Last week, we wrote about the concept of discounting. This is how to assess the value of any asset that generates cash flow. You calculate a present value by discounting earnings for each future year. And the discount rate is the market interest rate. We said:

“If the Fed can manipulate the rate of interest, then it can manipulate the value of everything…

There is no other rate to use, other than the market rate. You don’t know the right rate any better than the people who centrally plan our economy. The problem is not that the wrong people are in the job. The problem is not even that they use the wrong magic formulas to determine what rate to set.”

The Fed cannot make a company more profitable, but it can reduce the discount rate so that market participants are willing to pay more for its shares. We noted that no one knows the right rate any better than the Fed. Thus, the only rate to use is the market rate. But we did not really make the case in favour of using the market rate.

Without an arbitrage theory of economics, it might be hard to prove this. One could say that there is a certain elegance in using the market rate, but then one could argue for various fudge factors to adjust the market rate too.

But arbitrage cuts to the chase. Suppose you could borrow $1,000,000 at 2%. That means you pay $20,000 in interest. But suppose you can buy $1,000,000 worth of stock that generates 3% earnings. That is, it earns $30,000. There is a profit to be made in this trade.

We are deliberately leaving aside three issues. One is the risk of owning equity, which is on top of the risk of owning debt. Two is the choice of which interest rate to use: Fed Funds Rate, 6-month LIBOR, 5-year corporate AA bond yield, etc. Three is whether to look at earnings vs dividends.

But these details aside, it is simple conceptually. If one can borrow at 2% to buy a 3% yield, there is an actionable arbitrage.