A Bird in the Hand

is Worth Two in the Bush. 

is an old maxim for risk adjusting asset valuation.  It suggests a 50% discount for recording unrealized values.  Notice that is not a discount for recognizing unrealized GAINS, it is a discount on VALUE. 

You have to wonder whether that 50% discount is because there is only a 50% chance that you will catch a bird in the bush or if it reflects a higher chance of actually catching the bird, plus some risk premium because there is some chance that you will catch none.  Is catching none your risk tolerance, or can you go several days without bird for supper, so you have a risk tolerance of zero birds for two or even three days? 

How do you provide for that worst case?  Do you hold a bird in reserve?  Or half a bird?  How do you keep the reserve bird?  Do you have to feed it or refrigerate it? 

Older versions of the saying show a much higher discount.  Two versions from the 1400’s suggest a 90% discount for birds that are on the fly or in the wood.  Were the risk tolerances much lower then or methods of catching birds much less developed?  We may never know. 

But times change and discounts change.  Following the pattern of diminishing discounts, the current standard is that one bird in the hand is worth one bird in the bush according to current accounting standards.  

That is called mark to market accounting.  Older acounting standards might have applied 100% discounts to unrealized GAINS.  But the current wisdom is to not discount anything ever.  So holding cash is exactly the same as holding paper that does not even promice to be worth any cash if at some time in the recent past, someone thought that paper had a particular value. 

With a 50% discount on unrealized VALUES, there was little chance of ever having to do a write-off.  Usually recoveries even in dire situations exceed 50%.  With no discount, there is a very high chance of a write-off because the assets are booked at a value that is the most that one might expect to recover. 

Clever people have figured ways to go even further.  For assets where there are no easy market prices, they get to count future birds that they haven’t even seen yet. 

That is one reason why banks are fighting so hard to keep derivatives off of exchanges, so that they can keep those future birds on their books and do not have to suffer the discounts that an exchange would impose.

Explore posts in the same categories: Mark to Market, Risk


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