How to compute the present value of an asset?

How to compute the present value of an asset?

William Longin

In this article, William LONGIN (EDHEC Business School, Global BBA, 2020-2024) elaborates on the concept of Present Value.

What is present value?

The present value (PV) of an asset is usually computed as the value of the stream of its future cash flows discounted at a given rate of return. In the calculation of the present value of an asset, there are two inputs: the expected future cash flows generated by the asset and the discount rate which takes into account the risk on the future cash flows.

The discounting operation takes into account that an amount of money today is worth more than the same amount tomorrow. €100 lent or invested today at an interest rate of 10% is equal to €110 in one year. If you are to receive €100 in one year, you can borrow €90.90 to get this money today. In one year, you will repay the amount borrowed €90.90 and the interests €9.10 with the €100 that you are supposed to receive. This refers to the concept of time value of money. “Remember that time is money” – Benjamin Franklin (1748).

How is present value computed?

The formula for the present value of a cash flow occurring at time t, denoted by CFt, discounted with the discount rate r, is given by:

 Present value of a cash flow

The above formula can be used to illustrate the time value of money. What is the present value of €100 obtained in 1 year, 5 years and 10 years? The table below gives the present value by discounting of €100 obtained in 1 year, 5 years and 10 years with a discount of 10%. Present value shows that money received in the future is not worth as much as an equal amount received today.

Present value of a sequence of cash flows

Excel file to compute the present value of a sequence of cash flows

This formula can be generalized for a series of cash flows, CFt, from t=1 to t=T:

Present value of a sequence of cash flows

Application 1: Computation of the present value of a stock

The concept of present value can be applied to a stock.

For a stock, the sequence of cash flows corresponds to the dividends paid at the end of each period t (coupon DIVt) and the price PT at which the stock is supposed to be sold. The present value (PV) is equal to the discounted value of the sequence of cash flows at the discount rate r.

Present value of a sequence of cash flows for a stock

Excel file to compute the present value of a stock

Steps to compute the present value of a stock

  • Step 1: Estimate the expected value of future dividends
  • Step 2: Estimate the discount rate given the risk characteristics of the stock
  • Step 3: Compute the present value

Application 2: Computation of the present value of a fixed-rate bond

The concept of present value can be applied to a bond. For a fixed-rate bond, the sequence of cash flows corresponds to the interest paid at the end of each period t (coupon Ct) and the principal value (V) reimbursed at maturity T. The present value (PV) is equal to the discounted value of the sequence of cash flows at the discount rate r.

Present value of a sequence of cash flows for a bond

Let us take the example of the valuation of a bond with a nominal value of €1,000, a nominal interest rate of 10%, payment of interests on a yearly basis, and maturing in 5 years. The annual interests are computed as follows: 0.10*1,000 = €100. The last payment corresponds to the interests of the last year (€100) and the reimbursement of the initial capital (€1,000). The series of cash flows is then given by +100, +100, +100, +100, +1,100. Using a discount rate of 10%, the present value of this bond is equal €1,000.

Excel file to compute the present value of a bond

Steps to compute the present value of a bond

  • Step 1: Find the characteristics of a bond
  • Step 2: Compute the cash flows associated to the bond
  • Step 3: Compute the present value

Link to download excel file:

How to properly compute cash flows?

The future cash flows may be certain or uncertain. When the future cash flows are uncertain, the expected value of the future cash flows, computed as the average of the possible values weighted by their probability, enters the formula for the present value.

Who is using present value?

In financial markets, it is used by traders and investors to estimate the value of financial securities like stocks and bonds.

In the asset management industry, it is also used by asset managers in investment firms (like private equity) to value firms to buy or sell.

In the corporate world, it is used by project managers to estimate the value of future investments.

In the accounting context, it is used by accountants to compute the model value of some elements of the balance sheet according to the International Financial Reporting Standards (IFRS).

So, we can see that the concept of present value is useful to a large range of professionals needing to calculate and estimate the value of assets.

Related posts

NPV
Valuation of fixed-rate bonds
Valuation of stocks

About the author

Article written by William Longin (EDHEC Business School, Global BBA, 2020-2024).

Posted in Aspects techniques, Contributeurs | Leave a comment

Gamestop: how a group of nostalgic nerds overturned a short-selling strategy

Gamestop: how a group of nostalgic nerds overturned a short-selling strategy

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze
In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) talks about the Gamestop case which has shaken up Wall Street last january.

Gamestop: an unprofitable company with slender turnaround prospects

Gamestop is a US company specializing in the distribution of video games and electronic equipment (similar to Micromania in France). After golden years in the 1990’ and 00’, Gamestop has sunk since 2010 into a spiral of debt and successive sales of its stores around the world. The company’s response has been to cut costs and shut down underperforming stores, rather than trying to adapt to new trends of consumer behavior. Indeed, physical stores have lost momentum over the years, this decrease being powered by the rise of e-commerce and recently COVID-19 and lockdown restrictions. Hence, at the end if 2020, Gamestop’s future appear to be bleaker than ever.

Last January, Gamestop became the target of a short-selling strategy (see below) by several hedge funds. In a short-selling strategy, hedge funds bet on the decrease of a stock to pocket profits. But, retail investors came into action to “save” Gamestop from the claws of these hedge funds.

Indeed, in the United States, the stock market has opened up in recent months to small investors. Since the beginning of the Covid-19 crisis, many stocks have fallen, allowing an entry into the world of the stock market with little investment. Thus, students, employees or even retirees have been tempted. After having learned that some hedge funds were betting on a decrease of Gamestop’s stock, a retail investor began buying Gamestop stock on the Robinhood application, then calling on Reddit for other retail investors nostalgic of Gamestop to come to the rescue and buy more Gamestop’s stock to increase the stock price. Their strategy paid off: the stock price surged up to 1400% and the hedge funds had to incur losses.

What is short-selling strategy?

A short-selling strategy revolves around selling something you do not own. If you do not own something you want to sell, you can borrow it, sell it and then give it back at the end of the borrowing time. A short-selling strategy can be simplified into 3 steps:

  • Investor A (that can be a hedge fund) borrows a number N of shares of the targeted companies from Investor B (usually an ETF or a mutual fund through a broker)
  • Investor A sells the borrowed shares to Investor C at a price p
  • When it’s time to give the shares back to Investor B (the lender), Investor A buys back N shares of the targeted company at the price p’ and gives them back to Investor B with fees f. Investor A pockets the following profit: (N * p) – (N * p’) – f = N * (p – p’) – f

In other words, a short-selling strategy bids on the fact the stock price of the targeted company will drop between the moment Investor A sells the shares it has borrowed, and the moment it buys them back to give them back to Investor B with fees.

Hedge funds pocket money only and only if the selling operation yields more than the absolute value of buying the shares back and paying the fee. This is why hedge funds target companies of which the stock price is expected to fall, due to poor financial management or bleak turnaround prospects. In this case, Gamestop was the perfect candidate for a short-selling strategy.

The lessons of the Gamestop case

Picture1
Due to the mayhem around Gamestop’s stock price, Robinhood had to block its retail customers from purchasing GameStop shares because of a “too volatile” price (while hedge funds were still able to trade elsewhere). GameStop achieved its first quarterly sales increase in two years during Q1 2021, thanks to the notoriety brought by the case. Nonetheless, the hype around GameStop has quickly come to an end, as it is still an unprofitable company with slender turnaround prospects. The fall is GameStop stock price following the end-of-January records and the recent events demonstrate it. At the beginning of April, GameStop announced it may sell up to $1bn of additional shares as it looks to take advantage of the Reddit-driven trading frenzy. This announcement was quickly sanctioned by the market, and the stock price fell.

This demonstrates that a hype created by nostalgic retail investors is not sufficient to entail a turnaround of the financial situation of GameStop. It still has some major management problems, such as wages below average. A Stanford University Management Professor, Jerry Davis, argue on this case that “Rescuing an extremely low-wage employer from short-sellers by pumping up its stock is not exactly storming the Bastille.”

A few retail investors pocketed a lot of money by selling their GameStop shares at the right moment. But the majority were caught up by the harsh reality of the market and the decline in the stock price. Will GameStop be able to take advantage of the frenzy around its stock price to bring measures and decision which could make its future better without being sanctioned by the market? Time will tell.

Useful resources

The Financial Times (February 25, 2021) GameStop shares extend surge in early trading

The Financial Times (April 5, 2021) GameStop shares fall after it announces plan to sell up to $1bn in stock

The Financial Times (February 7, 2021) The biggest lesson of GameStop

Related posts

Short Selling

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How do “animal spirits” shape the evolution of financial markets?

How do “animal spirits” shape the evolution of financial markets?

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) explores the concepts of rationality of economic agents and animal spirits to explain the behavior of individuals in financial markets.

A rational economic agent at the heart of classical and neo-classical approaches

Since the dawn of economic theory, the classical school of thinking has defended the vision of a rational economic agent. Adam Smith’s concept of “invisible hand” and his vision of the division of labor and free trade are all based on the hypothesis of a rational economic agent.

Later, the neoclassic movement introduced the concept of “homo economicus”, a theorical representation of the human’s rational behavior.

  • A homo economicus can maximize his satisfaction by making the best use of his resources: he will maximize his utility.
  • A homo economicus knows how to analyze and anticipate the situation and events in the world around him in order to make decisions that will maximize his satisfaction.

If we attribute these rational characteristics to all economic agents, and if the market is completely free (the conditions of pure and perfect competition are met), then it is possible to build economic models that maximize everyone’s utility. Pareto’s optimum theory is based on the hypothesis all economic agents are rational. It is the same for Léon Walras, which explains that through the process of the Walrasian auction (“tâtonement walrasien” in French), it is possible to find the market equilibrium.

These theories paved the way to Eugene Fama’s market efficiency theory. A market is informationally “efficient” if the market price for a financial asset incorporates all relevant information available to market participants. As a consequence, statistically speaking, the best forecast of the future price is the present price, and the asset price follows a random walk with unpredictable future price changes. Economically speaking, the price of securities corresponds to their fundamental or intrinsic value, thus allowing an optimal allocation of resources. He thus rejected the post-1929 theories of behavioral research which had concluded that cognitive, emotional and collective imitation errors distort price formation. He re-examined the impact of market anomalies on market efficiency and concluded that the market efficiency hypothesis is finally resistant to the long-term rate anomalies put forward by the Keynesian and behavioral literature.

“Animal spirits”: a Keynesian counter-theory to the behavior of economic agent

The rational economic agent theory has been heavily criticized by behavioral research, sociology, and the Keynesian school. The French sociologist Pierre Bourdieu argued that the “myth” of the homo economicus is challenged by behavioral realities. Neoclassical economic theories are based on assumptions of behaviors (e.g. consumption) that are always sophisticated and rational, ignoring the fact that people also have their “little habits” linked to their past and their close environment. Not everyone manages and rationalizes its budget as a homo economicus would.

For Keynes, it is not certain that individual agents are rational, and it is not certain that the combination of individual decisions leads to an optimal collective situation. According to him, market imbalances are due to the instable behavior of economic agents. They respond to spontaneous expectations (“animal spirits”) through overconfidence and optimism, which lead to cyclical disturbances. Furthermore, Keynes argues that economic agents adopt a mimetic behavior: they elaborate their strategy according to that of the others. Contrary to the neoclassicals, he considers that there is no solid (i.e. non-probabilistic) basis for defining long-run expectations: the economic cycle lies in the endogenous instable behavior of economic agents. It is for this reason that he considers that it is possible that the regulatory action of the public power is preferable to the free play of the individual initiative.

A cohabitation of rationality and “animal spirit”

In view of recent market developments, it is fair to suggest that there is some cohabitation between rationality and “animal spirits” in the financial market. Indeed, it is indisputable that prices in the markets are governed in most cases by trends that are found so often that they become rules of operation. For instance, in most cases, after the issuance of a dividend, the offer and supply will adjust the stock price (in this case decrease it) in order to match the dividend issuance: the stock price falls by the amount of the issued dividend. Similarly, in the case of an M&A transaction announcement, the stock price of the target usually increases towards the offer price proposed by the acquirer. Markets are therefore imbued with a certain rationality, notably because economic agents seek to maximize their profit.

Nonetheless, if trends and mechanisms can be found in the markets, exceptional and sudden variations in stock prices are due to non-rational and mimetic behaviors. Herd behaviors can drive sudden spikes or drops. The GameStop frenzy is a good example of this herd dynamic, where the call of one user of Reddit to buy GameStop’s stock resulted in a frantic rush that caused the stock price to soar for a few days. Similarly, the crises of 1929, 1987 and 2008 are characterized by the same irrational herd behaviors. The fear of some investors due to a new information arriving on the market spread like wildfire and fueled a global panic, leading to a stock market crash.

To conclude, economic agents are globally rational because they generally seek to maximize their situation. Nevertheless, this rationalization should not be exaggerated, as it can also be biased by the intervention of external and internal factors (such as “animal spirits”). Financial speculation and the creation of bubbles demonstrate that the economic agent, even when aware of the absurdity of the situation, can still contribute to making it worse (herd instinct).

Key concepts

Walsarian auction

The equilibrium price can be found through a “trial and error” process, which will allow to adjust little by little the demand to the supply. This “trial and error” process is often designed as a spiral on a graph representing simultaneously demand and supply, spiral which will end at the point of intersection of the two functions – the market equilibrium.

Useful resources

http://ageconsearch.umn.edu/record/15587/files/wp000001.pdf (Walras theory)

Fama E. (1970) “Efficient capital markets a review of theory and empirical work” Journal of Finance 25(2) 383-417.

Fama E. (1998) “Market efficiency, long-term returns and behavioral finance” Journal of finance Economics.

Bourdieu P. (2000) « Les structures sociales de l’économie ».

Financial Times (02/10/2021) How herd behaviour drives action on r/WallStreetBets

Keynes J.M. (1936) The General Theory of Employment, Interest and Money.

Emergent Order YouTube channel (2010) Fear the Boom and Bust: Keynes vs. Hayek – The Original Economics Rap Battle!

Related posts

Gamestop

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Producer Price Index

Bijal Gandhi

In this article, Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022) elaborates on the concept of Producer Price Index.

This reading will help you understand the meaning, calculation, uses and limitations of the Producer Price Index.

What is Producer Price Index?

Producer price index or PPI is a statistical estimation used to measure the change in the prices of goods and services. It is used to track the selling prices of the products received by domestic producers for their output. Producer price index can be calculated in two ways:

  • the goods leave the place of production called the Output PPI
  • the goods enter a new production process called the Input PPI

PPI is an estimation of the change in the average prices that a producer receives, and it is not generally what the consumer has to pay for that same product. PPI in manufacturing measures this change in the prices of products when they leave the producer i.e., they exclude any taxes, transportation, and trade margins that the consumer may have to pay. Due to this very reason, PPI cannot be used to calculate the standard of living in an economy due to the difference in the price paid by a producer and the final consumer. PPI tracks the price change in goods and services and therefore provides a general overview of inflation in an economy.

The Producer Price Index acts as a good leading economic indicator since it identifies various price changes in the economy before the goods enter the final marketplace. It is useful for the Government to formulate fiscal and monetary policies for the economy. Here, you can see the evolution of PPI from 1920 to 2020 for all commodities in the U.S.
Bijal Gandhi

Understanding Producer Price Index (PPI)

This index tracks the change in the cost of production. And due to the variety of businesses available, PPI is often classified using broad categories. In the US, the Bureau of Labor Statistics (BLS) distinguishes three categories:

1. Industry Level Classification

This level of classification measures the cost of production incurred at an industry level. It measures the changes in prices incurred for an industry’s output which is outside the sector itself by calculating the industry’s net output.

2. Commodity Classification

This is the second category of classification. This classification neglects the industry of production and instead amalgamates goods and services based on similarity and product make-up.

3. Commodity-Based Final Demand-Intermediate Demand (FD-ID)

This is the last category of classification where the system groups commodity indexes for various goods, services, and construction into sub-product classes (the specific buyer of products). This classification revolves around the physical assembly and processing required for goods.

Example of the use of Producer Price Index (PPI)

Usually, businesses indulge in long-term contracts with suppliers. And since price fluctuation is a common phenomenon over time, long-term deals are bound to be a difficult situation with only a single fixed price for this supply of goods or services. To curb the situation, the purchasing businesses and suppliers normally include a clause in the contracts that adjust the cost of these goods and services by external indicators, such as the PPI.

For example, firm X purchases a key component for its manufacturing unit from firm Y. The initial cost to procure that component is $10 along with the provision in the contract that the price will be adjusted quarterly, according to the PPI. So, after the end of a quarter, the cost of the component would be adjusted at a price higher or lower than $10 according to the change in the PPI (if it went up or down and by the degree with which it changed).

Benefits of Using Producer Price Index

1. Accurate Measuring of Inflation

Inflation causes an increase or decrease in the cost of consumer goods purchased by the people, affecting the purchasing power. Since the calculation of the Producer Price Index occurs before than the calculation of the Consumer Price Index, the Producer Price Index can be utilized to minimize or eliminate the effects of inflation in the economy. The PPI can be used to accurately determine the inflation rate by considering the price of goods whether the price increases or decreases when the goods are sent for distribution.

2. Predictive Value on Retail Changes

While the consumer price index indicates the prices of products when they reach the marketplace of end-consumers, the producer price index mentions the cost of goods before they are released in the market, ready to be consumed. Hence PPI can have a projecting value directly concerning their retail prices.

3. Contract Negotiations

A longer sale agreement usually involves the dynamic nature and uncertain consequences of inflation and how I can alter the future market. The PPI can help with the negotiation of these clauses because it can correspond to an independent measurement of price alterations.

Related posts on the SimTrade blog

Useful resources

About the author

Article written by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022).

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Consumer Price Index

Bijal Gandhi

In this article, Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022) elaborates on the concept of Consumer Price Index.

This reading will help you understand the meaning, calculation, uses and limitations of Consumer Price Index.

What is Consumer Price Index?

The Consumer Price Index (CPI) is a statistical estimation to measure the aggregate price level in an economy. It measures the change in the price level of a basket of consumer goods and services, purchased by households and businesses. This basket is a market basket which is an amalgamation of goods and services most used by consumers. The CPI is a means to acknowledge the changes in the purchasing power of a country’s currency. It can be further used to compute the cost of living. The change in CPI is used to measure inflation in the economy.

Statistical agencies compute CPI to understand the price change of various commodities and keep a track of inflation. CPI is also an important medium to understand the real value of wages, salaries, and pensions. In most of the countries, CPI is one of the most closely watched national economic statistics.

The index is usually computed monthly, or quarterly including different components of consumer expenditure, such as food, housing, apparel, transportation, electronics, medical care, education, etc.

Calculation of CPI

The consumer price index is calculated as an expression of the change in the current price of the market basket for a particular period by comparing it to a base period. It is calculated as an expression to represent the expenditure pattern that includes people of all ages throughout the population. It is calculated as follows:

Bijal Gandhi

The calculated CPI acts as an indicator for inflation in an economy. For example, if the CPI is 120, it means that there has been a 20% rise in the prices of the market basket compared to the base period. Similarly, an index of 95 indicates a 5% decrease in the prices of the basket compared to the base period. The following graph tracks the CPI from 1950 till 2020 for the U.S city average.

Bijal Gandhi

Determining the Market Basket

A suitable basket of commonly used goods and services is developed using detailed expenditure information. The government spends a considerable number of resources including money and time to accurately measure this expenditure information. The source of this information includes surveys targeted at households and businesses.

A specific good or service is added to the basket after an initiation process. For example, the initiation process for shoes goes as follows: let us assume that there are three types of shoes A, B, and C, which make up 70%, 20% and 10% of the shoe market, respectively. The choice of the shoe is directly related to the sales figures. In this case, shoe A is being chosen as it represents 70% of the market share. After the selection, this shoe will continue to be priced each month in the same store for the next four years after which a new representative will be chosen.

Uses of the Consumer Price Index

CPI acts as an economic indicator since it is a measure of inflation in an economy. It can help in determining the purchasing power of an economy. It also aids the government in the formulation and effective implementation of a government’s economic policies. It is also used for the adjustment of other economic indicators for price changes. For example, the CPI is used to adjust various components of national income. Since CPI is an indicator of the cost of living in an economy, it helps to provide adjustments to the minimum wages and social security benefits available to the residents of a country.

Limitations of the Consumer Price Index

  • The consumer price index may not be perfectly applicable to all population groups. For example, the CPI of an urban area will be able to represent the urban population in the economy, but it will not be able to reflect the status of the population living in the rural areas.
  • CPI does not provide an official estimation for subgroups of a population.
  • CPI is a conditional cost of living measure and it does not include every aspect that affects the living standards of the consumers.
  • CPI provides the change in the price level of a basket of goods and services by comparing the prices of the basket’s current price with a base price. Hence two areas cannot always be compared since the base price of the basket may differ. Therefore, a higher index in one area does not necessarily mean that the prices are higher in that area.
  • CPI does not consider the social and environmental factors in the scope of its definition.

Limitations in measurement of the CPI

  • It is highly prone to sampling error since there is always a scope that the sample of the population chosen might not accurately represent the entire population.
  • The estimation of CPI can be prone to errors arising out of price data collection and errors associated with operational implementations.
  • One of the biggest drawbacks of CPI is that it does not include energy costs (for example, gas) in its basket of commonly used goods and services even though energy costs are a major part of the household expenditure.

Related posts on the SimTrade blog

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About the author

Article written by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022).

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Hedge funds

Hedge funds

Akshit Gupta

This article written by Akshit Gupta (ESSEC Business School, Master in Management, 2019-2022) presents the role and functioning of a Hedge fund.

Introduction

Hedge funds are actively managed alternative investment vehicles that pools in money from several investors and invest in different asset classes. Only accredited investors have the access to invest in hedge funds. Accredited investors refer to high-net worth individuals, financial institutions, retail banks, and large corporations who satisfy certain conditions to obtain a special status to invest in these high-risk funds.

The first hedge fund was started in 1949 by Alfred Winslow Jones, coined as the father of the modern hedge fund industry. He tried to eliminate the systematic risk in his portfolio by buying stocks and short selling equal amounts of stocks at the same time. So, his portfolio returns were dependent on the choice of stocks he bought and sold rather than the direction in which the market moved.

Hedge funds use complex investment techniques to generate absolute market returns that are generally higher than the market benchmarks. These funds are less rigorously regulated (by the SEC in the US or the AMF in France) as compared to mutual funds by asset management firms or insurance companies which empowers them with greater flexibility.
The types of strategies used by hedge funds are risky and can lead to huge losses (like Long Term Capital Management in 1998 or Archegos Capital Management in 2021). In terms of performance, hedge funds try to achieve a positive performance regardless the direction of the market (up or down).

Benefits of a hedge funds

Hedge funds provide their clients (investors) with tools and mechanisms that enable them to handle their investments in an efficient manner and optimize their portfolios with high returns and well managed risk. The hedge funds invest in a variety of assets, thus diversifying the clients’ portfolios and dispersing their absolute returns. So, asset management firms are often acknowledged as the alternative funds in the industry.

Fee structure

Hedge funds usually follow the 2 and 20 fees structure practice. Under this practice, the hedge funds usually charge 2% management fees on the total assets under management (AUM) for the investor and 20% incentive fees on the total profits generated on the investments over the hurdle rate. The hurdle rate is generally the minimum returns that investors expects on their investments. The minimum return is set by the hedge fund while making investment decisions.

For example, a hedge fund has AUM worth $100 million and by the end of the year the total portfolio size is $140 million. The management fee is 2% and the incentive charges are 20% for a hurdle rate of 10%.

So, the hedge fund will receive total fees equivalent to:
The total fees is the sum of the management fee and the Incentive charges
Thus, total fees is equal to $8 million

(Calculation for the management fee: $100 million (Initial investment) x 2% which is $2 million
Calculation for the incentive charge: $100 million x max.(40% – 10%; 0) x 20% which is $6 million
Here, 40% is the portfolio return and 10% is the hurdle rate)

Types of strategies used by hedge funds

Hedge funds follow several strategies to try to get returns higher than the market returns. Some of the actively employed strategies are:

Long/Short equities

Long/short Equity strategy involves taking a long position and a short position on underlying stocks. The aim of this strategy is to find stocks that are undervalued and overvalued by the market and take long and short positions in them respectively. The positions can be taken by trading in the underlying shares or by trading in derivatives that have the same underlying.
The funds maintain a net equity exposure which can be positive or negative depending on the size of the long and short positions.

Event driven strategy

Under this strategy, the hedge funds invest their money on assets in which the investment returns, and risks are associated with specific events. The events can include corporate restructuring, mergers and acquisitions, spin-offs, bankruptcies, consolidations, etc. The hedge fund managers try to capitalize on the price inconsistencies that exist due to such events and use their expertise to generate good returns.

Relative value strategy

Hedge funds use relative value arbitrage to benefit from the discrepancies that exist in the prices of related assets (can be related in terms of historical price correlation, company size, industry, volume traded or several other factors). One of the strategies used under relative value arbitrage is called pairing strategy where hedge funds take positions in assets that are highly correlated (like on-the-run and off-the-run Treasury bonds). Relative value arbitrage strategy can be used on different asset classes including, bonds, equities, indices, commodities, currencies or derivatives.
The hedge fund manager takes a long position in the asset that is underpriced and simultaneously takes a short position in the relative asset that is overpriced. The long positions are highly leveraged which helps the manager to generate absolute returns. But this strategy can also lead to losses if the prices move in the opposite direction.

Distressed securities

Under this strategy, the hedge funds invest in companies that are experiencing distress due to any reason including operational inefficiencies, changes in senior management, or bankruptcy proceedings. The securities of these companies are often available at deep discounts and the hedge funds may see a high probability of reversal. When the reversal kicks-in, the hedge funds exit their positions with high returns.

Major hedge funds in the world

Hedge funds are usually ranked according to their asset under management (AUM). Well-known hedge funds are:

Hedge funds major
Source: https://www.pionline.com/interactive/largest-hedge-fund-managers-2020

Risks associated with hedge funds

Although the investments in hedge funds can generate absolute performance, they also come with high risk which can lead to huge losses to the investors. Some of the commonly associated risks with hedge fund investments are:

  • High risk exposure – the hedge funds invest in several asset classes with highly leveraged positions which can multiply the number of losses by several times. This characteristic of hedge funds makes it a risky investment vehicle.
  • Illiquidity – Some hedge funds require a lock-in period of 2 to 3 years on the investments made by the accredited investors. This characteristic makes hedge funds illiquid to investors who plan to redeem their investments early.
  • High fees and incentive charges – Most of the hedge funds follow a 2 and 20 fees structure. This means 2% fees on the total assets under management (AUM) for an investor and a 20% incentive charge on the returns generated by the hedge funds over the initially invested amount.
  • Restricted access – The investments in hedge funds are highly restricted to investors who qualify certain conditions to be deemed as accredited investors. This characteristic of a hedge fund makes it less accessible to investors who are willing to take high risks and invest in these funds.

Related posts

Asset management firms
High frequency trading
The Hummingbird project

Useful resources

Lasse Heje Pedersen (2015) Efficiently inefficient – How smart money invests & market prices are determined. Princeton University Press.
Investopedia article: Strategies used by hedge funds
Corporate finance institute article: Hedge funds

About the author

Article written by Akshit Gupta (ESSEC Business School, Master in Management, 2019-2022).

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Understanding financial derivatives: forwards

Alexandre VERLET

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explains why financial markets invented forwards and how they function.

What’s a forward?

A forward is a derivative that is rather simple to understand. To illustrate the principle, let’s say you own a farm that you want to sell since you’re fed up with living in the countryside. However, you will have to wait until harvest time (i.e. a year) to get the best price (around 100,000 euros). But bad weather can ruin your plans. To protect yourself against these risks, you can use a financial product: a forward contract!
With a forward contract, you will be able to fix your selling price today (105,000 euros), but you will only receive the money in a year’s time, when you sell the farm. This is an ideal solution that solves all your problems at once. If you look at it another way, the risk that the price of your farm will fall in a year’s time is no longer borne by you, but by the natural or legal person with whom you have concluded the forward contract; this is also known as the counterpart. So, whether the price of your farm rises to 120,000 euros or falls to 80,000 euros, your forward contract guarantees that you will be able to resell it at 105,000 euros in a year’s time. However, you have a small question: why did you sign a contract for 105,000 euros when the farm is valued at 100,000 euros?

Well, because time is money. We can use the compound interest formula to determine the exact value of this “higher amount”, where P is the principal, r is the interest rate and n is the number of years.

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Yes, in the world of money, time has a price. That’s why you get interest when you put money into your savings account, and that’s why you pay interest (usually at a higher rate) when you borrow money from your bank. For the same reason, in your forward contract, the amount you will receive in one year is 100,000.(1+0.05)1, or 105,000 euros, if we assume an interest rate of 5%.
To summarise, a forward contract can be defined as a firm commitment between two counterparties to buy or sell a specified quantity of an asset (the underlying) at a given date (the maturity date) and at a price (the strike price) agreed in advance.
Let’s take a closer look at this definition. We have the term “firm commitment”, which distinguishes forwards from another family of derivatives: options, where the commitment is optional. We can also note the term “underlying”, a clue that we are in the presence of a derivative product which, as its name indicates, is derived from another asset. The maturity date distinguishes our forward contract from a spot contract, in which the transaction is carried out immediately (the stock market is an example of a spot market). But this definition does not allow us to distinguish forwards from other contracts that are very similar to them, namely futures contracts. Indeed, the main difference between forwards and futures is that forwards are traded over-the-counter, or OTC, while futures are traded on organised markets.

The forwards market

The origin of forwards is very old, as they do not require the establishment of an organised market. Today, they occupy an important place in the range of financial instruments used by market operators. In fact, the forwards market has been globalised, but it is mainly concentrated in large financial institutions.
In theory, a forward contract is negotiated between two participants with opposing needs. In practice, however, the transaction is usually between a client and a broker, with the broker indirectly linking parties with opposing needs. The brokers here are often the large global banking institutions. Clients are financial institutions, multinationals, governments, and non-governmental organisations. Despite the common perception, derivatives can be of real use to companies. For example, to fix the price of a future sale or order, a company may use a forward contract. This is because forwards, like other derivatives, were originally designed as insurance or, more precisely, as a hedge against market risks. But, of course, they can also be used as powerful speculative instruments

Foreign exchange forwards

As we have seen, forwards are widely used in the foreign exchange market. And there is a historical reason for this. In 1971, President Richard Nixon decided to put an end to the fixed exchange rate system that had been put in place in 1944 after the war. This decision led to an unprecedented increase in volatility (price variation) in the currency market. Increased volatility means increased bonuses but also increased risks, which means that instruments are needed to reduce or even neutralise these risks.
This is where currency forwards come in. Imagine that you have just been promoted to the head of a company. On your first business trip, you manage to secure $600 million in orders. The problem is that you won’t receive the money for six months. In the meantime, a change in the EUR/USD exchange rate could wipe out your already tight margins. The solution? A currency forward, obviously! Let’s assume that the current EUR/USD rate is 1.2. Through your bank, you set up an exchange rate forward for an amount of 600 million dollars (i.e. 500 million euros). Six months later, the EUR/USD exchange rate has risen to 1.3 and your client pays you the 600 million dollars as stated in the contract. However, since the EUR/USD rate is 1.3, the 600 million dollars is now worth only 450 million euros, instead of 500 million euros. Fortunately, you have been careful, and the currency forward will save you from losing EUR 50 millions

Equity forwards and index forwards

Equities are also widely used as underlyings in forwards. We speak of equity forwards, but the Anglo-Saxon equivalent, “equity forward”, is also widely used. The most common forwards contracts are for the most liquid stocks (i.e. the stocks with the highest trading volumes). Equity forwards can be used for hedging purposes in order to neutralise price changes in an underlying asset, in this case a stock. Like other derivatives, forwards can also be used as speculative tools.There are also many forwards contracts on stock indices, such as the CAC 40. These contracts are generally very popular with investors because they are very liquid.

Interest rate forwards

Interest rates are not to be outdone. Indeed, there are forwards on interest rates. They work in much the same way as equity forwards.
However, Forward Rate Agreements (FRAs) are interest rate forwards that fix an interest rate today for a period of time starting at a future date. In terms of volume, these contracts surpass all the forwards we have discussed so far. So let’s take a look at FRAs, which, along with interest rate swaps, are the most widely used derivatives in the financial markets of any kind. But first, let’s try to understand what an FRA is and where it can be useful.
Let’s assume that you want to buy a flat in London. You have just found a particularly interesting property. Unfortunately, it will not be available for sale for another three months. What’s more, you want to finance this acquisition with a loan that you will repay in the short term, i.e. in six months. It should be noted that the UK has just gone through a serious economic crisis, which has led the central banks to reduce interest rates to a particularly low level. But the economic situation is improving rapidly and the financial press is now reporting an imminent rise in interest rates.
In short, we need to take out a loan in three months’ time, at today’s interest rate. We want to repay the loan in six months. The three months of waiting and the six months of repayment mean that our financing package is spread over nine months. This is exactly what a three-by-nine FRA is all about, where you borrow money in three months and pay it back in six months at today’s interest rate. However, it is very important to note that in the financial markets, the interest rates used are usually market rates, or reference rates. The LIBOR rate is the most widely used for this purpose. LIBOR, which stands for London Interbank Offer Rate, is the interest rate at which international banks based in London lend the dollar to other banks. These banks are said to be exchanging Eurodollars. All dollar currencies traded outside the United States are referred to as Eurodollars.

Other types of forwards

There are, of course, other types of forwards besides those mentioned above. First of all, there are commodity forwards. Among precious metals, gold is of course the most famous representative of this category of forwards. Among the energy forwards, we find, not surprisingly, crude oil forwards. The imagination of financial engineers being very fertile, we have seen the emergence of more and more exotic product categories, notably climate forwards. Here, the underlyings can be temperature, rainfall or even wind speed. In the event of a hurricane, some people might be making money out of it!

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Working in finance: trading

Alexandre VERLET

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) describes in detail the daily routine of a trader.

 

An iconic, yet unknown position

Trading is undoubtedly the most iconic position of the market finance sector. Yet, popular movies (The Wolf of Wall Street, Margin Call or The Big Short just to name a few) contributed to build a myth around traders that belies the reality of the job. Moreover, the constant decrease in the number of traders in the past decade due to the automatization of the trading tasks makes it harder to come across a real trader nowadays. Since assistant traders are all the more scarce, it is almost impossible to find anyone among your ESSEC peers with a trading internship experience, which is probably why very few students actually know what the job is about and even considers giving it a try.

So what does a trader actually do?

Well, basically three things: hedging, speculation or diversification.In all cases, the traders’ activity depends on the products they trade, which defines the type of risk they take and the techniques they use.

  • FX traders buy and sell forwards, futures, options, and swaps of national currencies on the Foreign Exchange (Forex) market, the most important market in terms of volume
  • Fixed-income traders mainly trade government and corporate bonds, relatively low risk products that generate fixed cash flows, but which face interest rate risk and default risk.
  • Equity traders, the best known but much smaller in volume than debt markets, buy, sell (or short sell) company shares on the stock market.
  • Commodities traders buy and sell forwards, futures, options of raw products such as oil, gold, coffee or even cattle.

A trader works in a trading floor with front officers, and works on daily basis with quants, sales, middle and back officers, positions that few people outside of the financial sphere actually know about.Unlike in movies, it is usually rather calm, but the work environment can definitely get lawless when markets plummet. The main task of a trader is to complete transactions based on the live information displayed on his or her nine computers, on behalf of the employer or a client. But trades are not placed on a simple hitch: modern traders also evaluate and improve trading algorithms, implement trading strategies designed by the quants, check that their portfolio is guideline compliant and report their P&L on a daily basis.
 
Every day is extremely intense and requires the trader’s full attention at all times, but the working hours are much tighter than in other well paid financial positions, and usually run from 6 AM to 6 PM. Of course, the salary is undoubtedly the main driver for traders, but there are huge earnings inequalities among traders. Within the “high-earners”, the salary + bonus range from 1 million to 50 million euros a year. But those happy few are much less numerous than two decades ago, as there are just a few thousand of them in all Europe, and mostly in London. The starting salary in investment banks ranges from 60K to 90K euros, but graduates start as assistant traders rather than actual traders. With a couple of years of experience, the promotion to the rank of associate brings 6 number figures with a 50% average bonus. Once again, it all depends on the trader’s performance and the type of risk he or she takes.
 

What does it take to become a trader?

To be a trader, one needs similar qualities as in any financial position, but they have to be a lot more developed than what is usually expected: extreme resistance to pressure, extreme rigor, thinking and acting in seconds, and unbounded ambition. Regarding the hard skills, a solid knowledge of financial markets, financial mathematics, and programming (VBA, C++ and Python) are expected, which is why traders usually have quantitative degrees. This is particularly true to work as a trader in France, where most trader come from top engineering schools or specialized masters (Dauphine or Paris VI). Nevertheless, an ESSEC degree, preferably with a finance track, is more than enough to pass the screening of the London offices of major banks, and the rest mostly depends on the performance in interviews and assessment centers (AC).
 
The main employers are the major banks (JP Morgan, Deutsche Bank, Citi, Goldman Sachs, BAML, UBS, HSBC, BNP Paribas, Soc Gen, etc.) in cities considered as financial centers (London, New York, Hong Kong, Frankfurt, Paris). To get in, you need to apply for a summer internship in the Sales & Trading department from October, pass the screening and a phone interview, and then go to London for the assessment center. Smaller structures such as Treasury departments within companies or hedge funds also employ traders but buy-side traders are growingly considered as mere executioners of strategies designed by algorithms or senior investors and are therefore more exposed to the AI revolution. Although it gets trickier every year to get a job as a trader, the high earnings and the adrenaline still makes it a very attractive position for many graduates.
 

Useful resources

https://www.goldmansachs.com/careers/divisions/global-markets/

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Unemployment Rate

Unemployment Rate

Bijal Gandhi
In this article, Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022) explains in detail about Unemployment Rate.
This read will help you understand the types of unemployment, the categories of unemployed individuals and the measures to calculate the unemployment rate.

What is the unemployment rate?

The unemployment rate is simply the percentage of the total labor force that is currently unemployed. These are individuals who are available to work and have taken measures to find work. The labor force is the total number of employed and unemployed people. This economic indicator is measured in percentage and is seasonally adjusted. The unemployment rate is considered a lagging indicator.
The unemployment rate is a very useful tool used to measure the underutilized labor force. It reflects the economy’s ability to generate employment. It basically helps in analyzing the effectiveness of the economy and its future performance.

Types of unemployment

Unemployment has been one of the most tenacious and unmanageable economic problems for several decades. Almost every country in the world has been affected by the same and therefore it is quite important to understand the types of unemployment and the reasons behind the same. There is a long list of unemployment types, but we will focus on the following important ones.

Structural unemployment

Structural unemployment is a result of technological shifts in the economy. It occurs when the existing skills of the workers are redundant due to mismatch of the skills that they possess versus the skills required. A common example would be automation of manufacturing processes, usage of robots, etc., which would cause unemployment as the workers might no longer be needed. The training of these workers may prove costly or time consuming, resulting in the workers often being displaced and unemployed for extended periods of time.

Frictional unemployment

Frictional unemployment refers to the period of unemployment after an individual leaves a particular job and till he/she finds a new one. It occurs when people voluntarily leave their jobs. It is generally short-lived. This short period of unemployment is caused naturally because it takes time for the individual to find the right job and for the companies to find the right employees. From an economic perspective, it is the least troublesome.

Cyclical unemployment

Cyclical unemployment is a result of economic downturns. It is caused during or before recessionary periods when the demand for goods and services drops drastically. The businesses to cut costs or save their companies would lay off workers resulting in unemployment.
These workers would now spend less, resulting in an even lesser demand for goods and services. Therefore, more workers would be laid-off. Cyclical unemployment creates more cyclical unemployment and therefore it becomes necessary for the government to intervene. The government may either use the monetary policy or the fiscal policy to stop this downward spiral.

How to calculate the unemployment rate?

The standard method for calculating unemployment would simply be:
Unemployment rate = Unemployed/Civilian Labor Force  100
The above formula is used to calculate the most cited unemployment rate called the U-3. For U-3 calculation, categories of individuals who work temporarily or part-time are considered employed and so are the individuals who perform at least 15 hours of unpaid family work like homemakers.

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Alternative measures of calculation

However, there are several other factors that need to be considered for calculation of the unemployment rate. Therefore, The Bureau of Labor Statistics (BLS) releases several variations of unemployment rates such as the U-1, U-2, U-4, U-5, and U-6. This is because the U-3 singularly does not convey the true picture of the unemployed labor force.

For example, the U-6 is considered as the “real unemployment rate” as it includes marginally attached workers and part-time workers unlike U-3. Marginally attached workers are the ones who have stopped looking for work in the past 4 weeks but have been looking for work for the entire year before. Those part-time workers are included who would like a full-time job if given the opportunity.

Bijal Gandhi
Source: Federal Reserve Bank of St. Louis

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About the author

Article written by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022). Bijal has two years of experience in the financial markets and is currently working as a financial analyst at Mega Biopharma.

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Inflation Rate

Inflation Rate

Bijal Gandhi
In this article, Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022) explains in detail about the inflation Rate.

This read will help you understand the causes for inflation, the pros and cons of inflation and finally how to control inflation.

What is inflation?

Inflation in simple terms means an increase in the cost of living. It is basically an economic term which means that an individual must spend more money now than before to buy the same goods or services. The percentage increase in the prices over a specified period can be termed as the inflation rate. As the prices increase, the purchasing power of each unit of the currency decreases. The change in the price level of a well-diversified basket of goods and services can help estimate the decline in the purchasing power. This basket should include commodities, services, utilities, and everything else that humans need to lead a comfortable life. Therefore, the calculation of inflation is a complex process. It is measured in several ways depending upon the goods and services included in the calculation.
Deflation is the opposite of inflation and it indicates a general decrease in the prices of goods and services. It occurs when the inflation rate is lesser than 0%.

Types of inflation

Inflation rates can be divided into the following categories depending upon their characteristics,

    • Creeping inflation means that the prices have increased by 3% or less during a year.
    • Walking inflation refers to an increase in prices between 3-10% a year. It is destructive in nature and is harmful for the economy.
    • Galloping inflation causes an absolute havoc in the economy as the prices rise by 10% or more.
    • Hyperinflation is a rare phenomenon which occurs when the prices rise by 50% or more.

What are the three causes of inflation?

The rise in prices is most associated with the rise in demand. But there are several other mechanisms that result in an increase in the money supply of an economy. These mechanisms can be classified into the following three types,

Demand-pull effect

The demand-pull effect refers to the situation in which the demand exceeds the supply for goods and services. This may occur due to an increase in the money supply and credit, stimulating the overall demand. The consumers are willing and able to pay higher prices for a product thereby leading to a price rise.

Cost-Push Effect

A cost-push effect occurs when the supply is restricted while the demand is not. The supply could be restricted due to several factors like the scarcity of raw materials, the increase in the prices of production inputs, pandemics, etc. These additional costs may result in a higher cost for the finished product or reduce supply. In any case, the prices would rise resulting in inflation.

Built-in Inflation

The built-in inflation is a result of the cause-effect relationship. It is based on the people’s expectations of inflation in the coming years. The laborers and workers will demand a higher wage if they expect that the prices of goods and services will rise. Thereby increasing the cost of production. This will further result in an increase of the prices of goods and services again.

Measure of inflation

The Consumer Price Index (CPI) evaluates the change in the average price of a selected basket of goods and services over time. This predetermined basket mainly includes necessities like food, medical care, and transportation. The change in price of each component is calculated over a period and averaged to its relative weight in the basket. It is a widely used measure for both the inflation and effectiveness of the government’s policy. In the US, the CPI reports are published on a monthly and yearly basis by the U.S. Bureau of Labor Statistics. The value of inflation can be calculated over a period between two dates using the following methodology:

Bijal Gandhi

 

 

If you wish to know the purchasing power of a certain sum of money from one period to another, you can input data in this Inflation Calculator by the U.S. Bureau of Labor Statistics and see the results. This calculator uses the same methodology and CPI data as mentioned above.

Is inflation good or bad?

Inflation can be either good or bad depending upon the situation of individuals. For example, individuals holding cash or bonds would not like inflation as the purchasing power of their holdings would decrease. Individuals with investments in assets like real estate, commodities, etc. would appreciate inflation as the real value of their holdings will increase.
Central banks often struggle in maintaining an optimal level of inflation. Spending is encouraged over saving as increased spending will help boost economic activities. This is because it would be profitable for individuals to spend now instead of later if the purchasing power of money is expected to fall. For example, in the U.S., the Federal Reserve aims for a target rate of inflation of 2% YoY. A very high inflation rate can have catastrophic consequences. For example, Venezuela, which was suffering from hyperinflation (1087%) in 2017, collapsed into a situation of extreme poverty and uncertainty. Individuals who depend upon savings or fixed income are affected the most. This is because the interest rates in their savings accounts in the banks are lesser than the inflation rate, thereby making them poorer. Similarly, lower-income families are highly affected if the rise in their wages does not keep up with the rise in the prices. A high inflation also pressurizes governments to take actions to financially support the citizens as the cost-of-living increases.

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Similarly, a deflation situation is not healthy as well. Consumers may put off spending as they may expect a fall in the prices. The reduced demand for goods and services will result in slow economic growth. This could further result in a recession-like situation with increased unemployment and poverty.

How to control inflation?

As discussed in the Interest rates post, the financial regulators of a country shoulder the responsibility of maintaining a stable and steady inflation rate. In the US, the Federal Reserve communicates inflation targets well in advance to keep a steady long-term inflation rate. This is because price stability helps businesses plan well ahead in future and know what to expect. The central banks through the monetary policy actions controls the money supply. For example, they adopt methods like quantitative easing to either counter deflation or to maintain the targeted inflation rate.
One powerful way for individuals would be to increase their earnings either through demanding a higher pay or promotions to keep up with inflation. Other options include investing in the stock market. Stocks are a good way to hedge against inflation. This is because a rise in the stock price will be inclusive of the effects of inflation. Another alternative would be to invest in instruments indexed to the inflation. Treasury Inflation Protected Securities (TIPS) and Series I Bonds are examples of such instruments.

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About the author

Article written by Bijal Gandhi(ESSEC Business School, Master in Management, 2019-2022). Bijal has two years of experience in the financial markets and is currently working as a financial analyst at Mega Biopharma.

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