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Thursday, March 2, 2017

What stocks to buy in an interest rate rising environment?

In financial doctrine, we learn that a stable cashflow (low-volatility) company will be highly sensitive to interest rate compared to a high volatility company.  This means that low volatility cashflow will be positively correlated and high volatility cashflow will be negatively correlated to the interest rate.

As banks and insurance companies have relatively stable cashflows, these companies will benefit in an interest rising environment.

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Eric Ho said...

Why is this so?

When the economy is good, the interest rate will rise to contain inflation and a company can make a good profit because business is thriving.

When the economy is bad, the interest rate will fall to boost economy. However, a company profit will decline because the cashflow will contract due to bad business. Therefore, interest rate sensitivity is positively correlated to the stability of cashflow.

Gd economy ---> interest rate up ----> High profit
Bad economy ---> interest rate down ---> Low profit
(interest rate up=profit up, interest rate down=profit down) ===> Stable cashflow(predictable) is positively correlated to interest rates

Stable cashflow (predictable) ---> low volatility (more stable, more sensitive to interest rate)

Unstable cashflow (unpredictable) ---> high volatility (less stable, less sensitive to interest rate)

Eric Ho said...

For example:

Bank has stable cashflow (predictable) and will make a good profit in high-interest rate environment. (positively correlated to interest rate)

Startup has unstable cashflow (unpredictable) and will make a low profit or loss in high-interest rate environment because its funding cost has gone up. (negatively correlated to interest rate)