Sunday, August 6, 2017

Ceteris Paribus

If it sounds Latin to you, yes it is. In English the term ceteris paribus is “other things equal”, meaning in an experiment or observation setting where the relationship between two variables or factors are studied, all others are taken as constant or unchanged.

Ceteris paribus is often used in economic studies, where analysis of cause and effect between two variables in a given situation is carried out to give a result in the absence of other variables. Though in the real world there are many factors at play to produce a given market or economic situation, ceteris paribus could at least provide a basic assumption at the lowest level.

Demand and Supply Example

For example, using one of the basic economic models, the law of demand, where the variables price and quantity of let’s say, apples, are studied, from the consumer point of view, the demand for the quantity of apples will go down when their price increases.

Using another basic economic model, the law of supply, with the same variables of price and quantity of apples but from a supplier’s viewpoint, the quantity of the apples will increase when their price goes up.

Combine these two, and you will get the demand-supply graph of apples, ceteris paribus. Since it is ceteris paribus, other items (such as oranges, bananas, grapes, etc), which may have an impact on the demand and supply of apples, are not taken into account in this whole analysis.

Use in Fundamental Analysis

For The Bedokian Portfolio fundamental analysis (FA) style, the implementation of ceteris paribus can be used at the environmental factors and economic conditions level, where more assumptions are required as compared to financial statement analysis at the company level. Remember in carrying out the assumptions, the most straightforward and simplest explanation is to be considered first. Taking the telco sector for instance, a fourth telco operator to the status quo would mean more competition in the sector, ceteris paribus. Or for the case of interest rates, their rise would bring inflation down, ceteris paribus.

The ceteris paribus is just the beginning in the whole scheme of things in FA. A lot of assumptions and scenarios would have to be placed together to form a more coherent picture, but then again this would be subjective. This would probably explain why analysts and economists have different opinions and interpretations on the state of the financial markets and the economy, even though they could be working on the same set of information.

1 comment:

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