macrocephalopod

Sad that the tweet this was replying to got deleted, it was a good learning opportunity!https://twitter.com/macrocephalopod/status/1391865409561899008 …

There's a very general point here which is that the price of literally every asset that exists can be explained with a combination of 1. Replication 2. Expectations 3. Risk premiums 4. Technical effects

Replication mostly applies to derivatives, especially v liquid ones with v liquid underlyings (eg ES futs) which closely track their underlying index/basket/whatever. Also applies to eg ADRs or multiple share classes of same stock. Mostly boring. Next three are more interesting.

If there is no replicating basket the jumping off point is expectations. You figure out what the fundamentals are, build something like a DCF model and figure out where the price "should' be based on "rational" expectations.

That rarely agrees with the market price! One big reason is risk premium i.e. "I think there is a 85% chance of this company repaying their bond at par and a 15% chance they go bankrupt and repay nothing, which is why I will give you 70% of face value for it"

The clearest example of a risk premia in my mind is dividend futures, where obviously the expectation is that dividends will generally increase year on year, but the dividend futures curve is almost always backwardated, i.e. far dividends can be bought for less than nearby divs.

The reason is risk premia -- obviously dividends are correlated with stocks, and taking the risk on long-term dividends requires a much bigger discount than a relatively safe bet on near-term dividends.