between discount rates and stocks. “The traditional Macaulay duration captures the direct effect of discount rates on stock prices via the discount-rate channel,” the author tells us. However, it has a major limitation. “The Macaulay duration assumes that future cash-flow growth does not vary with the discount rate,” says Chen.
The assumption that cash-flow growth is independent of rate shocks is incorrect. “For stocks, the expected future cash-flow growth often increases with the discount rate,” explains Chen. As a result, “the indirect effect of discount rates on stock prices via the cash-flow channel becomes important.”
The Macaulay calculation is based on financial information available at the time of the calculation. However, “future cash flows and discount rates of stocks are usually unknown,” the author writes, “which makes such estimation difficult.” Chen proposes a new model, effective equity duration, to capture the impact of future cash flow fluctuations. This model, he explains, is an “event-based estimation of the effective equity duration that uses price information.” Instead of assuming that future cash-flow growth is unaffected by discount rate changes, it captures the “total effects of discount rates on asset prices.”
To assess the impact of rate changes on stock prices and inform the new model, Chen analyzed 47 “policy surprises”—unexpected rate changes announced by the Federal Open Market Committee (FOMC)—and their impact on securities. “FOMC surprises include unexpected policy inactions or unexpected policy moves,” explains Chen. He used these “informational events” to measure the effective equity duration.
While based on complex calculations, the difference between the two models can be captured visually. The Macaulay yield curve is demonstrated visually as a “downward sloping curve,” whereas the effective equity duration takes the form of a “hump-shaped curve”. Why is that? “Stock returns increase with the duration when the duration is relatively short,” the author explains, “but the equity yield becomes downward-sloping when the duration is longer.” This happens because the expected future cash-flow growth increases with the discount rate. Simply put, when rates go up, cash flow increases.
The new approach offers important lessons for stock pickers and portfolio managers. “Gross profitability increases with duration among short-duration stocks,” writes Chen, “whereas book-to-market equity decreases with duration among long-duration stocks.” This intelligent model offers unprecedented flexibility, helping investors to “manage portfolio risks when facing discount-rate shocks”.