The price of (holding) cash

What is the true value of cash you hold in hands? There are actually two very interesting views

1. Cash as a option, priceless!

What Warren would say is this:
"Cash is an call option, with no expiration date and no strike price."

2. "Money is (a form of) debt"

The academia might have another perspective to offer. In this interview with Harald Uhlig, John Cochrane, and Gideon Magnus at Morningstar, they consider money as debt.

Unraveling the Mysteries of Money (just in case the video won't show up directly, you could use the combined with the title)




Do these views contradict to each other? Not necessarily. If we consider "cash" is just one of asset classes, what we discuss here is about "What Characteristics" it presents.

And we can see here: Some say it is more like an option, others say it is more like a debt.

1. Money as Option:
Here comes the classic call option payoff chart. You pay a fixed price(option premium), then expected the associated stock price would go up.

The crucial part is the lower bound. As an option buyer, the maximum loss is the premium. At expiration, option premium goes to zero, the profit goes along with the corresponding strike price. 

Cash is even better, because it doesn't present an expiration date. 

However, such analog presenting money as a call option, or even better, an option that won't go expired, should satisfied a condition.

"Cost is fixed, in certain period of time"

That is where the Morningstar interview video should kick in.

2. "Money is (a form of) debt":

In this interview, speakers exchange ideas regarding to the nature of cash: a "very short-term" government debt. 

Most people use it to exchange for the goods/services they need in life. When people presenting a bank note to the other, they accept such form of payment only because they know they can "exchange something" in the next round. This is the transaction value of cash.

If people use cash to invest, the story would depict as: a person do "Exchange this short-term government debt for another assets"

Thus, holding cash, i.e. not exchange the "debt" for any other asset classes,  means investor believe the value of this "short-term" government debt is better than other asset classes. 

If we scroll up a bit to look at the option payoff table, the "premium" investor pay is fixed before its expiration time. 

So, what's the cost/price of holding cash? Inflation.

Inflation is "the premium" an investor pay. As the time people holding cash, price level moves. Usually it does not change over a short period of time, yet it does fluctuate. 

Furthermore, cash has its nature as a "very short-term debt". We then have to take a look who issue such debt. Government.

If a government raised so much debt that people believe it won't be able to service, no one would be willing to hold this asset class. Even "a very short-term debt" would not be immune to default problem. Such result have a "scary" term: hyper-inflation.

Such scenario is not common, yet we cannot completely rule out the possibility.

3. If we think of exchange rate.....
For Mr. Buffet, as an U.S. investor, he has every reason to believe the value of dollar won't change a lot. That is why he believes cash is like an option. Inflation is there, such price is rather stable, under this assumption:

"U.S. won't be default on its national budget!"

Yet, if we take one step on international level, "the price of holding cash is rather stable" become questionable. 

As we see EURO might still have a decent purchasing power within Euro zone, its value fluctuation a lot in FX markets. Such movement would have impact on import price, limiting the purchasing power at least in firms level. 

So, holding EURO comes to the cost of its depreciating value in exchange of assets denominated in another currency. It would translate into inflation, just a matter of time.

"a matter of time": still sounds a lot like an option, right? There is an expiration date that such "premium" hold stable. In other words, holding cash sounds a lot like holding an option. Yet, the expiration time is not determined. 

4. Money is an option only if......
Going through these ideas, we found that, considering cash as an option, it should satisfy:

1. The government won't present a default scenario, giving the value of very short-term debt stable
2. Value of such asset would be good, at least within the border.
3. (imported) Inflation is not an acute concern.

Alternatively, debt perspective is quite useful. Simply put, as investors, we constantly consider an bond/stock asset allocation problem. In bond portfolio, we consider a allocation among different maturity.

Personally, I found 3 "if" are a lot of "if". I found a "cash equals to a very short-term debt" a easier concept. In case you find "option view" interesting, remember to take the expiration/inflation seriously.