Deflation Made Simple (Part I)
A falsely vilified phenomenon (Image 072)
The broker had done his homework.
There were three money-in-use rates (prices) — namely, rates of return (ROR) — to consider in the negotiation: the going ROR at a reputable Amsterdam investment bank, the expected ROR of a VOC share, and the expected ROR on Hendrik’s bond.
Do not be afraid of these three RORing lions, for when they bite they bring financial wisdom.
The going ROR at the bank would determine the investor’s default transaction — what he would do with his money, if Hendrik refused to sell his bond at a price acceptable to the investor. So, this was the minimum ROR that Hendrik could offer and still sell his bond.
In contrast, the maximum ROR that the investor could reasonably demand was the expected ROR from a VOC share. After all, the investor had already made it clear to the broker that the VOC is where he would put his money, if only he had enough to purchase a VOC share — what he clearly did not have.
With the lower and upper limits of the transaction clearly in mind the broker set to work. As the ROR for time-deposits was common knowledge at 4 percent, and the ROR on the bond was its stated coupon rate, if the bond were purchased at the value of its principal, the broker had only to calculate the expected ROR on a VOC share. He used the same calculation as Ans (Images 65-66), but with a little more knowledge about where the market was likely headed. He calculated as follows:
Current price of a VOC share: 9,000 Guilders
Expected dividend: 540 Guilders
Expected ROR: 540 ÷ 9,000 = 0.06
Notice that the VOC share price had tripled since the time of Hans (Images 37-39) and Thomas (Image 41).
Now, the coupon rate (rate of interest) on Hendrik’s bond was 5 percent (0.05) and the value of the bond’s principal (face or par value) was 5,000 Guilders. Unlike the VOC’s share price and dividend payment the bond’s values were fixed. This latter was not entirely true, for the stadtholder and his revenue collectors were ultimately in charge. The stadtholder was the effective sovereign, and good luck suing him in a court of law. This said, were the Stadholder not to honor his obligations, the next time that the provincial government wished to levy more taxes or borrow more money, it would surely be met with resistance. Keep in mind, the Dutch were a hardy lot, an upright folk, who believed in fair play.
So, with the three relevant prices in hand — namely, the ROR of each use of money-in-use, the broker calculated the expected return on 5,000 Guilders for all three financial instruments.
Bank Deposit: 5,000 x 0.04 = 200 Guilders
Provincial Bond: 5,000 x 0.05 = 250 Guilders
VOC: 5,000 x 0.06 = 300 Guilders
The benchmark for the trade would be 250 Guilders, the expected return on Hendrik’s bond. And, the upper and lower limits of the negotiation would be 5,050 Guilders (VOC) and 4,950 Guilders (time deposit), respectively.
Upper limit: 5,000 + (300-250) = 5,050
Lower limit: 5,000 - (250-200) = 4,950
In the broker’s mind, he and the investor had 100 Guilders to haggle about. What additional considerations would be taken into account? How would the negotiation play out?
We have nearly learned how to price money-in-use.
See you next time. And, remember! Do not be afraid of the lions’ ROR.
In liberty, or not at all,
Roddy A. Stegemann, First Hill, Seattle 98104
ps: Also, please do not be afraid to share, for the lion’s ROR is the key to investment. It is the price that everyone who invests needs to know, and it is sound investment that makes a real economy grow.