My experience as a portfolio manager in a central bank

My experience as a portfolio manager in a central bank

During my studies at ESSEC Business School, I had the chance to attend the SimTrade course. This course helped me to secure an internship as a risk manager at Bank Al-Maghrib (the central bank of Morocco) as I was asked during my interviews technical questions about financial markets that were covered during the course.

Youssef_Louraoui

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2020) shares his experience as an intern in the risk management department (middle office) at the Central Bank of Morocco (Bank Al-Maghrib) in 2020.

Bank Al-Maghrib

The central bank of Morocco was founded in 1959 after Morocco proclaimed its independence. It is a 100% state-owned bank that regulates the markets and the economy by implementing monetary and economic policies to ensure the welfare in terms of the parity of prices and the control of inflation. Inflation is a major economic indicator that possesses strategic importance and is part of the major focus for the central bank.

Bank Al-Maghrib

I describe below my experience at Bank Al-Maghrib.

My internship at Bank Al-Maghrib

I was affected at the middle office department, which is in charge of measuring risk exposures and profits and losses on the positions taken by the bank on an investment portfolio of 27,4 billion euros of foreign reserve. One of the key risk exposure metrics is volatility measured by the standard deviation statistically defined as the dispersion of a random variable (asset prices or returns in my case) from its expected value. The standard deviation indicates how much the current return is deviating from its expected historical returns. It is one of the most widely used metrics for investors when analyzing the risk of an investment. Among other key exposures metric, there is what it is called the VaR (Value at Risk) at 99% and a 95% confidence level for 1-day and 30-day positions. In other words, the VaR is a metric used to compute how much loss can the portfolio incur at a % degree of confidence for a given time horizon.

Every day, the Head of the Middle Office organizes a general meeting where he talks about global debriefing of the main financial news that happened overnight and debriefing the middle office desk for the “watch out” assets that could have a potential investment opportunity. Accordingly, the team has also the task of staying in line with the investment decision that characterizes the organization, as it does not operate as an investment banking corporation nor a hedge fund in the risk and leverage used. As the central bank has the special task of keeping safe the national reserve and searching for a good mix to invest in a low risk asset (AAA bonds from European countries coupled with American treasury bonds).

My task aimed to get a hand on the investment mechanism in the middle office of the bank. The investment mechanism consists of the division of the overall portfolio into three main tranches where each one has its characteristics. The first tranche (called also the security tranche) is calculated by analyzing the national need for a currency that needs to be kept safe to establish welfare on the exchange market (based mainly on short term position in low-risk profile asset (Liquid and high rated bonds). The second tranche is based on buy and hold and a market strategy. The first one consists of taking a long position on more risky assets than the first tranche till maturity, there is no selling during the lifetime of the asset (riskier bonds and gold). The second strategy is based on buying and selling liquid assets for an expectation of yielding higher returns.

During my time at the middle office desk, I’ve managed to develop a tool to represent the investment mechanism used for asset allocation. The tool, developed in an Excel spreadsheet, is an intuitive and simplified model that enables the understanding of the investment mechanism. Indeed, it is capable of continuously refreshing the data by importing the most recent quotations (from data providers like Bloomberg or Reuters as the two main financial data providers) to allow for an update of the different exposures and thus allow to respect the proportions of portfolio allocations. It has also a dynamic risk management tool to effectively compute draw-downs (a peak-to-trough decline during a specific period for an investment) and stressed conditions, as I experienced how the markets reacted to the novel Covid-19 pandemic with one of the most historic market movements in a long time.

Some of the key learning outcomes:

  • The introduction to data analysis by manipulating large datasets
  • Portfolio optimization based on the Markowitz efficient frontier
  • Dynamic portfolio allocation based on the fundamentals of the modern portfolio theory
  • The theory of efficient markets to understand how the markets evolve and move in a different direction as a reaction to events.

Front office, middle office and back office

My internship was also a good opportunity to discover the different departments of the bank: the front office, the middle office, and the back office:

  • The front office directly deals with the individual or corporate clients of the bank. Salespeople propose adequate products and solutions to the clients (they are in front of them!). Traders intervene in the financial markets on behalf of the clients or for the bank itself (proprietary trading). To answer the demand of clients, financial engineers and quants also develop new products and the associated mathematical models to price them. One of the main trends that are emerging in the front office is the automatization with the help of AI and algorithmic trading that is taken some room in the trading desks. At this time the bank didn’t implement any technology based on high-frequency trading, but it is taking the financial industry by surprise and it goes a long way back, nearly decades ago since the first usage of algorithmic trading.
  • The middle office situated between the front office and the back office (somewhere in the middle!) deals with the risk management of the bank. Risk managers control the traders’ positions (respect of constraints such as value-at-risk limits and stress tests) and compute the profits and losses (P&L) on traders’ positions daily.
  • The back-office deals with the conformity and the security check of every trade to ensure a proper settlement.

Note that the frontiers between the front, middle, and back-office may change from one bank to another. And last but not the least, the IT people are also supporting all three departments to make the whole system work. In other words, they are in charge of the maintenance of the technical infrastructure that the bank uses daily to operate fluently, as all the departments are dependent on internal software to intermediate and operate in the market or to communicate between each department of the bank or with another organization. The IT desk has great importance in offering a flawless experience for the employees when using the internal electronic infrastructure. There is the backbone of the bank skeleton.

All in all, the SimTrade module served me well as I managed to gain quickly the necessary knowledge and bridge the gap that I had to be in the best position to achieve the missions I’ve been affected. I especially used the content of Period 2 of the SimTrade certificate, which deals with market information. The concepts of trading and investing were also obviously useful for the development of my portfolio management tools.

Related posts on the SimTrade blog

   ▶ All posts about Professional experiences

   ▶ Akshit GUPTA Portfolio manager – Job description

   ▶ William ARRATA My experiences as Fixed Income portfolio manager then Asset Liability Manager at Banque de France

   ▶ Alexandre VERLET Classic brain teasers from real-life interviews

   ▶ Jayati WALIA Capital Asset Pricing Model (CAPM)

   ▶ Youssef LOURAOUI Markowitz Modern Portfolio Theory

Useful resources

Bank of Morocco

About the author

The article was written in November 2020 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: Too Big To Fail

Film analysis: Too Big To Fail

Foreward

A pervasive moral stigma follows the financial sector, which has a dogged reputation for unethical and illegal behaviour. However, the ethical lapses often associated with finance are not always intentional. Instead, a contributing factor is that the teaching of finance and other business disciplines presents the challenge of linking theories and conceptual models to the “real world”. Entertainment media – such as films or books – are useful in this aspect as case studies; they provide students with an organisational frame of reference to better understand both situational contexts, and importantly, the human dimension behind financial numbers.

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the Too Big To Fail film and explains the related financial concepts.

“Too Big to Fail” is a dramatic retelling of the near collapse of the US banking system during the 2008 financial crisis. No-one saw the financial crisis coming, nor knew how to deal with the disaster when it arrived. This film follows financial leaders US Treasury Secretary Henry Paulson and Ben Bernanke as they try to protect a faltering U.S. economy, and eventually offer a no strings bailout, but leaves Paulson wondering if banks will lend. The issue of moral hazard is explored and begs the question, should banks really be too big to fail?

Film summary

“Too Big to Fail” gives a behind the scenes look at the conversations between major players during the 2008 financial crisis from March to mid-October. In 2008, Lehman Brothers were on the verge of collapse and its CEO Richard S. Fuld Jr. blamed the declining share price on short sellers, refusing to recognize his bank’s weaknesses. Instead, he sought a cash fill from Warren Buffett, and even pursued mergers with Bank of America (BOA) and Barclays. Treasury Secretary Henry Hank Paulson rejected the use of public money to save Lehman, and so in September 2008, Lehman filed for bankruptcy. However, shortly afterwards, Paulson announced AIG’s $85bn bailout, confusing investors with this message. Lehman could fail, but AIG couldn’t? In response to a deteriorating economy, Paulson pushed forward a plan where the US government purchased $500bn worth of toxic assets. After failing to pass congress, he redrafted the plan to assume direct ownership of stocks in banks. The Troubled Asset Relief Program (TARP) was hence created to normalise banks and increase investor confidence, putting the market back on the path to recovery.

The Wolf of Wall Street movie

Financial concepts from the Too Big To Fail film

Too Big to Fail (TBTF)

The name of this film is a financial term referring to institutions which are so large and essential to the functioning of the economy that they cannot be allowed to collapse, no matter the cost to the taxpayer. This was the logic behind the $182 billion bailout the US government provided to AIG, for example, along with the relief funds directed to titans like JPMorgan Chase, Citigroup, and the Big Three automotive companies.

Moral hazard

Moral hazard is a term used to describe how if a party is protected from risk, they will increase their risk tolerance and act less cautiously. In the context of banking, if the leaders of major banks feel confident that they are too big to fail – that is, that the government will bail them out – they will make increasingly risky decisions with the confidence that taxpayer dollars will rescue them if their bets go bust.

Bear Stearns

One of the first banks to fail, Bear Sterns’ hedge funds had accumulated over $20 billion in collateralised debt obligations (CDOs) and exposure to other toxic assets. In March 2008, due to the subprime mortgage crisis, Moody’s downgraded Bear’s MBS to Grades B and C (junk bond levels) and triggered a bank run leaving Bear with only $3.5 billion in cash. As Bear relied on repurchase agreements (short-term loans) – meaning it traded its securities to other banks for cash – Bear imploded when other banks called in their repos and refused to lend more. Bear’s insolvency forced a rescue organised by the Federal Reserve, where JPMorgan Chase bought out the bank for $2 a share (one month prior to this share price was $48). Bear’s demise triggered a panic on Wall Street and caused a banking liquidity crisis, where banks became unwilling to lend to each other. This is often used as a marker for the beginning of the 2008 financial collapse.

Lehman Brothers

On September 15th, 2008, the investment bank Lehman Brothers filed for bankruptcy. It was the biggest filing in U.S. history, with Lehman’s holding $691 billion in assets at the time. By the end of trading that day, $700bn had been wiped off the global stock markets. The Dow Jones had plummeted 500 points, its biggest drop since the terrorist attacks of 9/11. Lehman then sold its IB and capital markets operations to Barclays, kickstarting a global liquidity crisis.

Government Bailout (TARP)

A $700 billion bank bailout bill was signed on October 3, 2008 and was used to establish the Troubled Assets Relief Program (TARP). The fund was used to launch the Capital Purchase Program, which included buying $105 billion in preferred shares in Chase, Wells-Fargo, Goldman and five other leading banks. The insurance giant AIG had also become a major seller of credit default swaps to boost its profit margin, which insured the assets that supported corporate debt and mortgages. If AIG went bankrupt, it would trigger the bankruptcy of many of the financial institutions that had bought these swaps. TARP funds contributed $67.8 billion to the $182 billion AIG bailout, and also used $80.7 billion to bailout the Big Three auto companies.

Homeowner Affordability and Stability Plan

In addition to the TARP, $75 billion was put aside to help homeowners refinance or restructure their mortgages. HOPE NOW required the Treasury Department to both guarantee home loans and assist homeowners in adjusting mortgage terms.

Great Financial Crisis (GFC)

Although TBTF banks were not the sole cause of the recent financial crisis and Great Recession, given the scale of job losses, home foreclosures, lost savings and costs to taxpayers, there is no question that their presence at the centre of the financial system contributed significantly to the magnitude of the crisis and to the extensive damage it inflicted across the economy.

Key insights for investors

Banking reform

Major changes were made to prevent another financial crisis, including introducing stricter capital requirements and ensuring banks are less interconnected or vulnerable to contagion. However, some familiar risks are creeping back, and new ones have emerged as global debt continues to grow – for many countries, the combination of large debts in foreign currencies and weakening local currencies is becoming harder to sustain.

Significance of politics

A key takeaway is the intertwined relationship between politics and finance. Moral hazard asserts that ties between bankers and politicians create dangerous incentives for both parties and indicates the importance of observing not just numbers in our market research, but also non-quantifiable factors which influence expectations.

Learn from the Past

Note that “too big to fail” is a phrase still used today in finance and big business. For example, “Is Facebook too big to fail?” As well, while significant progress has been made to strengthen financial systems internationally, the biggest banks are most likely still too big to fail. It’s useful to be aware of this potential risk to an economy when considering the roles that massive companies and institutions play in our society. Economists will always speculate that we may be “overdue” for another crisis and learning from the past is the best way to prepare for the next crisis.

Relevance to the SimTrade certificate

SimTrade is your introduction to the global financial market; through a combination of theory and simulations, you learn to develop your confidence in your decision making and critical thinking skills. The course teaches you how to analyse the impact of events on expectations and stock prices, eventually teaching you how to build a position and make the market work for you.

Famous quote from the Too Big To Fail film

Paul Giamatti: “I spent my entire academic career studying the Great Depression. The depression may have started because of a stock market crash, but what hit the general economy was a disruption of credit. Average citizens unable to borrow money, to do anything. To buy a home, start a business, stock their shelves.”

Trailer of the Too Big To Fail film

Related posts on the SimTrade blog

All posts about Movies and documentaries

▶ Akshit GUPTA The bankruptcy of Lehman Brothers (2008)

▶ Akshit GUPTA Analysis of the Margin Call movie

▶ Marie POFF Film analysis: The Big Short

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: The Wolf of Wall Street

Film analysis: The Wolf of Wall Street

Foreward

A pervasive moral stigma follows the financial sector, which has a dogged reputation for unethical and illegal behaviour. However, the ethical lapses often associated with finance are not always intentional. Instead, a contributing factor is that the teaching of finance and other business disciplines presents the challenge of linking theories and conceptual models to the “real world”. Entertainment media – such as films or books – are useful in this aspect as case studies; they provide students with an organisational frame of reference to better understand both situational contexts, and importantly, the human dimension behind financial numbers.

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the The Wolf of Wall Street film.

The movie The Wolf of Wall Street is the true story of how rags-to-riches trader Jordan Belfort started with an OTC brokerage firm using pump and dump schemes, but eventually became a main player on Wall Street, where he launched the IPOs of several large companies. This black comedy shows Belfort’s rise to the high-life and excess of Wall Street, followed by a sharp fall involving crime and corruption – all while being seriously entertaining.

Film summary

The movie The Wolf of Wall Street follows one of Wall Street’s most infamous brokers, Jordan Belfort, who makes a fortune by defrauding investors out of millions. Directed by Martin Scorsese, the film starts with Belfort as an entry-level stockbroker at a Wall Street brokerage firm, where he is schooled on their cut-throat selling techniques. After a major market decline, he loses his job and goes to work for a small business selling penny stocks. After discovering the higher commission on penny stocks, he establishes his own firm, Stratton Oakmont, where he sells penny and IPO stocks with speculative returns. Jordan builds a business empire by presenting himself as a polished entrepreneur and training his employees on effective selling techniques. He is soon living the high life and becoming one of the major players on Wall Street, but soon discovers the dark side of success when he blurs ethical boundaries, quickly falling into a world of crime and corruption.

The Wolf of Wall Street movie

Financial concepts from the The Wolf of Wall Street film

Penny stocks

Penny stocks are low-priced stocks that do not trade on major stock exchanges and are issued by companies that typically do not publish financial statements. These trade anywhere from a fraction of a cent to a few dollars, and because the market capitalization, stock price, and the daily volume of these stocks are quite low, they are highly vulnerable to manipulation. For example, a sudden large volume of purchase or sale could cause the price to drop by triple-digits in a single day.

‘Pump and Dump’ schemes

‘Pump and Dump’ penny stock schemes are explained as the manipulation of the market through the accumulation of shares from penny stock or other companies, which are then stored in secret accounts. Investors are then ‘cold called’ to convince them that these companies are potential stocks for investments. The influx of purchasing orders would rapidly inflate the price, assuring investors that the shares are showing bullish behaviour. Belfort’s firm was a type of boiler room, with a team that pressured investors to place their money into highly speculative securities. At its peak, the firm is said to have employed about 1,000 stockbrokers overseeing more than $1 billion worth of investments.

Sales vs financial advisors

While working at L.F. Rothschild in the 1980s, Belfort is quickly taught that a stockbroker’s only goal is to make money for himself. Brokers seemed to focus on selling stocks and generating sales commissions, instead of advising clients on the financial risk of an investment or suitability for their portfolio. Belfort and his team are depicted as sales professionals, not financial ones, who are trained to sell investments at the expense of the client. Today, it’s still debatable whether financial professionals should be held to a fiduciary standard, requiring them to act in the best interest of a client, rather than simply providing a product.

Key insights for investors

Too good to be true: be your own investment expert

As the saying goes; if it sounds too good to be true, it probably is. Especially for beginners to the stock market, it’s important to remain clear-headed about your investment decisions and do your own research. Many of Belfort’s victims trusted him and invested all their life savings in ‘guaranteed’ stocks. Even with an advisor, it’s useful to understand financial markets and strategies, perhaps by at first investing small and diversifying your portfolio.

Legal vs ethical behaviour

Legal standards are the rules which govern the financial sector; but while something can be legal, it may not always be ethical. Belfort’s company was within the law when selling penny stocks, but not fully disclosing the speculative nature of the stocks was completely unethical. While he started by simply blurring this line, Belfort soon crossed the line and was convicted for not following securities regulations. Ethical business practices are the foundation of trust and goodwill; it’s important to take responsibility for your actions.

The road to success

While perhaps not the best role model, Belfort shows that long-term success is not a straight road. He experienced both failures and successes before reaching the height of his career on Wall Street. Losing his job lead to him starting as a stockbroker, and even after going bankrupt and serving time in prison, Belfort finished his sentence and turned his strength in sales and communications into a career as a motivational speaker. Financial mistakes can be rectified and instead become lessons for success. The most important step a person can take, is the next one.

Relevance to the SimTrade certificate

SimTrade allows you to make mistakes in a simulated setting, without suffering the financial consequences of trading with your personal funds. This course teaches you how to analyse the impact of events on stock prices and understand important concepts like market efficiency. As well as theory, you practice building a position, liquidating a position, and how to make the market. SimTrade is the best way for you to take risks, make mistakes, and learn how to make the best decisions for your portfolio.

Famous quote from the The Wolf of Wall Street film

Jordan Belfort: “Sell me this pen.”

Trailer of the The Wolf of Wall Street film

Related posts on the SimTrade blog

All posts about Movies and documentaries

▶ Akshit GUPTA Analysis of The Wolf of Wall Street movie (another analysis)

▶ Alexandre VERLET Working in finance: trading

▶ Akshit GUPTA Market manipulation

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: The Big Short

Film analysis: The Big Short

Foreward

A pervasive moral stigma follows the financial sector, which has a dogged reputation for unethical and illegal behaviour. However, the ethical lapses often associated with finance are not always intentional. Instead, a contributing factor is that the teaching of finance and other business disciplines presents the challenge of linking theories and conceptual models to the “real world”. Entertainment media – such as films or books – are useful in this aspect as case studies; they provide students with an organisational frame of reference to better understand both situational contexts, and importantly, the human dimension behind financial numbers.

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the The Big Short film and explains the related financial concepts.

The film “The Big Short” recounts the subprime housing bubble which lead to the financial crisis in 2008. Through a compelling storyline, the complexities of the financial market – including CDOs, mortgage backed bonds, and the reckless trading of complex derivative instruments – lead to the subsequent financial collapse of the US housing market.

Film summary

“The Big Short” directed by Adam McKay and based on the best-selling book by Michael Lewis, explains how the subprime housing bubble, caused by increasingly risky subprime mortgage bonds, lead to the 2008 financial crisis. The danger was hidden such that only a few players predicted the collapse and used it to “short” the market. Once the bonds failed, the value of billion-dollar securities dropped to nothing, which bankrupted major investment banks and forced a government bailout to prevent economic collapse.

The film is presented as three concurrent stories about the investors who realised the risk of the subprime housing bubble and predicted the 2007 housing market crash. Wall Street investor Michael Burry realised that many subprime home loans packaged in the bonds were in danger of defaulting, and bets against the market with one billion dollars in credit default swaps. We also follow the stories of banker Jared Vennett, hedge-fund specialist Mark Baum, and two younger investors – Charlie Geller and Jamie Shipley – who work with retired banker Ben Rickert. After reading Burry’s findings, they also make a series of successful bets and profit off the downfall of the economy.

The subprime housing bubble caused worldwide chaos as banks entered a liquidity crisis, stock markets crashed, reputable companies collapsed, and millions suffered in the wake of the disaster. The crisis was felt worldwide, irrespective of your position and whether you benefited, survived or lost everything you’d worked towards. This movie helps those who aren’t in the financial sector, understand exactly what happened.

The Big Short film

Financial concepts from the The Big Short film

Financial derivatives

Leverage

Financial leverage can be used to increase (expected) profits but also increases risk by accentuating the gains and losses of a market position. When the largest banks and financial institutions in the world leveraged using derivatives, CDOs and other highly complex securities – the exacerbated losses can lead to collapse.

CDO

A Collateralised Debt Obligation (CDO) is essentially the repackaging “old” products as new, by the securitisation of loans into a product sold to investors on the secondary market. Another example are synthetic CDOs, which essentially bets on the direction the market is going to take and amplifies the monetary gain of a bullish market, but heavily exacerbates the losses from a bearish one.

Subprime Mortgage Backed Securities

Subprime mortgages are a loan to borrowers with a low credit rating, which increases the risk that they will default. Tranches in subprime mortgage-backed bonds are when subprime mortgages are mixed with top-rated mortgages, which effectively hides their risky nature from unsuspecting customers. These top-rated securities could not stand when the subprime mortgages failed, but the danger was looked over even by the banks who sold them.

‘Shorting’ the market

By predicting the danger of mortgage-backed securities and expecting defaults on subprime mortgages, some investors profited from the crisis through credit default swaps. However, this does not mean shorting the market is a good idea. As said by J.M. Keynes; the market can stay irrational much longer than you can stay solvent. Due to unpredictable factors such as politics, going short is a bet that can run out of time – even with a simple options strategy, your options will eventually expire. Sticking with a long term, value-based approach eliminates that problem. Keep short investments on the side to meet short term cash flow needs, but also know that a quality company will generate profits, dividends, and market returns over the long term, without ever expiring.

High Risk vs High Reward

Why did the banks making the loans expose themselves to subprime borrowers at such high levels? Because high-risk borrowers also offered high rewards. Before home prices imploded and the labour market tanked, banks were able to charge sufficiently high interest rates on loans to subprime borrowers which more than overcame the costs of their higher default rates. This combined with the banks’ ability to securitize loans and sell them meant that banks thought their risks were mitigated. Instead they focused on how higher subprime interest rates could boost their margins and profits. However, those default rates eventually grew too high for any interest rate to justify the risk, and the entire system collapsed.

Impartial assessors

Impartial regulators and assessors are critical to the safe functioning of the financial sector. A contributing factor to the crash was years of financial malfeasance and incompetence among the top salesmen and executives among Wall Street’s largest banks. Conflicts of interest and abuse of power by the banks meant credit rating agencies as well as professionals supposedly managing CDOs for the benefit of the customer, were in fact working in the bank’s interest. This fraudulent system meant the credit rating agencies were rating housing debt securities highly, right up until the crash.

Counter-party risk

This simply means the risk of the other party, if their investments are not able to pay out when the time comes. An example is how Baum and Geller bet against the banks, but when the crisis hit the banks eventually went bankrupt – these two investors had to be careful about receiving payment before the banks became insolvent.

Key insights for investors

Trust your instincts

It’s important to do your own homework and trust your instincts. Despite external pressure, the investors shorting the market held their ground, ensuring their investments paid off in the long-term. When the numbers go up and down, it’s important to be patient and study the reasons behind any change. While investment advice is useful, the incentives of others may conflict with yours. It’s your money, and just because an opinion is popular, doesn’t mean its correct.

See the reality

When buying securities, it’s vital to understand the reality of what the numbers represent – real people, real companies. In the film, we see workers paying off loans for three properties at varying rates, and how the incentive system cushioned bank managers’ salaries, helping the mortgage market expand. “No-one can see a bubble; that’s what makes it a bubble” – people lost their ability to see the forest for the trees. They were the weak link in the chain, which once broken, caused the crisis. Your finances are only as strong as their weakest link, so it’s important to diversify your risk.

Mentors

In the film, Geller and Shipley asked their mentor and retired trader Rickert for his support to meet the ISDA threshold. More than that, he taught them that greed is not good, and that their win was at the expense of millions of Americans who would lose their jobs. Have a mentor to guide you both morally and financially.

Opportunity in adversity

A final lesson from this movie, albeit a dark example, is that you can find the good in adversity. By shifting your mindset when facing failures or disasters, you can learn to find opportunity in anything.

Relevance to the SimTrade certificate

Through the SimTrade course, as well as a strong understanding about trading platforms and orders, you are taught about information in financial markets and how to use this to make successful trades. Several case studies teach you how to analyse market information to make valuations, and correctly assess how market activities will affect your own trades. The simulation and contest allow you to compete against others in the course and deepen your understanding of how a market reacts to different players.

Famous quote from the The Big Short film

An investor: “No one can see a bubble. That’s what makes it a bubble.”

Trailer of the The Big Short film

Related posts on the SimTrade blog

All posts about Movies and documentaries

▶ Akshit GUPTA The bankruptcy of Lehman Brothers (2008)

▶ Akshit GUPTA Analysis of the Margin Call movie

▶ Marie POFF Film analysis: Too Big To Fail

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: Rogue Trader

Film analysis: Rogue Trader

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the Rogue trader film and explains the related financial concepts.

Based on a true story, ‘Rogue Trader’ details how risky trades made by Nick Leeson, an employee of investment banking firm Barings Bank, lead to its insolvency. This film explores how financial oversight and a lack of risk management from Leeson’s supervisors, lead to irrecoverable losses and the eventual fall of the banking giant.

Film summary

‘Rogue Trader’ recounts the exploits of Nick Leeson and his role in the downfall of Barings Bank, one of the single largest financial disasters of the nineties. Directed by James Dearden, this film encapsulates the economic and social changes of a tumultuous period. Leeson is a young derivatives trader sent to work in Singapore for Barings Bank, a major investment bank at the time. After opening a Future and Options office in Singapore, Leeson is placed in a position of authority where he takes advantage of the thriving Asian market by arbitraging between the Singapore International Monetary Exchange (SIMEX) and the Nikkei in Japan. He begins making unauthorised trades, which initially do make large profits for Barings – however he soon begins using the bank’s money to make bets on the market to recoup his own trading losses. At first, he tries to hide his losses in accounts, but eventually loses over $1 billion of Barings capital as its head of operations on the Singapore Exchange. He eventually flees the country with his wife, but inevitably, he must face how his actions lead to the bankruptcy of Barings Bank.

The Rogue Trader film

Financial concepts from the Rogue Trader film

Financial derivatives

For any new investors, financial derivatives describe a broad class of trading instruments that have no tangible worth of their own, but “derive” their value from a claim to some other financial asset or security. A few examples include futures contracts, forward contracts, put and call options, warrants, and swaps. Derivative trading started from the practice of fixing contracts ahead of time, as a way for market players to insure against fluctuations in the price of agricultural goods. Eventually the practice was extended to cover currencies and other commodities. As exchange rates became increasingly unstable, the derivatives trade facilitated huge profits for those estimating the future relative value of various commodities and currencies, through the buying and selling complex products.

Barings Bank

Founded in 1762, Barings Bank was the second oldest merchant bank in the world before its collapse in 1995. Barings grew from being a conservative merchant bank to becoming heavily reliant on speculation in the global stock markets to accumulate its profits. The derivatives market was somewhere this could be done in a very short space of time. Following the stock market crash of 1987, derivatives became central to the banks’ operations as they sought to offset their declining profits. The volume of their derivative trading soared from less than $2 trillion in 1987, to $12 trillion in 1993. As finance capital became increasingly globalised, Barings branched out to exploit these new markets in Latin America and the Far East.

Tiger Economies

The term “tiger economies” is used to describe the booming Southeast Asian economies of South Korea, Taiwan, Hong Kong, and Singapore. Following export-led growth and especially the development of sophisticated financial and trading hubs, Western interest spiked for these untapped markets in the 1990s.

Arbitrage

Profitable arbitrage opportunities are the result of simultaneously buying and selling in different markets, or by using derivatives, to take advantage of differing prices for the same asset. In the film, Leeson makes a profit by exploiting the small price fluctuations between SIMEX in Singapore and the Nikkei 225 in Japan.

Cash neutral business

A cash neutral business means managing an investment portfolio without adding any capital. For Leeson, any money made or lost on the trades should have belonged to the clients, and only a small proportion of the trades were meant to be proprietary. However, Leeson used Baring Bank’s money to make bets on the market to recoup his trading losses.

Short straddle position

A short straddle is an options strategy which takes advantage of a lack of volatility in an asset’s price, by selling both a call and a put option with the same strike price and expiration date, to create a narrow trading range for the underlying stock. Lesson used this strategy but sold disproportionate amounts of short straddles for each long futures position he took, because he needed to pay the new trades, the initial margin deposits, and meet the mounting margin calls on his existing positions.

Errors account

An errors account is a temporary account used to store and compensate for transactions related to errors in trading activity, such as routing numbers to an incorrect or wrong account. This practice allows for the separation of a transaction so that a claim can be made and resolved quickly. Leeson used this accounting to conceal the losses to Barings Bank which eventually amounted to over £800 million, though the account was supposedly activated to cover-up the loss made by an inexperienced trader working under Leeson’s supervision.

Key insights for investors

Don’t Lose Sight of Reality

An important insight is noticing how Leeson forgot to consider the real-world impact of his trades. He reflects on seeing trading as just artificial numbers flashing across screens, “it was all paid by telegraphic transfer, and since we lived off expense accounts, the numbers in our bank balances just rolled up. The real, real money was the $100 I bet Danny each day about where the market would close, or the cash we spent buying chocolate Kinder eggs to muck around with the plastic toys we found inside them.” Leeson saw the Kobe earthquake as nothing more than an opportunity and conducted more trading in one day than he ever had before as the market was butchered. Investors can avoid Leeson’s mistake by keeping a firm grasp on reality, and remembering the real companies and people represented by the stock exchange.

Destructive Practices

Other employees at Barings Bank most likely relied on internal auditors to discern wrongdoings or mistakes made by others, but as can be seen from Leeson’s case, regulators can be slow to catch on to any wrongdoing – especially when there are large profits involved. The lesson here is that an investor must be aware and proactive in helping to prevent other investors from engaging in destructive trading practices. This is especially true when it comes to newer markets or products, where regulators are unsure what entails best practice.

Tacit Agreement

While Leeson is assumed to be the villain, consider how Barings was able to contravene laws forbidding the transfer of more than 25 percent of the bank’s share capital out of the country for nearly every quarter during 1993 and 1994? Ignorance is not an excuse – tacit agreement is as effective as active engagement. A lesson here is that investors should remain informed on all their business engagements regardless of how much profit it being made.

Relevance to the SimTrade certificate

Through the SimTrade course, as well as a strong understanding about trading platforms and orders, you are taught about information in financial markets and how to use this to make successful trades. Several case studies teach you how to analyse market information to make valuations, and correctly assess how market activities will affect your own trades. The simulation and contest allow you to compete against others in the course and deepen your understanding of how a market reacts to different players.

Famous quote from the Rogue trader film

Nick Lesson: “Despite rumours of secret bank accounts and hidden millions, I did not profit personally from my unlawful trading. To be absolutely honest, sometimes I wish I had.”

Trailer of the Rogue trader film

Related posts on the SimTrade blog

All posts about financial movies and documentaries

▶ Akshit GUPTA Analysis of The Rogue Trader movie (another analysis)

▶ Akshit GUPTA The bankruptcy of the Barings Bank (1996)

▶ Jayati WALIA Value at Risk

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: Other People's Money

Film analysis: Other People’s Money

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the Other People’s Money film.

“Other People’s Money” is a film about a near obsolete publicly traded company, the New England Wire and Cable Company, interwoven with romance and community spirit. Issues arise because the original wire and cable division has become an obsolete parent firm of an otherwise profitable group of subsidiaries, but it employs much of the town’s population. While exploring the world of hostile corporate takeovers and the market for corporate control, this film shows the human impact of shareholder decisions. Good capitalism and greed clash in this fight to keep shareholders satisfied and save the factory from a dying industry.

Film summary

“Other People’s Money” directed by Norman Jewison, delves into the hostile takeover of New England Wire and Cable Company (NEWC) by Garfield Industries, where corporate raider Lawrence “Larry the Liquidator” Garfield is president. New England Wire is a publicly traded, debt-free company founded and managed by the Jorgenson family. Garfield arrives offering a peaceful takeover, explaining that the wire and cable division is in a dying industry, and is harming the profitable subsidiaries by depressing the share price. He believes that liquidating the harmful wire division is necessary to act in the best interest of the shareholders. However, Jorgenson denounces this offer as a death sentence for the employees and their town, arguing that companies should protect their community and have social responsibility. However, the market value of the company’s common stock decreases to equal less than the underlying value of its assets. Garfield then makes a takeover attempt, which culminates at the company’s annual shareholders’ meeting with Garfield succeeding in closing the wire and cable division of NEWC. The film ends with Kate Jorgensen calling with good news from a Japanese automobile company, who are interested in hiring the NEWC to product stainless steel wire cloth instead of wire.

Otehr peoples's money film

Financial concepts from the Other People’s Money film

Other People’s Money

Other people’s money (OPM) is a slang term referring to financial leverage, whereby using borrowed capital it’s possible to increase the potential returns, but also increase the risk, of an investment. In the film, the NEWC had an inefficient capital structure with no debt to leverage the company. Instead the company had a high amount of cash and liquid assets, as well as a fully funded pension plan for its employees, but had a debt-to-equity ratio of zero. There are trade-offs to having a higher debt-to-equity ratio, but in this case, leveraging OPM would have allowed the NEWC to remain in business by transitioning into a more profitable industry.

Corporate restructuring

Corporate restructuring is a process where the structure or operation of a company is significantly modified, usually in periods of significant distress and financial jeopardy. This could involve for example, mergers, takeovers, or divestiture. In this film, Garfield persuades the shareholders to divest of the failing division by selling the division and its remaining assets. Kate Jorgensen offers a better solution – a Japanese automobile company which will hire the NEWC to produce stainless steel wire cloth, allowing the company’s assets to be repurposed instead of liquidated.

Corporate takeovers

A corporate takeover refers to when one company makes a bid to acquire or take control of another, without necessarily obtaining the actual title. A takeover is usually done by purchasing a majority stake in the shares of the target company. In the film the NEWC is debt-free, making it attractive to corporate raiders or ‘takeover artists’, who aim to provide shareholders with a better return for their money.

Market for corporate control

The market for corporate control is the role of equity markets in facilitating corporate takeovers, and mainly refers to the market for acquisitions and mergers where there is competition for control rights. In this film, takeover artist Garfinkle is blocked from purchasing more shares in the NEWC by a judge’s injunction. He fights this as he believes that a free market for corporate control is needed to enable restructuring essential for the company to remain competitive. As a value-focused individual, Garfinkle believes in market dynamism as an effective tool for poor management, where market forces put pressure on managers to perform or risk sale of the company.

Creative destruction

Creative destruction is the union of evolutionary natural selection and economics. Resources are necessarily scarce, so the world advances only when outdated industries are encouraged to die quickly, allowing capital to be reallocated to more efficient and innovative industries. In this film, cable and wire is a dying industry due to the widespread adoption of fibre optics, so Garfield encourages shareholders to sell to him and reallocate their money towards a more productive venture. The underlying assumption is that though a transitioning industry will cause disruption, there is more to gain than lose when capital is put to best use and assets are used in an economically rational manner.

Key insights for investors

Wealth maximisation vs Social responsibility

As investors, the main goal is often to maximise wealth, and the game of making money can make it all too easy to value a business solely on its share price. However, this film shows that behind the numbers are the people who keep the business afloat, and who in turn rely on employment at the NEWC to support themselves. Jorgensen’s focus is on his social responsibility to the employees whose livelihoods depend on the wire plant, while Garfield believes in free enterprise and shareholder wealth maximisation. It’s clear that a balance between the two is required to create ‘good capitalism’, where all parties involved are treated fairly and humanely.

Many sides to every story

A meaningful insight from this film is that both players had valid reasons for their actions. While Garfield is painted as profit-focused at the expense of the employees, he’s also acting in the best interests of the shareholders – he refuses to take a “greenmail” bribe because he believes it would be immoral to sell out and victimise the shareholders whose funds are not being put to best use. Conversely, while Jorgensen is painted as the town’s hero, he is also neglecting his obligation to the shareholders by failing to recognize that his company was in a shrinking market, and would become obsolete if he did not accept innovations in the industry. This dual perspective is an introduction to business ethics, showing how utilitarian thinking can clash with other ideals pushing social responsibility and awareness. As investors, this is a reminder that there are always many perspectives to an issue, and real life is never black and white.

Relevance to the SimTrade certificate

SimTrade is a course designed to teach investors how the market works, including how to make orders and build a market position, while also teaching investors how to interpret and understand what these numbers represent in the real world. A combination of theory and practice helps you to understand the complexities of the stock market – including firm valuations, the impact of events on stock prices, and how to appreciate the degree of market efficiency.

The Other people’s money concept is introduced in Period 3 of the SimTrade certificate:

  • The Financial leverage course
  • The series of simulations about market making

Famous quote from the Other people’s money film

About leverage: “I love money. I love money more than the things it can buy. There’s only one thing I love more than money. You know what that is? Other people’s money.”

Watch Garfield making his point about wealth maximisation at the shareholders’ Annual Meeting of their company.

This could be compared to Gordon Gekko explaining “Greed, for the lack of a better word, is good” to the shareholders during the General Meeting of their company (in the Wall Street movie).

Trailer of the Other People’s Money film

Related posts on the SimTrade blog

▶ Shruti CHAND Financial leverage

▶ Akshit GUPTA Wall Street: Money Never Sleeps

▶ Kunal SAREEN Analysis of the Wall Street movie

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Book review: Barbarians at the gate

Book review: Barbarians at the gate

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the Barbarians at the gate book.

“Barbarians at the Gate” is a book title which quickly became a catchphrase in the finance industry. It describes how the once benevolent business practice of leveraged buyouts (LBOs), morphed into something more sinister under the influence of Wall Street in the 1980s. This book describes in detail the LBO and subsequent failure of the RJR Nabisco merger, and dives deeper into a Wall Street culture driven by greed and excess. An exciting read, with valuable lessons which still apply to investors today.

Book summary: Barbarians at the Gate

“Barbarians at the Gate” written by investigative journalists Bryan Burrough and John Helyar, follows Ross F. Johnson as he merges two of America’s biggest brands in the 1980s, RJR and Nabisco, becoming the CEO and president of tobacco and food corporation RJR Nabisco. What follows is the leveraged buyout (LBO) of RJR Nabisco, with a frenetic Wall Street bidding contest between members of the RJR Nabisco management, the investment banking firm Shearson Lehman Hutton, and the LBO firm Kohlberg, Roberts and Co, for the takeover of the company. This takeover was the peak of a wave of LBOs in the 1980s, and after a competitive bidding process, private equity firm Kohlberg Kravis Roberts & Co. (KKR) put in a winning $24.5 billion bid. This netted Johnson over $60 million and put millions more into the hands of executives, lawyers, and bankers involved in the deal.

Barbarians at the Gate Book

Financial concepts from “Barbarians at the Gate”

Leveraged Buyout (LBO)

A leveraged buyout is a financial transaction where a company is purchased using a combination of equity and debt, and where the company’s cash flow is the collateral used to secure and repay the sum borrowed. LBOs started as a work-around by the wealthy to avoid estate taxes; investors would create a shell company and acquire the target company using bank loans and insurance bonds, with only 10% coming from the personal funds of the investors.

Wall Street and LBOs

In the 1980s, the word LBO became synonymous with corporate greed – a representative of the unhinged excess of Wall Street. At the time, the US Internal Revenue Code allowed deductions of interest tax, but not dividends, encouraging companies to go into debt and pay interest, rather than operate at a profit. As well as this, junk bonds – speculative investments with a higher risk of defaulting – then made it possible to raise massive sums of money quickly. This further enabled the transformation of an LBO from a slow financial loophole, to a process used in hostile corporate takeovers.

The Downsides of LBOs

The use of LBOs for hostile takeovers left a heavy debt burden on companies and sparked widespread criticism. Government officials warned that a leveraged takeover one day could mean bankruptcy the next. The original shareholders would thus see their investment value crumble as the company took on enormous debt. The human cost was of course the employees of the targeted companies – many of whom would lose their jobs.

The RJR Nabisco Fiasco

In 1985, Nabisco and RJR merged into RJR Nabisco because of the growth opportunities it would afford both companies. However, the flashy behaviour of the Northern US company, Nabisco, conflicted with the values of its Southern counterpart, RJR. For example, employees at the RJR factory rarely saw limousines, whereas it was the preferred mode of transportation for Nabisco managers. In 1988 there was an LBO takeover for the firm, and the dramatic bidding process put millions into the hands of those involved in the deal, but left the company crippled with a $30 billion debt. Private equity firm KKR agreed to insane terms to win the deal, including giving a huge cut to CEO Johnson, and agreeing to ensure the maintenance of certain departmental budgets and retirement packages. These concessions compromised the austerity measures which enable an LBO, such as downsizing departments to repay the debt. Crippled with debt, RJR Nabisco didn’t survive the long-term effects of the LBO, and in 1999 split back into tobacco and food companies.

Negotiation fees

An overlooked aspect of an LBO are the fees involved; in the case of RJR Nabisco, the upfront fees for advising, moneylending and a ‘success fee’ was upwards of $200 million alone. In all negotiations there are administration and other costs affecting the bottom line of the deal.

Wall Street in the 1980s

It’s worth mentioning the differences between Wall Street in the 1980s and today. The world moved slower without the internet, and newspapers were the most influential (though much slower) medium for financial reporting. A Time cover story condemning the lavishness of Wall Street – “Greed on Wall Street” – was enough to influence the outcome of a deal. Many of the big players on Wall Street wanted above all else to maintain their luxurious lifestyles, often at the expense of others; they truly epitomize the greed and excess of Wall Street in the 1980s.

Key insights for investors

Stay updated

As an investor your primary concern is a return on your investments, so it pays to be aware of any changes to company structure or management, for example changes in the debt/equity structure, which could affect the longevity of the company. By staying aware of mergers, buyouts or other changes involving companies you own, you can better decide if it’s a hold or sell by considering the long-term impact on your investment.

Detrimental effects of greed

Whether it’s the go-go 1980s or the sub-prime wave of the 2000s, greed is a recurring factor when it comes to detrimental financial practices. In the book, KKR was desperate for a piece of the LBO pie, and blinded by the promise of profit, agreed to extremely disadvantageous terms. Johnson also made a bid, but executive Charles Hugel saw how much he aimed to profit at the expense of thousands of Nabisco employees, and appalled by Johnson’s greed, accepted KKR’s lower bid. The lesson here is that numbers should never be the only consideration when making a deal. Taking Forstmann’s “real people, real money” approach, it’s clear that KKR’s bid of “phoney junk bond crap” only lead to fast profits for the dealmakers, and destroyed the long-term health of the company. As investors, it’s important to consider the real-world impact of our investments; by investing into people and ideas, we can help grow the companies of tomorrow, maintain the health of our business sectors, and make reliable long-term profits in the future.

The relevance of the Barbarians at the Gate book for the SimTrade course

An important aspect of finance is learning how the market is directly influenced by the expectations and actions of others. In the SimTrade course, after learning how the market works through the limit order book, prices and transaction volumes, students engage in a simulated market situation where they learn how to send orders, and see first-hand how this directly influences the market. SimTrade also teaches students to understand how a firm is valuated, the impact of events on stock prices, and the real-world effects of your investments. SimTrade is an incredible learning opportunity for those who want to both understand the market, and practice market activities safely in a simulated environment.

Related posts on the SimTrade blog

▶ Shruti CHAND Financial leverage

▶ Akshit GUPTA Analysis of Barbarians at the Gate movie

▶ Akshit GUPTA Analysis of the Wall Street: Money Never Sleeps movie

▶ Marie POFF Film analysis: Other People’s Money

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).