Rate of Change

Vol # 35 - April 23, 2021

dY/dX. R-naught. Rise over run.

You can’t escape this math, it’s everywhere. Derivatives traders, infectious disease experts, and automobile engineers are all obsessed with how fast things can move. Even folk singers recognize that the first one now, will later be last.

Understanding the rate of change is critical for making predictions about the future. Whether it’s how much this stock will move or how to get from 0 - 60MPH; the smallest tweaks can have a major impact. 

If you’ve ever played with a model or built a budget, you know the power of assumptions. A little bit of Excel wizardry can magically create projections of profitability. (It also seems a lot easier to cut an extra restaurant meal in front of the computer than walking down the high street.)

The difference between a 15% or 25% growth rate seems relatively minor, until you project that forward, and it’s the difference between doubling in 3 years or 5 years. If you layer on assumptions about retention rate and cost of capital, you’re playing with nuclear fission. 

As pricing models get more complicated and the time horizon grows longer, the assumptions become increasingly important. The single most important factor that goes into any financial model is the interest rate. 

We’ve talked a bit before about how the credit markets rule everything, and how important it is to understand different interest rates. Whether you’re compounding on the saving and investment side, or paying on the loan side, those basis points are incredibly meaningful.

It’s hard to believe that interest rates are so important, given that it’s been nearly a decade since anyone made more than a few pennies on their cash savings accounts. Even high yield savings accounts that could boast a full percentage point last year, have fallen to half that. 

While the interest rate on your cash savings account might not be changing that fast, it seems like the rate of change on other assets is moving quickly. How did lumber get so expensive, and why does the stock market keep going up?

Low interest rates fuel investments by companies into new projects they might not have otherwise pursued. Remember, if you lower the model’s assumption - whammo - profitability ensues. Dovish monetary policy is designed to encourage economic development. 

If dollars are widely available to borrow at low cost, savings accounts aren’t going to earn much interest. The rate of change on your cash balance is going to be suppressed and compounding assumptions get pushed further into the future.

Bitcoin and other crypto currencies are highly demanded as collateral. This comes not only from a capped supply, but from the potential use cases for digital assets. While there are many projects that look like budding Ponzi schemes, there are projects and trades with significant return potential demanding digital assets to fund them. The investment potential means builders, traders,  and entrepreneurs are willing to pay a high cost to borrow those assets. 

Interest rates on “cash” balances in digital assets are paying between 8-10%. Simply converting your dollars into a stable coin - a crypto asset that’s backed by reserve dollars - allows you to earn a significantly higher return on your money. At any time you can convert your stable coin back to USD at parity. 

What sounds like an impossibly high yield, is simply a function of supply and demand. The banks paying these interest rates are able to lend against over-collateralized digital assets at an even higher rate. The opportunities for asset arbitrage and project staking make it worth it for those borrowers. 

The rate of change for digital assets is far greater than traditional assets. You don’t have to be a crypto maximalist to participate here - you don’t need to own a single bitcoin. I even proposed a possible cross asset structured product that leverages crypto yields to provide pure upside exposure to the S&P 500 with a near guaranteed principal. 

As the world evolves across multiple dimensions, finding opportunities to shift into accelerating rates of change is what keeps investing interesting.