Money and finances

Equities

admin — Mon, 29 Mar 2010 09:56:26 +0000

Estimating VARs for equity positions has one fundamental difference compared with estimating VARs for interest rate and foreign exchange positions in that there is no underlying risk factor that can be simply used for aggregation purposes.
A bank may have holdings in very many different debt instruments of similar duration whose price changes can be determined in a linear way from a single underlying risk factor, such as a yield taken from a specific point on the yield curve. Foreign exchange positions change with foreign exchange rates. In more formal terms we can say that the changes in the value of vanilla interest rate and foreign exchange products have perfect, or close to perfect, correlations with changes in their underlying risk factor.
This is not the case with equity positions, where stock price changes are not perfectly correlated with the market. If we take our two stocks, Blue Sky’s returns have a relatively high correlation with market returns while that of Bore Inc.’s is low.

Business lines

admin — Mon, 25 May 2009 21:03:36 +0000

A bank or fund is usually the sum total of several business lines. Each of these business lines has an associated risk to its assets that Basel II wishes to label Beta or Gamma. The total risk exposure can be summed as the total of the risk-weighted assets. Thus, best practice in one department does not mean it translates into a bank’s best practice.
We have deﬁned the risk appetite to risk offer relationship in another line of our Loss Database that evolves into a Basel II compliant system. A standard-certiﬁed risk-taking bank will have higher regulatory capital assigned because its risk management processes and system are adequate, but not extremely sophisticated. An advanced-certiﬁed risk-taking bank will have lower regulatory capital allocated because its risk management is highly developed and is evaluated as a lower overall risk. The risk of losses increases, and this should be reﬂected in the Beta or Gamma risk weight.
The long-term investors can almost be in danger of extinction under the rush of the incoming speculators. More traditional wealth-creation business lines involving “hard” assets and less turnover or “churn” attract lower comparative costs and risk.
Moreover, under the advances of the Internet and online dealing, we have the increased presence of naive traders in the jungle. For such a public, there are a score of animals that can seek to prey upon such victims; smart operators, banks and brokers can play the role of scavengers. These people may be naive gamblers, even more tempted by margin trading and buying highly leveraged derivatives contracts, even with borrowed money. Thus, there is little in the way of risk management to protect us – a fool and his money are easily parted. There are other methods in risk management for the investors from the traditional ones offered, they are:

risk avoidance
risk retention
risk reduction (e.g. diversiﬁcation)
risk hedging
transfer of risk.

Maybe fund managers and bank professionals have too much information at times. It is a mess and too much to process efﬁciently. Everyone is perennially too busy. They do not have enough useful data to make the best investment decisions. Risk management is partly the presentation of useful and readable information, then the translation into action and concrete risk countermeasures. So, in the absence of a clear solution, they take Occam’s Razor for a business decision. Stated very simply, if there are two or more choices, then the simpler and better option is likely to be one that offers the least line of resistance. Thus, when confused, call in the experts and dump the problem (or risk) on them.

The credit ratings procedure

admin — Wed, 20 May 2009 20:59:56 +0000

The credit raters are not to blame as such; they only review the data and aspects of a company presented. It is a consensual process, in that the agencies do not barge in uninvited, nor do they pay surprise visits. The company visited pays for the inspection, or it may have been requested and funded by a party intending on buying a large stake or take-over.
If the ﬁrm wishes to hide or misrepresent the truth, then it is difﬁcult for the rating agency to ﬁnd out the accurate picture. The rating agency may be given a short time of a day or less to make an inspection of the company. More complex inspections can take a bit more time on site. Follow visits may be done in one or two hours some time or years later. Such visits can be rather superﬁcial inspections, depending upon the conditions, but time is tight and the extent of cover-up would be difﬁcult to spot in many cases. So, deep information is unlikely to be revealed where intent of deception remains.
Nevertheless, many unbiased analyses are made by the credit raters where a “favourable assessment cannot be bought”. Rating agencies disagree more often on banks and insurance companies. The strength of a balance sheet in a ﬁnancial company can be difﬁcult to assess, even after several on-site visits.
Where the subject ﬁeld is broader, there is likely to be even more room for controversy and disagreement. Sovereign, market, interest rate or currency risk carry a lot of attention. The room for surprise is quite large. The rouble’s dramatic devaluation in 1998 or the Argentinean peso in 2001 reﬂect how experts can get it wrong.
Yet, banks and ﬁnancial institutions cannot blame the credit-ratings agencies. This former get-out clause is further closed where the banks themselves choose to gauge their own risk rating under the Basel II AMA (Advanced Measurement Approach) or IRB (Internal Ratings Base) system proposals. Yet, the blame for a bad investment decision cannot reasonably be laid at the door of the raters. Caveat emptor clearly states that caution had to be exercised by the buyer, and no ratings agency forced investors into Argentina or WorldCom.
Frankly, it is not the job of the rating agencies (Moodys, S&P, Fitch) to be the world corporate police ofﬁcers. All they do is survey past data and monitor news releases or pay a short visit to the companies themselves. The ultimate decision on investing money after the assessment of fundamental enterprise risk rests with the owner of the capital of the person who is mandated to make the choices. The passing the buck:
“I only made the decision because the credit-raters told me it was a good company”, is an insufﬁcient excuse. To say anything less would be cowardice, and chicken capitalism thrives.
Business investment decisions must be made by the investor, resting upon a straightforward train of processes:
1. Formulate business plan.
2. Marry risk appetite to risk offer.
3. Manage reputational risk/due diligence.
4. Risk support/risk monitoring.
Not only is risk appetite directly linked to risk offer, but risk appetite is also covered by regulatory capital. Risk support means that the danger of capital becoming inadequate to cover expected losses automatically signals an alert to the bank. What we have created is a web-based system for warning of banking danger areas.
The spectre for shouldering risk increases under the latest Basel II standards where “higher rated” banking and ﬁnancial institutions choose to rate their own risk under AMA (Advanced Measurement Approach) or IRB (Internal Ratings Base). This essentially means that the banks will develop their own ratings systems (geared towards showing that they are lower risk banks) and justify their models to the regulators. Naturally, it would be in the banks’ best interests to portray themselves as lower risk to the regulators and the credit-ratings agencies. It is going to be very interesting what sort of assumptions and theories underpin their models.

CREDIT RATINGS

admin — Fri, 15 May 2009 20:57:05 +0000

Credit ratings are just one of the benchmarks of banking and fund management industrial standards. They are a good attempt to protect against potentially wayward performance in the ﬁnancial markets, but they represent only one technique. They provide a short single ﬁgure or code e.g. AA, B
The research ﬁgures distilled into one succinct summary may be ﬁne for a university, but it can be dangerous when looking deeply into market investments. Risk management systems embody the knowledge or assumptions of industrial best-practice norms that have been built up over the years. Thus, the up-to-date credit rating of counter-party ﬁrms are essentially a reactive move to risk-monitor companies, quite possibly using data that might be up to 12 months old. Also, bank decision makers may take the individual ratings and amalgamate them, thus losing data accuracy or granularity. This introduces risk of its own.
There are real dangers about using credit ratings as a proxy for full-scale risk management, of which due diligence is just one tool. When the ratings are up to date and accurate, they work well in deﬁning an extent of risk attached to a company or investment. If not, they can fail you. Credit-rating agencies used in the risk management exercise can be late or irrelevant where the search is done post facto, i.e. the decision has essentially been made and all that is needed is a rubber stamp. The process of estimating the risk from past data reﬂects the subjectivity of credit ratings published. Where balance sheets and similar audit data are used, we are imposing two layers of subjectivity. This error is increased where the published information is out of date. Thus, you have distilled a mass of complex (and sometimes dubious data) into one single ﬁgure or grade. This sifting process can have inherent faults at play to provide a misleading result.

Looking Deeper into Levels of the Rate of Change Indicator

admin — Tue, 12 May 2009 10:54:46 +0000

The rate of change oscillator conveys a good deal of information in and of itself, but it provides more information if the time is taken to study the market action that errated the current reading.
More specifically, each day’s new rate of change indicator level actually involves two variables: the current day’s change in price level and dimction of movement, and the level and direction of the price movement of the day that is being removed from the calculation being made.
If the day being removed was a day of market decline, rate of change measurements will turn upward even if today shows no gain in price, for as long as it shows lesser loss than the day being removed. Therefore, if weaker market periods are being eliminated from rate of change calculations, rate of change levels tend to rise easily, often before price trends tum upward. If today happens to be a rising day and the day eliminated from the calculation was a falling day, rate of change measurements might rise rapidly.
Conversely, if the days being removed from your calculations were days of market advance, it will be more difficult for your rate of change indicator to gain ground. During strong market periods, rate of change indicators are likely to track sideways, but at relatively high levels. It might appear at such times that negative divergences are taking place, but if you examine the data stream carefully, you might notice that the stock market is not really weakening at all and that, in fact, the ability of its rate of change readings to remain high is a sign of strength.
Let’s go back to our data September was a period of sharply declining stock prices, so rate of change levels rose quickly in October, even prior to price gains of any significance. Not until the turn of the month into November were the days being eliminated in the calculations rising market days. Rate of change measurements remained flat, though high for several weeks. The inability of rate of change measurements to advance further was, in this instance, not a sign of market weakness, but rather simply a reflection of the ongoing strength that had been maintained over several weeks.
Relative strength readings did not seriously begin to fail until the end of 2001, when, after a dip, prices rose to new highs while rate of change measurements clearly failed to do so. Prices and rate of change measurements declined simultaneously early in 2002, the decline preceded by the negative divergence that had developed between December 2001 and January 2002.
The first dip down in early December, accompanied by declines in the rate of change indicator, was not necessarily indicative of a more negative market climate. Even the strongest market advances have periods of consolidation. You might notice that at no time did rate of change levels decline below 0 during December. However, a negative divergence, with more bearish implications, did develop at year end.
What made tlh negative divergence more significant than the flattening of the rate of change indicator during October and November? Well, for one thing, rate of change readings were no longer tracking at high levels, declining to near the zero line. For another, patterns of price movement had changed, with price trends flattening. As a third consideration, there was very little time between the time that the rate of change failed to reach new peaks that would have confirmed new highs in price, and the rapid turndown in price levels from the early January peak.
Again, declines in rate of change readings and the presence of negative divergences are more significant if they are accompanied by some weakening in price trend. Double-top formations in price (two peaks spaced a few days to a few weeks apart) accompanied by declining double top formations in rate of change measurements can be quite bearish.
Conversely, rising patterns in rate of change measurements are more significant if they are confirmed by a demonstrated ability of the stock market to turn upward. Double-bottom stock market formations, spaced a few days to a few weeks apart, accompanied by rising rate of change readmgs often provide excellent entry points.

INTERNATIONAL ACCOUNTING STANDARDS (IAS)

admin — Sun, 10 May 2009 20:55:14 +0000

International accounting standards (IAS) or the latest US GAAP (generally accepted accounting principles) accounting guidelines will reform the auditing world in the post-AEW investment climate. The revised accounting drafts are of major relevance to banks, funds, insurers and all types of corporation.
In particular, the latest IAS 39 and FAS 133 spell major revisions for reporting and valuation that enforce a stricter manner of stating corporate accounts.12 These have particular signiﬁcance for the statement of derivative valuations in the corporate accounts. This has a direct implication in the daily mark-to-market exercise where the company is exposed to ﬂuctuating values of derivatives.
Similarly, FRS17, the new accounting measure for funds requires them to state an actuarial valuation of funds’ assets and liabilities that are regarded as a stricter and harsher view. All parties, investors, accountants and audited companies are arguing over the animal that is called “fair value”. Like the blind man touching different parts of a camel, it is a difﬁcult creature to pin down.
In fact, a previous ﬁnancial disaster, the US Savings and Loans collapse, led to new CAMEL regulations to bolster the banking sector. Bank regulators examine subjects and judge them on a scale of 1 (best) to 5 (worst/likely to fail). The criteria are:

capital adequacy
asset quality
management quality
earnings performance
liquidity.

In all, the companies audited may well complain that the new accounting standards are too strict and draconian, while being costly to implement. Thus, for example, the IAS cousin in the USA, as deﬁned by the FASB, has shown more leeway for the corporate heads than might have been allowed in Europe. US company stock options held by key staff are not normally treated as expenses and deducted from corporate proﬁts account. The usual practice is excused by the reasoning that the valuation of the options is either too complicated or inaccurate, so ﬁrms tend to leave this entry as a footnote in the corporate accounting statements. The FASB has stated that it will review this practice. Meanwhile, the IASB has decided that the options should be treated as corporate expenses – a standard for EU auditors starting 2005.
IAS standards serve to give us better foresight of corporate illness before it hits us. Some companies will invariably slip through the net, but we should (hopefully) stand a better chance of catching a cold rather than a debilitating sickness in the pre-AEW era. The new IAS are hoped to be part of a stronger corporate AEW radar to detect errant performing or corrupt companies before they implode and cause further public damage. IAS and new FAS procedures can only be part of a risk management toolkit, not the whole answer. A wider corporate picture is needed.

Adjusting Overbought and Oversold Rate of Change Levels for Market Trend

admin — Sat, 09 May 2009 10:54:27 +0000

The levels at which momentum indicators can be considered “oversold” (with the market likely to try to firm, especially during a neutral or bullish period) and “over bought” (with the market likely to at least pause in its advance, especially during i bearish or neutral period) often vary depending upon the general market climate.
During bullish market periods, rate of change readings rarely reach the negativty extremes that can exist for many weeks or even months during bear markets. Where they do decline to their lower ranges, the stock market frequently recovers rapidly During bearish market periods, rate of change readings tend not to track at levels a: high as those during better market climates; the stock market more likely decline rapidly when readings reach relatively high levels for bear market periods
When assessing whether momentum indicators suggest an imminent market reversal based on overbought or oversold levels, adjust your parameters based up the market’s current price trend, moving average direction, and rate of change parameters that are currently operative. These adjustments are, of course, somewha subjective rather than completely objective.
For the most part, significant market advances do not start when rate of chang and other momentum oscillators stand at their most negative or oversold reading! They tend to begin after momentum oscillators have already advanced from their most negatively extreme readings. The October 2002 advance did not start until the 21-day rate of change oscillator had ahead established a rising, double-bottom pattern, the second low point of which was corsiderably higher than the first.
The end of the November-December market advance did not stand until the 21-day rate of change oscillator had already retreated from its peak level with a descending double-top formation created in the process.
The summer 2002 decline did not end until rate of change measurements established a pattern of rising lows (diminishing downside momentum). A divergence developed within Area A on the chart; the price level of the Nasdaq 1 (Index fell to new lows, whereas its 21-day rate of change level did not. You can already see a minor-tern but nonetheless significant secondary positive divergence in A n B, with prices declining to a final low while rate of change measurements became less negative.
The recovery from the lows of September 2002 developed in a classical fashion. The first step was a strong leg upward that carried prices above a resistance an (the peak in August) and momentum readings to high levels, more positive than any time since March. However, the initial spike came to an end after approximately two months.
Was there a warning of the forthcoming two-month decline? Yes, indeed. Check out Area C on the chart, the area in which prices rose to new recovery peaks in November while rate of change levels declined, a classic negative divergence that foretold developing market weakness.
The dedine in the stock market in Area D appeared to be developing from a bearish-looking head and shoulders market top formation (defined as “Bottom Fishing, Top Spotting, Staying the Course: Power Tools That Combine Momentum Oscillators with Market Breadth Measurements for Improved Market Timing”), but the positive divergence (lower prices unconfirmed by rate of change patterns) that developed in January 2003 argued for a more favorable outcome, which did develop.

REPUTATIONAL RISK

admin — Tue, 05 May 2009 20:49:54 +0000

What due diligence is meant to do is to protect you before you buy. Caveat emptor! Unfortunately, the banks and funds have concentrated on white-collar executives cramming themselves into a large boardroom for a long discussion, possibly punctuated by lunch and drinks. Bankers, ﬁnanciers, accountants, lawyers, technical specialists and backup staff all enter into the fray. This makes the due diligence a top-heavy, unwieldy and often ineffective process. This is because there are people of the like mindset who are often intent on take-over or merger.
Ambiguous evidence and management stubbornness can override the due diligence ﬁndings, even in the face of corporate failure. Risk appetite overrides the limit for bearing risk – eventually they give up after the event failure. During 1999–2000, 11 556 US M&A cases of >51 % equity were announced. Only a tiny proportion, 383, did not complete as the project momentum carried most through.
Most M&A failed to meet their targets. Management stubbornness or self-interests against shareholder beneﬁt (a k a “agency theory”) are attributable. One major perk could be a larger salary or bonus upon M&A; bigger workforce and more sales and revenue. Based on fulﬁlling sales and growth performance targets, the CEO’s stock options start to kick in. Such remunerative packages are deceptive and only lead to executive greed, further putting the company at risk.
The innate greed pattern, coupled with the short-term tenure of the CEO, lead executives to extract as much out of the company rapidly before a forced exit. CEOs have a temptation to get a percentage of an ever bigger pie – that pie becomes commensurately larger under M&A. A leader’s overambition creates an overvalued company within M&A, whose chances of success are loaded against it. This subsequently leads to a boom–bust cycle in the share price.
The case around the directors’ table may for be clear for M&A, but the damage and failure afterwards are visible for all.
How can we improve on the due diligence process? Due diligence can work, but not for every ﬁrm. We can instigate a more ﬂexible “slimmed down” due diligence. Due diligence can be cheap and quick, a rapid detective investigation, not an expensive boardroom affair.
It can progress from simple elements such as:
Internet search on name e.g. local community website or Google.com.
Check for name in library or newspapers.
Check criminal record or court appearance in public ofﬁce and legal documents.
Asset liens and tax judgements.
Real-estate holdings in property register.
Trawl companies documents for record of directorship and holdings in other companies.
Call in a private investigator.
Gathering together the ﬁndings, with the accounting experts’ input, we can track the company’s health or movements in a risk map.
Post-Andersen and Sarbanes–Oxley, there is some doubt that they will reveal the true corporate health in a timely and accurate fashion for interested investors. Both the US Sarbanes–Oxley Act and European legislative directives are designed to make CEOs and accountants more accountable when signing ﬁnancial statements. These legal moves stand or fall on the crux of whether these key staff signed a ﬁnancial statement knowing of any irregularities. The auditing industry is still very concentrated in the Big Four, even after corporate audit and management consultancy are split. Apart from the lack of choice, there is also the spectre of these four companies having the same type of operational procedure, more or less, from each other. Buying one company’s auditing services instead of another does not necessarily represent a qualitative improvement, nor a substantial quantitative discount in the daily rate charged.
The current legal and accounting system militates against swift justice and compensation for those who have suffered loss.
In 1998 there were nearly 2 million pending civil tort cases. The cost of the U.S. tort system for 1999 was over $200 billion. . . . The RAND Institute for Civil Justice studied transaction costs and determined that about 43 cents on the dollar goes to the plaintiff. The other 57 cents goes to transaction costs, which include attorney fees paid by the plaintiff.
All professions are policed by their own institutions to some extent. This does not mean that billed rates are reduced. There are associations of bankers, insurers, lawyers, accountants etc. There is some recourse for complaint and reporting breach of contract or trust. The lawyers, for example, have the Law Society, while accountants have the Joint Disciplinary Tribunal. A client’s complaint is not always satisfactorily resolved by any means, but it is usually an inexpensive way to whistle-blow on the professional. It is a cost-effective manner, but often not the end process, to start getting compensation. It would be better not to get ensnared in the ﬁrst place, so you need an alert system.

DIRECT INVESTMENT

admin — Fri, 01 May 2009 14:49:06 +0000

Direct investments are largely restricted to private family-owned companies and star t-up companies that have attracted specialist venture capital or private equity interest. Many small companies have to rely on direct investments for the bulk of their ﬁnancing. In general, however, direct investments present a number of speciﬁc problems to both the providers and users of capital:
Matching. It is difﬁcult for individual investors to ﬁnd suitable companies or projects to invest in. It is also difﬁcult for these companies to identify individual potential investors. There is also a matching problem between the size of individual’s savings and the ﬁnancing needs of large companies.
Liquidity. Direct investments are inherently illiquid, due to the absence of a secondary market, and this means that savers cannot readily turn their investment into cash. Par ties needing to raise funds in a hurr y from direct investments would also ﬁnd it extremely difﬁcult.
Counterparty risk. It is difﬁcult for individual investors to determine the credit-wor thiness or viability of the company or project they are investing in. This makes such investments relatively high risk. This higher risk is reﬂected by the higher returns demanded by investors and hence higher ﬁnancing costs for the users.
Costs. Appraisal costs for investors in total will be high if each investor has to carr y out their own analysis. The costs of attracting investments will also be high if each investor has to be persuaded of the merits of the case. It is much cheaper and more effective for a company to raise a relatively large amount in one go than raise relatively small amounts from many investors and have to ser vice each investor individually.
Diversiﬁcation. It is difﬁcult for individual savers to diversify their risks by ﬁnding lots of attractive companies or projects to invest in directly.
There is, however, one common form of direct ﬁnancing that is easy to overlook. This is the credit that many suppliers provide their customers for ser vices and products that have been delivered and on which payment has not yet been made. Most of this credit is ver y shor t term (30- to 60-day payment terms are common) but in a few specialized industries, the aviation business is a good example, vendor ﬁnancing can be very long term.

THE SUPPLY SIDE – INVESTORS, SAVERS, PROVIDERS OF CAPITAL

admin — Sun, 26 Apr 2009 14:47:16 +0000

Individuals, cor porations and even governments and state institutions may have savings or money that is sur plus to their current requirements. For convenience sake we will refer to them all as investors. Investors seek the following:
Risks and returns. To get the highest level of return available for a given level of risk taken, or the lowest level of risk possible for a given level of return. These are not at all the same thing. There is a wide range of tolerances to risk between investors.
Economic term. To make investments whose economic term matches that of their liabilities. An individual seeking to invest in order to generate an ongoing income in their retirement will look for investments that meet that objective rather than investments offering a shor t-term return only, for example.
Liquidity. To match the liquidity of their investments with their own liquidity requirements. Some investors need to keep most of their funds in investments that are close to being cash equivalents and can be easily and quickly liquidated. Other investors may be willing to accept a much lower level of liquidity in return for higher long-term returns.
Counterparty risk. To minimize counter par ty speciﬁc risk.
Costs. To keep the costs associated with making the investments, and liquidating them if necessary, as low as possible within the primary constraints of meeting the overall objectives in terms of risks and returns.
Diversiﬁcation. To select a level of diversiﬁcation that matches their risk tolerances. Diversiﬁcation reduces speciﬁc risks and individual investors may be willing to pay for diver- siﬁcation beneﬁts that they cannot readily achieve on their own.
Although these investment objectives appear relatively straightforward, when taken in combination they result in ver y many different speciﬁc objectives. Many ﬁnancial intermediaries (fund managers) have developed whose only products are investment funds tailored to meet these varying, and conﬂicting, objectives. All investors would like to make the investments that have the highest returns and the lowest risks. The only place where such investments exist is in their dreams.