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Finance

Don’t touch that Sortino ratio

March 2, 2010 in Finance, Math

The Sortino ratio has emerged as a popular risk measure when evaluating investments. It is a modifcation of the Sharpe ratio, a workhorse indicator of mean/variance economics.

The Sharpe ratio is constructed like this:

$S = \frac{E(r)-r_b}{\sigma}$

where $E(r)$ is the expected return, $r_b$ is a benchmark hurdle, and $\sigma$ is the standard deviation of the returns. If you buy into a Gaussian mean/variance paradigm, then the Sharpe ratio tells you how many units of excess return you receive per unit of risk you take.

The Sortino ratio is constructed similarly:

$S = \frac{E(r)-r_b}{\sigma_D}$

Here, $\sigma_D$ is the downside deviation, or the standard deviation of returns below the benchmark. The intuition of using this statistic is that people do not penalize investments for positive volatility (i.e. unpredictable but beneficial returns); they only care about negative volatility.

And here lies the rub: it’s very easy to calculate a misleading Sortino ratio. The popular method – you’ll see it floating around the web – is to take any positive (or above-benchmark) return, change it to a zero, and calculate a standard deviation as one normally would, across all returns.

To me, that’s not right. You are artificially introducing a steady stream of zeros into your calculation, depressing the volatility calculation. A more proper way is to throw out any positive returns, and calculate the standard deviation of the negative returns (it should not be surprising that this method complies with the intuition for using the Sortino in the first place).

So the next time you’re presented with a Sortino ratio, take care to understand whether it includes zeros or not – if it does, the denominator is necessarily biased toward zero, and the ratio is overstated.

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I have the hammer

February 26, 2010 in Finance, Sports

Apologies for the slow posts… but the NYT explains:

Wall Street trading is often described as a blood sport. But inside the great investment houses, the sport of the moment is, of all things, curling — that oddball of the Olympics that is sort of like shuffleboard on ice.

This slow-poke game, which originated in 16th-century Scotland, has captivated the Type-A world of Wall Street almost by accident. CNBC, whose market chatter is the background music on trading floors, switches to curling from Vancouver shortly after the closing bell.

I thought I was the only one going curling-crazy, but it turns out all of Wall Street has spent the last couple weeks learning a new vocabulary (just call me “Skip”) and shouting at the TV. Whether or not everyone else has been honing their skills by playing shuffleboard, I don’t know… but my plan to open an NYC curling house/alley/place (?) just got a major boost.

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Viva la banker

January 3, 2010 in Finance

Coldplay’s Viva la Vida could be Wall Street’s anthem:

I used to rule the world
Seas would rise when I gave the word
Now in the morning I sleep alone
Sweep the streets I used to own

I used to roll the dice
Feel the fear in my enemy’s eyes
Listen as the crowd would sing
“Now the old king is dead! Long live the king!”

One minute I held the key
Next the walls were closed on me
And I discovered that my castles stand
Upon pillars of salt and pillars of sand

…

It was the wicked and wild wind
Blew down the doors to let me in
Shattered windows and the sound of drums
People couldn’t believe what I’d become

Revolutionaries wait
For my head on a silver plate
Just a puppet on a lonely string
Oh who would ever want to be king?

…

I hear Jerusalem bells a ringing
Roman Cavalry choirs are singing
Be my mirror, my sword and shield
My missionaries in a foreign field

For some reason I can’t explain
I know Saint Peter won’t call my name
Never an honest word
But that was when I ruled the world

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Progressive taxation

December 9, 2009 in Finance

The UK’s plan to tax banker bonuses at 50% is really quite clever. The tax is borne by the employer, not the employee, and so the following results:

Bankers keep their bonuses, and the incentive structure (for better or worse) remains intact…
Taxpayers extract value from the bank, and populist rage (somewhat) subsides…
Shareholders suffer.

Let’s just hope none of the taxpayers also happen to be shareholders, because at some point they’re going to figure this one out.

I’m particularly curious to see what RBS does, as the bank’s majority shareholder is none other than the British government. Thus far, the bank and the government have clashed over a series of controversial bonus plans: one side insisting it will make those payments, the other insisting exactly the opposite. Perhaps this tax scheme will incentivize the government not only to encourage bonuses but to ensure they are generous, as the tax essentially amounts to a bonus-linked dividend for the majority shareholder. Chances like this for the government to directly extract value from companies are few and far between…

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Another day, another article demonizing CDS

November 28, 2009 in Finance

Bloomberg has a new article up about how the CDS market is starting to crumble – the sort of piece that looks like it’s been sitting on a back burner waiting for an excuse to stoke the flames of derivative fear (thanks, Dubai!).

One of the article’s chief arguments is that “credit-default swaps tied to Thomson SA, the Paris-based owner of film processor Technicolor Inc., paid some holders 30 percent less than those with contracts expiring a day later.” First, however, a technicality – CDS can only expire on four days of the year: the 20th of March, June, September and December (the so-called “roll dates”). Thus, the description of contracts that expire “a day later” is inaccurate. This brings me to a key point: one of the nice things about (most) fixed income is that the terms are… well, fixed. Traders know in advance when a contract will terminate, as well as the quantity (or at least the terms) and timing of any future cashflows. Those definitions extend to procedures in the event of default.

The credit event in Thomson’s case was one of restructuring, the procedures for which were recently updated as part of ISDA’s new “small bang” European protocol. Naturally, in a restructuring event – the debate over whether it should even constitute an event will be left for another post – it may be tough to claim that insurance should pay out. On the one hand, the fixed income product that was being insured just had its terms adjusted (no longer fixed, no longer the same!). On the other hand, the present value of the cashflows should be unchanged which in theory would make investors indifferent (obviously, that’s not the case). Without a cessation of payments, it’s hard to claim that insurance should pay the balance. Therefore, rather than have all insurance contracts pay out uniformly for all referenced bonds, which would fail to capture the odd nature of the restructuring event, traders agreed to set up “buckets” which will each pay out a value deemed fair by market action. The buckets are divided by time to maturity; in Thomson’s case, there were multiple buckets including a 2.5 year bucket, a 5 year bucket, and a 7.5 year bucket. This way, debtholders could more accurately match their insurance claim to the affected bonds.

The crux of Bloomberg’s argument seems to be that a swap maturing on the last roll date of one bucket would pay differently than one maturing on the first roll date of the next bucket (note the semantics – none of this “maturing one day later” language). But under the terms of the protocol, which market participants ratified, that seems appropriate to me. Remember, fixed income means terms are defined in advance. If Thomson had bonds that matured one day before the restructuring was announced, then those bonds would pay out par while bonds maturing the next day would presumably have crashed on the revelation that there isn’t cash to pay them in full (remember, unlike CDS, bonds can and do mature on any day of the year). That actually just happened with the Nakheel December 2009 bonds, which were trading well above par before Dubai’s surprise announcement brought them back to the 70’s overnight. In sum, the fact that some fixed income instruments are treated differently than other is not alarming – maturity and seniority are prime components of the fixed income market and naturally force bonds into differently performing buckets on a daily basis.

So if we can’t fault CDS for the fact that one contract pays out differently than another, maybe we can find something to be upset about because the 2.5 year bucket recovered 30% more than the 5 year bucket (in CDS terms, recall that recovering more means the contract pays less: if a bond recovers its full value, the insurance would pay out nothing at all). But here’s a secret: the disparity arose because of problems in the underlying cash market, not the derivatives market! Okay, it’s not really a secret. Euroweek figured it out well before the auction even took place:

Most of Thomson’s deliverable obligations are thought to be complex private placements and little is known about their documentation. It is possible that none will be deemed eligible for delivery.

CDS payouts aren’t determined by a bunch of traders standing in a room shouting – they are set by the market-clearing price on bonds (“deliverable obligations”) that are submitted by CDS holders in return for insurance payouts. It’s a straightforward system: CDS buyers purchase bonds in the market, then give them to the CDS sellers in return for their par value. The net payment is therefore par less the bonds traded price, or recovery. If there are few bonds available, or little transparency or liquidity about those bonds, then their market price will fluctuate for technical reasons rather than fundamentals. This phenomenon can occur with any traded security: short squeezes are perhaps the most familiar example. That’s exactly what happened with Thomson – so few of the short-dated deliverables were available for public trading that the market clearing price was bid up extremely high. In the next bucket, bonds were more liquid and so reflected recovery more accurately.

Euroweek described it nicely (again, well before the auction even took place):

…it is very likely that there will be a shortage of deliverable obligations and a scramble to get hold of what is available. The consequent short squeeze will drive up prices and the recovery rate much higher than it would otherwise be — good news for protection sellers but bad news for the buyers. For example, the most likely and liquid deliverable obligation, according to Citigroup analysts, is the June 2012 revolver, which would fall in the 2-1/2 to five year maturity bucket. It has been pushed from a 40% price to 70% in recent days.

But the real difficulties lie in the 0 to 2-1/2 year bucket. Thomson, a French media firm, was a regular member of the main iTraxx Europe Index from series 1 to series 7 and was thus much referenced in index CDOs. There are a lot of single name hedges against the name with maturities between now and 2012, putting particular pressure on the 0 to 2-1/2 year bucket.

I’m still waiting for the article titled “CDS auction goes smoothly despite problems in bond market.”

To Bloomberg’s credit, there is a deserved debate over restructuring events and CDS more generally outside the Bang protocols (and even within them). Moreover, the Thomson example – though I disagree with the author’s specific points – is a good one for demonstrating how settling CDS remains a mystifying and seemingly arbitrary process. There is no doubt that further clarity is needed, for the benefit of all market participants. The rest of the article deals with the lack of transparency into what qualifies as a credit event and murkiness following that declaration. I have to point out that though the arguments there have merit, their very existence demonstrates that CDS by nature doesn’t force companies into default or anything along those lines – otherwise these arguments would be settled by a simple imperative to bankrupt the firm.

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We don’t want no interest-free loans!

November 18, 2009 in Economics, Finance

A long time ago, when I was first learning to manage my finances, my dad instructed me to prepay my credit card. This effectively transformed the credit card into a debit card by running a positive balance on the account. It was a great learning mechanism because it still required me to make monthly payments, but provided a cushion in case I missed one or made a mistake. In my father’s mind (and I agree), the few dollars I was losing in interest opportunity costs were more than made up for by a lengthy credit history with no late payments.

These days, I would never ordinarily prepay any of my cards. Just the opposite, in fact – I schedule payments for the last possible day. The economic rationale is simple: positive credit card balances don’t earn any interest, therefore I want to hold on to my cash for as long as I can. Occasionally, however, I send the credit card companies a little extra cash. The most common reason is also (believe it or not) economically rational: consumption smoothing. For example, I prepaid part of my October balance in September, anticipating an abnormally high balance that month (thank you, California trip). The net result after two months was the same, but there was no month in which I had to make a particularly large payment – and that’s easy on the mind.

So imagine my surprise today when I went off to make my first payment on my Discover card and the site informed me of the following (emphasis mine):

A credit has been applied to your Account since your last statement was posted. This credit has reduced your overall Discover Card balance.

Since you may not make an online payment for more than your current balance, we are showing you the Current Balance instead of your Last Statement Balance.

I found that very surprising (enough to write about, anyway!) – you would think, especially in this economic climate, that credit card companies would love to receive cash in advance on which they have no obligation to pay interest. I think that’s especially true because there’s a chance I might not use up my positive balance for some time, effectively giving the company an extended interest-free loan. So why would they ban this practice?

My theory is that their view is exactly the opposite of my father’s – by preventing customers from prepaying, they increase the probability of a customer paying late. That, in turn, allows the company to levy late fees which are far more lucrative than a few bps of short-term interest (at today’s levels).

Any other thoughts on why prepayments would be explicitly prohibited?

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Philosophies of risk management, briefly

November 18, 2009 in Finance, Risk

My last post made me think of a common question in risk management: “what is risk?”

A lot of time is spent deciding the various metrics, exposures, values, sensitivities, etc. that are considered “risks.” In the previous post, a simple change of perspective – is risk defined by dollars invested or shares controlled? – resulted in a dramatically different investment decision (granted, it was for a hypothetical insider trade… so it was definitely more illustrative than practical).

In the investment equation, the very definition of risk is a variable, not a constant.

This is probably much more interesting to talk about than write about, given the open-endedness of the question, but I would like to highlight how critical that question is. Before risks can be managed, they must be measured; and before they are measured, they must be identified. It’s very easy, particularly in a time when we are inundated by numbers and statistics, to look for a catch-all metric, or overlook risks that critical thinking would expose. Risk is rarely obvious.

Readers will know I am hardly espousing any sort of dive into complicated models or quantitative nonsense, merely an appeal to reason: every investment decision carries a unique set of risks which need to be identified and defined – from dollars invested, to sensitivities, to position in a larger portfolio, to leverage, and so on. More than merely identifying them, they should be understood – even VaR has its use, remember.

It wouldn’t be right to end this without a HHG2G quote which is almost, but not quite, entirely unrelated. Let’s just say it’s about things we take for granted:

Time is an illusion. Lunchtime doubly so.

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Stock is more efficient than options are more efficient than stock

November 18, 2009 in Finance, Risk

There is a very interesting debate taking place on the profitability of options as opposed to the underlying stock. It originates in this post from Ultimi Barbarorum on options volume following the Palm/3Com announcement, and continues in the comments on Felix Salmon’s coverage of that post.

The crux of the argument is the spike in options volatility immediately preceding the merger announcement, which many took as a clear sign of insider trading. Baruch argues that options are notoriously volatile, so one spike is hardly a smoking gun, and I agree (see also: superstitions regarding trading on option expiration days). However, I echo Felix in noting that it’s very hard, therefore, to draw any conclusion about insider trading whatsoever. Baruch’s second point is that if it were insider trading, it was misguided – the insiders could have made more money and attracted far less attention by trading the underlying stock rather than the options. This is where the debate lies – and I confess up front that my immediate impulse was to say “that can’t be right.” In fact, it could be right, depending on your point of view.

(p.s. hats off to Baruch for introducing his post with “Before the Zero Hedge folks get the pitchforks out, let’s stop and think a bit.”)

Baruch writes:

Had someone concrete knowledge of the 3Com deal, it would be far more efficient to buy the stock. The most important of the “Greeks”, as options dudes call the panoply of statistics surrounding options, is “delta”, the rate of change in the value of the option relative to the value of the shares (it’s a function of volatility, time to expiry, a whole lot of stuff, don’t trouble your head), and this is always less than one. 3Com options buyers made far less money on the takeover by buying options than they would if they had bought the stock.

It will be instructive here to discuss delta – I know some of TGR’s readers are already familiar with concept, and I hope you will excuse this detour.

“Delta” is a mathematical (as opposed to financial!) derivative of the option formula, as described by Baruch – but it is easier to understand as a “hedge ratio.” It tells you how many shares of stock you need to hedge your exposure to an option (I’m going to assume from here on that we are discussing calls). To see why, run back to the math for one second and consider that delta is the amount that the price of the option will rise if the stock price goes up by $1 – ok, now ignore the math. If the option is way in the money and trades at its intrinsic value, then it will gain $1 for every $1 the stock rises – a delta of 1. It the option is at the money, then its as likely about whether it will ultimately pay off at all, and so it only gains $0.50 for every $1 the stock rises – a delta of .5. Thus, if you want to hedge your option exposure, you would short [delta] shares for every option you hold. Delta is always less than 1; no option will gain more than $1 for every $1 the stock price rises.

The key to this delta business is that as long as delta is less than 1, you need to short fewer shares than the amount you control via options in order to hedge your option exposure. Put another way, it takes more options than shares to create the same exposure (on a per-share basis) to the underlying stock. If the stock price moves up, the dollar gain from holding that stock will be greater than the dollar gain from the options, hence the argument that stocks are “far more efficient” than options.

The closing price for COMS on November 10th, the day before the option purchasing frenzy, was 5.41. The $5 November calls cost slightly more than their intrinsic value at $0.55, trading with a delta of 0.72. On November 12th, the stock closed at $7.46, representing a gain of $2.05, whereas the options finished at $2.50, gaining just $1.95. Share for share, the stock outperformed.

However, shares controlled is an poor metric for comparing investments. This is particularly true for options, where you may not know until the day they expire if you actually control those shares or not! Instead, for risk management purposes we think of the number of shares the position is likely to control, given the current state of the world: the probability-weighted number of shares. Unsurprisingly, it’s the same as the number of shares it takes to delta-hedge the position. From this observation, a nice property of delta is revealed: it may be roughly interpreted as the probability of an option finishing in the money.

The important philosophical point here is not to make the mistake of thinking that the number of options you buy is equal to the number of shares you own – that’s only true the day they mature in the money. To set up the same exposure in options as we have with shares, at the time of purchase, we need to buy a few extra options. Specifically, for the November calls with a delta of .72, we need 1/.72 or 1.39 options for every share. Run the numbers and you’ll see that this results in a final profit of $2.71 on the option side, vs $2.05 for the shares. If an insider bought options on a delta-adjusted share basis, he’d find the options more profitable than the stock.

(If you constantly adjust the number of options to correspond to the prevailing delta, you’ll wind up making $2.05 on your options – this process is called dynamic delta-hedging [that's a real aside for this post, because the discontinuity in COMS stock price would make the rebalancing futile].)

So, on the basis of shares-at-maturity, stock yielded a better dollar profit. On the basis of shares-at-trade, options would have been preferable. There’s an argument to be made that, as an insider, you know the options will finish in the money, so shares-at-maturity is the right way to consider it. But there’s a third exposure metric: capital at risk.

You can look at capital at risk as either 1) the maximum loss you could experience OR (if you’re an insider who knows the trade will be profitable) as the opportunity cost of capital. This is very straightforward to explain: those options only cost $0.55; the stock cost $5.41. The percentage gain on the options is 355%; for the stock it’s just 38%. If you consider your exposure in terms of dollars invested, rather than shares controlled, you’d find the options a far better bet: they cost almost 90% less than the stock but return nearly as much per contract! So for every dollar you could put into the stock, you could instead put into options and return 10x as much. Options, from this perspective, are far more effective.

So this all depends on how you look at your risk and exposure. Baruch assumes that his insiders want to control a certain number of shares, and from that perspective they should absolutely have transacted stock instead of options (assuming that, with their perfect knowledge, they skip over the delta-adjust share argument). Personally, I would look at it from a capital at risk perspective – if I’m willing to spend $5.41/share to make $2.05, why not put that to work in options and make $19.18?

It all depends on your perspective – both answers could be correct, given some set of portfolio constraints and different definitions of risk/exposure.

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More derivative witch hunts

November 17, 2009 in Finance

Going through the FT’s original post on exchange traded currency notes, I saw a couple of sentences that really bothered me. One thing we do not need right now are witch hunt statements without basis (a point especially compounded by the fact that the FT completely misunderstood how these products worked, even as they wrote a piece describing them):

First:

In quick conclusion, the ETCs appear to be another fine example of how exchange-traded products are mutating from their transparent replication-based beginnings into ever more complex instruments.

Granted, an ETC isn’t going to be as easy to understand as SPY. But that doesn’t mean it’s “out to get” investors. Remember when Seeking Alpha tried to help people lose money even faster with FAZ and FAS? Now those were truly frightening derivatives – leveraged, options and/or swaps based plays with complex end of day delta-balancing schemes. These ETC’s are nothing compared to that. In fact, they’re no more terrifyingly complex – and much less manipulable – than the commodity ETFs Alphaville covers so frequently. Yes, they’re the first currency ETFs (sorry, FT insists that it’s wrong to confuse these for ETFs, even though they don’t say why). Get over it.

Second:

The type of financial whizz-kidery that brought us CDOs, meanwhile, appears to be thriving well in ETFs.

I don’t even know where to start with this one. Maybe the author wrote this because the word “collateral” appears frequently in the prospectus. I wonder if it’s the same financial whizz-kidery that brought us secured loans and mortgages, too? What is this sentence doing here, besides making people associate these products with those that ruined the financial system? We’re talking about total return indices on the deepest, most liquid market in the world – not distressed CDO tranches.

Third (regarding Morgan Stanley, the derivative counterparty):

Morgan uses the proceeds it receives to hedge its total-return-swap exposure — but essentially can do whatever it pleases with the money.

What does this really mean? Morgan Stanley might be fooling investors, opting to take their cash elsewhere rather than hedging their exposures? Well in that case, Morgan Stanley is taking on currency risk equal and opposite to those investors; so it’s not exactly a free trade. One of two things must be true:

MS doesn’t want currency exposure. In this case, they have two options: they use the ETC proceeds to hedge their currency risk OR they “steal” the ETC proceeds and use cash from elsewhere to hedge the exposure. The economic outcome is identical.
MS wants currency exposure. Again, two options: they use the ETC proceeds to hedge their currency risk, after which they put on the desired currency exposure OR they “steal” the ETC proceeds and pray that the ETC investors in aggregate have taken the exact opposite viewpoint from the one MS wants to take. Since option two is extraordinarily unreasonable and volatile, there’s really only one option here: hedge the currency risk with the ETC proceeds.

Fourth:

Bank of New York Mellon has the responsibility of monitoring the eligibility of the collateral, but to all extents and purposes, from what we can make out, Morgan Stanley determines the valuation on a daily mark-to-market basis.

Another piece of conspiracy-bait. Fortunately, FT lays out what that collateral can consist of: “AA-rated G20 government bond, AAA-rated shares of government or treasury money market funds, AAA-rated supranational bonds, unsubordinated bonds issued by Ginnie Mae and any equity listed on ’specified indices’ anywhere in the world” (and I’m going to hazard that adding “anywhere in the world” is yet more bait, since the “specified indices” are major ones in developed economies). Let’s call it like it is: Morgan Stanley is not going to be able to make up their own arbitrary marks, thereby cheating the investor out of their collateral backing, on these deep and liquid securities. In any case, they are disincentivized to do so (as FT reveals in the next paragraph) by a set of over-collateralization rules.

Fifth:

As for the investor — remembering the products were launched as a response to investor demand for “secure, transparent and liquid currency package”– it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then) and downside scenarios that include credit-exposure to Morgan Stanley, covered by a claim on potentially illiquid securities, as valued by Morgan Stanley. Compulsory redemptions at inopportune moments due to a myriad of different triggers. And in the event of counterparty default, a position third-in-line for repayment.

Right off, the carry trade claim is simply wrong. Moreover, these are total return indices, so there ARE all the benefits of interest and dividends – they are just reinvested rather than distributed. The downside scenario is correct that this gives some credit exposure to MS, but the “potentially illiquid” line goes a little too far. I know that the prospectus says that these securities might not have a deep secondary market, because it has to, but in default they are extraordinarily liquid – they represent claims on FX derivatives! There’s no uncertainty about what they are worth in default.

Sixth:

ETF Securities’ ETCs are based on Morgan Stanley’s MSFX Total-Return Currency Indices. The way they achieve that performance, however, is not by replicating the components of those indices, but by taking out a total return swap with a counterparty that assures the performance of that index.

In ETF Securities’ case that counterparty happens to be Morgan Stanley (and only Morgan Stanley for the time being).

Again, misplaced suspicion. Here’s a scenario: to get exposure to the S&P 500 I can either 1) use cash to buy all 500 stocks and actively manage their exposure every day, making sure to reinvest dividends or 2) enter a total return swap which tracks the level of the actual S&P 500, plus dividends, perfectly. (There’s a third option, which is to buy SPY – effectively paying someone to do option one on my behalf.) Which one has a lesser chance of error? (Hint: it’s the swap.) Yes, a TRS is a derivative – but it’s not evil by that virtue. It’s exactly the same as a vanilla interest rate swap, the most liquid derivative in the world, only it reference the level of the S&P 500 instead of Libor. So let’s not get all suspicious of these crazy methods for replicating payoffs.

I’m not going to pretend that these ETCs are vanilla securities. They carry risks – perhaps large ones – and will likely experience liquidity difficulties until (and if) their market attracts traders, just like any security. No, I haven’t read the prospectus, and my comments are based purely on the FT post; moreover, my concern regards the FT’s attitude rather than the securities themselves. I can’t endorse any sort of derivative witch hunt of this sort – its unfounded, based if anything in popular fears that themselves were borne out of ignorance (on the part of both retail investors and institutions). It may be in journalistic vogue, but it’s hardly appropriate here.

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Stepping back from the ETC confusion

November 17, 2009 in Economics, Finance

Following the lead of an FT article last week, FT Alphaville went exploring ETC’s (exchange traded currencies) and noted (emphasis mine):

As for the investor… it means a potential upside scenario of receiving all of the performance of a currency index, for relatively low management fees, but without any interest or dividend (no carry trade here then).

The bold phrase prompted Felix Salmon to wonder how an ETC could “provide exposure to local interest rates” (as stated in the original article), when the follow-up claims there’s no interest at all? Felix tracked through various prospecti and documents in search of an answer, but couldn’t get a clear description of the ETC’s exposure. The closest he came was this, from Morgan Stanley Foreign Exchange (MSFX) indices documentation:

For the Total Return versions of the MSFX Indices based on the deliverable MSFX Currencies, in order to replicate the return of a constant fully collateralized strategy, the related MSFX Index will accrue interest daily at the One-Month T-Bill Rate… Hence, the daily return on the related MSFX Total Return Index will be computed as the sum of the MSFX Currency return and the One-Month T-Bill return.

To which Felix notes:

There certainly doesn’t seem to be any mention of local interest rates there.

And so both Felix and FT Alphaville concluded that despite having currency exposure, these securities can not replicate the carry trade. But this morning, Felix posted that ETC’s do in fact have sensitivity to local interest rates and, by extention, the carry trade.

I’m a bit surprised that this has taken so many words and posts to resolve. I think everyone needs to step back and review the basic mechanics of these products rather than go chasing details Here are a few key definitions:

Total return: the return received on an investment, if all distributions (dividends and interest) were reinvested.
Interest rate parity: a theory which equates exchange rates and interest rates. The forward exchange rate is given by the spot exchange rate times the ratio of the two currencies’ interest rates. This model can decompose all FX moves into interest rate moves, and vice versa.

FT Alphaville was correct that the ETC’s do not pay any interest or dividends. However, because they are total return indices, they were incorrect that this eliminates the carry trade.

Felix was correct that the documentation made no mention of local interest rates, but that’s a technicality as he failed to appreciate that interest rates and exchange rates are two sides of the same coin, particularly because total return indices were used in the absence of distributing interest payments.

When you borrow yen to lend dollars, you are earning a dollar interest rate and paying a yen rate; the differential (according to interest rate parity) corresponds to the exchange rate and would normally erase itself if the BoJ didn’t keep rates so low. Thus, the return on that yen trade corresponds to the difference between local and domestic interest rates. Finally, adding the T-Bill return on top of the exchange rate return means that the ETC is equivalent to investing in the currencies themselves, interest payments and all. And that’s it.

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QOTD: asset allocation edition

November 10, 2009

After finding former Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin not guilty of misleading investors, one juror revealed just how convincing the defense had been:
[Juror] Hong said that if she had money, she would invest it with Cioffi and Tannin.

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A major international airport deals in derivatives…

November 10, 2009

Contrary to what you might expect, the WSJ reports that San Francisco International has had great success in their adventures with interest rate swaps, providing a breath of fresh air amidst the media’s usual “swaps ruin the economy” fare. SFO has taken on interest rate exposure in 2005 and 2008 has two more contracts that [...]

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The regulation bubble

November 10, 2009

Senator Dodd’s proposed financial reform bill is long on words (1136 pages, but there’s an 11-page summary) and short on solutions. Institutions, posts and policies will be created; reports, hearings and testimonies will be given; escape plans, living wills and registrations will be submitted; and in the end very little will actually be done.
This is [...]

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Things you should know before you invest

November 2, 2009

The WSJ’s top story this morning was one titled “The Cruel Math of Big Losses” – an article written as if it were an eye-opening expose into a little-known piece of financial wisdom rather than a blatantly obvious restatement of basic math: when you lose X%, it takes a gain of more than X% to [...]

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Keeping heads out of textbooks

November 2, 2009

Wall Street & Technology briefly discusses some survey results and concludes: “Wall Street’s Quants Feel Misunderstood.” There’s the obligatory quote from Dr. Wilmott:
“These numbers are alarming,” said Dr. Wilmott. “They indicate that even with the events of the past year, financial institutions are still not taking the importance of financial education seriously, especially as it pertains [...]

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Fuzzy AIG math

October 28, 2009

A bit of out-of-context math from a recent Bloomberg article on AIG:
The Federal Reserve Bank of New York, the regional Fed office with special responsibility for Wall Street, opened an $85 billion credit line for New York-based AIG. That bought it 77.9 percent of AIG and effective control of the insurer.
The government’s commitment to AIG through credit [...]

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More Zero Hedge nonsense

October 26, 2009

Via Naked Capitalism:
I just came across a post on Zero Hedge called “An Overview Of The Fed’s Intervention In Equity Markets Via The Primary Dealer Credit Facility.” Now, that’s a mouthful. As far as I can discern, the post’s purpose is to expose alleged equities market manipulation by the Federal Reserve. However, I found the [...]

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First rule of trading is you don’t talk about trading

October 16, 2009

In a post that caught my eye because it was titled “Smart Risk, Stupid Risk” – but then failed to elaborate in any way – CNBC chimes in with a few caveats about investing during earnings season:

You snooze, you lose If you’re waiting to find out the earnings before you make an investment in a [...]

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Because a little marketing goes a long way

October 16, 2009

From the WSJ’s back page:
Why bother? Despite posting a strong third quarter, Goldman Sachs Group went to extra lengths to put gloss on the results. The first bullet point in its earnings release says the firm ranked No. 1 in global mergers and acquisitions announced in the year through Sept. 25. That’s according to numbers [...]

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Haven’t we seen this movie before?

October 14, 2009

In a recent profile of KKR, Breakingviews.com (via the NYTimes) attempted to value the company by taking a look at Blackstone’s operations. I don’t have any comment on the analysis itself, but two excerpts stood out in my mind:
[Blackstone] didn’t do as well collecting performance fees and investment gains because its holdings have been falling [...]

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Felix takes on Tyler Durden

October 2, 2009

Felix Salmon calls out the Zero Hedge crowd. Bravo!

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The rise of VaR

October 1, 2009

Simon Johnson and James Kwak take a look at how VaR got to be so popular in the first place. They make the insightful observation that a bad (or at least an incomplete) model can gain acceptance not only because of its simplicity but, oddly, because of its output as well.
Indeed, VaR succeeded not just [...]

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An interview with Mandelbrot

October 1, 2009

The FT has posted a lengthy video interview with the brilliant mathematician Benoit Mandelbrot, whose book The (Mis)behavior of Markets first inspired me to enter finance and risk management in particular.
I do find that some of John Auteur’s questions mar an otherwise interesting (but extremely high-level) overview of Mandelbrot’s thoughts on finance. Right from the [...]

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Measuring aggregate risk in CDS markets

September 25, 2009

The ECB recently published this lengthy report (PDF link) on the state of the CDS market, with particular focus on counterparty risk. It is well worth a read for either a cursory overview or more in-depth look at the mechanics and concerns of that market.
Section 3.4 regarding counterparty risk measures was especially interesting to me. [...]

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Because no one knows commodities like we do

September 22, 2009

Why did a post up titled “How To Play Natural Gas With Small Cap Stocks” pop up in Silicon Alley Insider’s RSS feed? A little investigating (elementary, my dear Watson) shows that it’s actually from The Money Game – another blog under the Business Insider umbrella. The blogs themselves and current RSS feeds show no [...]

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You can keep the note

September 14, 2009

I re-watched the classic Marx Brothers movie Duck Soup last night and three (barely) finance-related bits stuck out. Yes, this as a thinly veiled attempt to get the Marx Brothers on TGR.
First, a timely discussion of the politics of debt, in Groucho’s extended introduction:
Groucho: “Now, how about lending this country 20 million dollars you owe, [...]

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Yet more risky testimony

September 11, 2009

Nassim Taleb and Chris Whalen also participated in Wednesday’s House hearing on risk management. The full text of their remarks are available here (Taleb) and here (Whalen).
Taleb’s thoughts are familiar, consisting largely of his well-known opinions on VaR and financial regulation. Whalen, however, provides an excellent quote:
The problem is not with models themselves. The trouble [...]

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Bookstaber’s testimony on risk

September 11, 2009

Rick Bookstaber testified to the House on Wednesday regarding risk management; the text of his remarks is available here. It is a must-read.
The bulk of his testimony focuses on VaR: it’s use, misuse and role in the recent crisis. I find his greatest insight in this paragraph:
I remember a cartoon that showed a man sitting [...]

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Only in America

September 3, 2009

The law firms of Pearson, Simon, Warshaw & Penny, LLP and Tydings & Rosenberg, LLP have just announced a class-action lawsuit against ProShares Trust on behalf of everyone who has ever owned shares of SKF, the double-short financials leveraged ETF. Key quote from the press release:
For example, in a six week period from September 15, [...]

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Greater fool theory

August 21, 2009

Today’s Dilbert:

I think the last panel could stand alone.

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