624 CHAPTER 16. INTERNATIONAL FIXED-INCOME MARKETS
the counterpart, the lender), the uncertainties are usually greater, so very often one
needs to be a bit more careful about default risk.
How well do we knowR, in reality?
This looks like a cut-and-dried problem. The only hitch is thatR, the required
rate of return, isn’t easily observable. Only the Great Banker In The Sky knows
it well. How come? Can’t we just take the prior that the npv is zero, which
would allow us to inferRas the internal rate of return? In perfect markets, of
course,npv’s from financial transactions must be zero. In reality we cannot bank
on that, though, because acquisition of information is costly and time-consuming.
This is especially an issue in the case of risky corporate borrowing, which is full of
information asymmetries—either between banks and borrowers, or among the banks
that might compete to act as lenders. Let’s look at each of these asymmetries.
- If the financiers know more about the market situation than you do, chances
are that they make a gain and you a loss. Notallbankers are angels. There is
court evidence how investment bankers have underpriced theIPOs they man-
aged, so as to be able to dole out goodies to friends and cronies. You may
also have heard how derivatives dealers openly mailed each other about the
“rip-off factors” they had included in their contracts, and how during theIT
bubble investment bankers made fun of the “fools” they sold to. - These are, of course, just anecdotes; but there exists a respectable academic
literature on “hold-up” behavior. House bankers have a bit of a monopoly
position, so the argument goes, since they have built up long-term knowledge
about the borrower. Breaking up the relation would be costly for the borrower,
since it takes time and effort for another bank to just re-discover all the info
and insights the incumbent already has. Thus, the house bank is in a position
to exact a monopoly rent—not too much, of course, otherwise they lose the
account. Empirical evidence shows that banks actually do so.
For these reasons, mildly negativenpvs are far from unlikely. The borrower might
still go along with a negative-npvbond deal if, as pointed out, the loss is not large
enough to justify changing banks or consortia and if the loss is small relative to the
npvof the direct investment that is being financed. In a way, the bankers just grab
a slice of the firm’s business gains. But the bottom line surely is that you cannot
just postulate that competition is perfect,npv’s therefore zero, andRvisible as the
irrof the deal.
Evaluation under Realistic Circumstances
Bearing all this in mind, let’s now critically review two feasible methods and see
how they relate to the ideal solution we just outlined.