Who will become London’s heir as Europe’s main financial center in the wake of Brexit?

May 17, 2021 by Alexandre VERLET

Who will become London’s heir as Europe’s main financial center in the wake of Brexit?

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) explores the Brexit’s consequences on the City’s monopoly over European finance, and which capital could possibly claim the throne.

A historic perspective on the City’s dominance

To determine whether Brexit will cause London’s fall as Europe’s main financial center, we shall examine if the causes of London’s rise might be undermined by its isolation from the single market. In 1973, Charles Kindleberger, an economic historian considered that London would not make it as Europe’s finance capital, saying that “Sterling is too weak, and British savings too little.” Obviously, he was wrong, since London concentrates a third of all European Union capital markets activity and 90% of euro-denominated derivatives clearing. This shows how London’s unquestioned position as the hypercentre of European finance is actually pretty recent, and that it is definitely not immutable, especially since assets move fast. The key element of London’s transformation is the Big Bang, the sudden and massive deregulation of financial markets that resulted from an agreement between Thatcher and the London Stock Exchange. But before that, the City and its iconic banks such as HSBC played a major role in the emergence of the Eurodollars market, making London a key partner for US banks’ European activities. When financial markets started their meteoric expansion in the 1980’s, London was ready to take advantage of it. Adding to that, the city had managed to build long term advantages such as a very favorable regulation through unquestioned political support from both Tories and Labor, a top-notch financial and legal system, and the highest concentration of highly qualified workforce you could find in Europe. It goes without saying that London’s success is first and foremost to have managed to become the financial capital of the economic heavyweight that Europe is. London is more of an investment heaven that any other European capital thanks to the British government’s unquestioned support but belonging to the EU was a required to be the EU’s financial hub.

The financial consequences of Brexit so far

Nevertheless, the Brexit is a slow and rather improvised process, and European financial hubs are interdependent, so it was in all parties’ interest that London did not collapse following the Brexit announcement. In the wake of Covid-19, the European Commission allowed European firms to keep using London’s clearinghouses as they currently do until 2022. The shift is happening slowly, and it is difficult to predict the long-term consequences of Brexit. Nevertheless, EU rules state that some trades such as euro-denominated derivatives, must be executed on an EU trading venue, so it is unlikely that London will keep its European competitors at distance for long. Soon after the Brexit was officialized, firms had already shifted about 7,500 staff and more than $1.6 trillion of assets to the EU, around 15% of US banks’ assets. However, while European financial centers have apparently benefited from Brexit, the US has by far been the main beneficiary of the new trading landscape. The direct regulatory consequence of Brexit is the loss of passporting rights, so the rights to trade are dependent upon equivalence decision made by the EU Commission. The City of London currently only has an equivalence arrangement in two areas of financial services, but the US have 22 arrangements. So, New York and Chicago have been executing many of the trades that London could not do anymore, as European financial centers who have passporting rights cannot rival with American cities’ capital markets. That is why Martin Heneghan and Sarah Hall (LSE) consider that so far, Brexit created a negative-sum game for European finance. What would make the EU’s hubs much more attractive is the capital markets union, which has been discussed for years with no progress so far. If that were to happen, European financial centers would finally take over most of London’s financial activity resulting from European economies, and the strength of a unified European capital market would prevent New York and Chicago from being the main beneficiaries of Brexit.

And the winner is…

What is happening so far is a decentralization of financial activities, each capital trying to emphasize their advantages to benefit as much as they can from Brexit. Dublin and Luxembourg’s fund-management hubs made it the priority destination for major, insurers, Amsterdam has attracted trading firms with its fast fiber network, and Paris and Frankfurt are battling to become the main hub of Euro clearing’s $75 trillion dollars market. But unlike what is often heard in the French media, nothing suggests that Paris or Frankfurt will be the financial sector’s obvious choice, quite the opposite actually: the competition is tight, and each city has its own advantages to offer. The focus on those two cities is due to the fact that both aggressively campaigned to become London’s heir, and their economic weight and political strength are long-term advantages that few other cities can rival with. Nevertheless, nothing indicates so far that Dublin, Amsterdam or Luxembourg are being left behind. Amsterdam is actually the winner when it comes to trading activities, as shown on the graph below (source: Financial Times). The low corporate tax and fintech activity of Dublin and the massive investment funds located in Luxembourg are other advantages that could sustain a decentralized finance system in Europe, therefore denying Paris or Frankfurt from taking it all.

Overview of the jobs’ redistribution: an opportunity for ESSEC finance students?

Although it will not be clear which city will have benefited most from the Brexit before 2030, you might be interested in checking the current trends of the major banks and investment firms where ESSEC students seek employment. Here’s what the think tank New Financial reported as of late 2020. In total, 440 financial services firms moved their staff due to Brexit, 135 firms choosing Dublin, 102 firms choosing Paris, 93 for Luxembourg, 62 for Frankfurt, and 48 for Amsterdam.
Bank of America is moving a significant part of its markets business to Paris, more than 400 people, and part of its banking business to Dublin. Barclays’ chose Dublin also and moved 250 people there. Blackrock is making Amsterdam its EU hub, but it also has an office for alternative investments (hedge funds and private equity) in Paris. The major French banks, BNP Paribas and SocGen, are obviously relocating to Paris, where their HQ are, and similarly Deutsche Bank is relocating to Frankfurt. Citigroup had planned to make Frankfurt its post-Brexit markets hub, but staff reportedly rebelled and lobbied to be moved to the French capital instead, because of culture, schools and proximity to London. Nevertheless, only 5% of the 6,000 people working in London for Citigroup were so far moved. JP Morgan initially expected to move most of its banking and markets businesses to Frankfurt after Brexit, but subsequently decided to move to Paris too. JP Morgan is however moving its asset management and wealth management businesses to Dublin and Luxembourg respectively. Credit Suisse planned to move its EU-focused investment bankers to Frankfurt post-Brexit, and its salespeople and traders to Madrid. Deutsche Bank’s European headquarters will clearly be in Frankfurt, where the bank’s global head office is located. Goldman Sachs is moving its investment banking and markets businesses to Frankfurt and Paris after Brexit. It is moving its asset management business to Dublin, but also opened new offices in Milan and Stockholm. In total, 500 GS jobs are leaving London. HSBC, which already used Paris as its European hub, is moving 1,000 people there. Morgan Stanley moved its investment banking and markets business to Frankfurt, and its asset management business to Dublin. Nomura and Standard Chartered chose Frankfurt, each moving around 100 people. The same goes for UBS, who decided to move 200 people to Frankfurt.

Although London remains the main financial center and employer in Europe, and while it is unsure if any city will replace it, London’s monopoly will inevitably end, and many jobs will be created or redistributed in the 5 competing European cities. All in all, if you wish to work in finance at some point, keeping up on the post-Brexit evolution of financial centers in Europe is a must.

About the author

This article was written in May 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Classic brain teasers from real-life interviews

January 30, 2024May 17, 2021 by Alexandre VERLET

Classic brain teasers from real-life interviews

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) provides 10 brain teasers from real-life investment bank interviews, and explains simple ways to solve it.

In most finance interviews, applicants must face the feared trial of brain teasers, defined as unusual questions which have basically nothing to do with finance. Investment banks and funds use them to assess the problem-solving skills, the creativity, the logical reasoning, and the ability to ask the right questions of their candidates. In this article, we will take a look at the most common types of brain teasers based on real examples from the major investment banks and see the simplest way to solve them. Keep in mind that your own method is probably the best since it’s yours, but if you get stuck on a brainteaser in the course of an interview, it can always be useful to remember the general methods on how to solve them. Here we go.

Examples of brain teasers

The bee: a classic distance/time question meant to confuse you

Let there be a point A 100 km from a point B. A car travelling at 50km/h starts from point A, at the same time a bee flying at 130km/h starts from point B. Each time the bee meets the car it returns to B and then once at point B it returns to the car, coming back and forth until the car meets point B. How many kilometres did the bee travel?

Answer: The car travels for 2 hours (since it travels 100km at 50km/h), and the bee flies for exactly the same time as the car travels, so the bee travels 260km (since it flies at 130km/h).
That’s it!

The cube: picturing volumes in your head

A cube of 10 m3 volume is divided into 1,000 small cubes of one cubic metre volume. This cube is dipped in paint. How many cubes are coloured?

Answer: The uncoloured cubes are the ones inside. If you think of the cube as divided into “3D” columns and rows that go through the cube, you will see that the first and last of each row will be coloured, and the 8 remaining will be inside. There are 8*8*8 uncoloured cubes inside i.e. 512, so the number of coloured cubes is 1000-512=488

The gold bar

The gold bar, a question for practical minds (or people who read this article).

I have a gold bar that weighs 7 kg, and I would like to give 1 kg of gold to a person every day for a week. I am only allowed to cut the bar twice. How can I do this?

Answer: Once you have figured that you can actually take back parts of the gold (you will quickly figure there’s no way to do it otherwise), the is to process step by step.
I cut the bar into 3 pieces: a 1kg piece, a 2kg piece and a 4kg piece.
Day 1: I give the 1kg piece.
Day 2: I give the 2kg piece and take back the 1kg piece.
Day 3: I give the 1kg piece.
Day 4: I give the 4kg piece and take back the other 2 pieces.
Day 5: I give the 1kg piece.
Day 6: I give the 2kg piece and take back the 1kg piece.
Day 7: I give the 1kg piece.

The arena

The arena: geometry and common sense.

I am in the centre of a circle of radius a, a lion is running twice as fast as I am, but it cannot enter the circle. The lion is running towards the point closest to me at all times.
How can I get out of the circle without being eaten?

Answer: Double the radius is shorter than the semicircle (2a vs a*pi). So the lion will not have time to catch up with me if I go to a point on the circle and then run directly in the opposite direction.

The clock

The clock: geometry (though owning a watch can help)

It is 3:15 pm, what is the degree between the minute hand and the hour hand?

Answer: Perhaps the most common of all brain teasers (I got it in an interview), so they expect you to be quick and right. Do not say 0, clocks are not so common these days but you should know that the hour hand moves forward while the hour hand turns. The hand has therefore advanced by a quarter of an hour, i.e. : 1/4*(1/12*380)= approximately 7.9

The glasses

The glasses: common but not so easy

We have a 5 L glass A, a 7 L glass B, and a water tap, how do we make 6 L?

Answer: We fill B, empty it into A to its maximum, B then contains 2L. We then empty A. Then, put the contents of B into A. We fill B and then empty it into A to its maximum. This leaves 4L remains in B. Empty A, then put the contents of B into A, then fill B and empty A to its maximum: there is then 6L left in B.

The racetrack

The racetrack: an even trickier distance/time question

A racetrack is 100 km long, a car does a first lap at 50 km/h, at what speed must the car go
in order to travel an average of 100 km/h?

Answer: Be careful, the answer is not 150 km/h. Indeed, if the car made the first lap at 50 km/h then it has driven 2 hours at the end of the first lap. However, if the car is driving at an average of 100 km/h, it must have done the 2 laps in 2 hours. This is impossible because it has already driven for 2 hours. This problem has no solution.

Slot machines

Slot machines: one of the real tough ones

There are 10 slot machines in front of me. In 9 of them the coins weigh 10g, in one of them the coins weigh 20g. You can take as many coins as you like out of each machine. How do you find the machine with the heaviest coins in one weighing?

Answer: Put 1 coin from machine 1, 2 coins from machine 2, 3 coins from machine 3 on the scale… If F is the final weight, then the difference between F is (1+2+3+…+10) allows you to find the machine with the heaviest parts. Indeed (F-(1+2+…+10))/20 gives us the number of this machine, so the number of the machine is (F-55)/20. That solution is super smart so congrats if you found it by yourself.

The crash

The crash: finally, the real distance/time question!

Let point A be X km away from point B. A drives at Y km/h, B drives at Z km/h. When will
A and B meet?

Answer: Simply solve for Yt=X-Zt with t as the unknown, then find t the time when they meet (in hour).

The bridge

The bridge: a typical back and forth question.

Four bankers have to cross a narrow bridge at night. They have only a torch and maximum 17 minutes to cross the bridge. The bridge cannot be crossed without a torch and can only support the weight of a maximum of two bankers. The analyst can cross the bridge in 1 minute, the associate in 2 minutes, the VP in 5 minutes and the MD in 10 minutes. How can they cross the bridge in time?

Answer: The analyst first crosses the pond with the associate, this takes 2 minutes. Then the analyst crosses the bridge in the opposite direction with the torch, this takes 1 minute. Then the analyst gives the torch to the VP who crosses with the MD, this takes 10 minutes. The VP then gives the torch to the associate who crosses the pond in the opposite direction in 2 minutes. Finally, the associate and the analyst cross the bridge in 2 minutes.
They have all crossed the bridge in 17 minutes.

Advice

Keep practicing, there are tons of it on the internet! Knowing the 50 most common brain teasers should allow you to nail any question in seconds, but keep in mind that you will probably face a question you have never done before, so the method is more important that knowing brain teasers by heart! Remember that sometimes you may think you recognise a brain teaser you know when you actually don’t. Take the distance/time questions for instance: I have presented you with 3 questions that looked similar but with totally different answers and methodologies, so watch out for that!

About the author

This article was written in May 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2019-2022).

Understanding financial derivatives: swaps

May 17, 2021 by Alexandre VERLET

Understanding financial derivatives: swaps

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

The origins of swaps

The origins of swaps lie in ‘parallel loans’. In the 1970s, while floating exchange rates were common, the transfer of capital between countries remained tightly controlled. Multinational companies were particularly affected when they transferred capital between their subsidiaries and their headquarter. In order to solve this problem, parallel loans were set up. To understand the principle of these loans, let us take an example. Michelin and General Motors (GM) are two multinational companies. Michelin, a French company, has a subsidiary in the United States, and General Motors, a US company, has a subsidiary in France. Suppose that both companies want to transfer funds to their respective subsidiary. In order to circumvent international transfers, the two parent companies can simply agree to lend an equivalent amount of money to their counterparty’s subsidiary. For example, Michelin’s parent company would transfer X amount in euros to General Motors’ French subsidiary, while General Motors’ parent company would transfer the equivalent amount in dollars to Michelin’s US subsidiary. With swaps, companies are also able to have access to cheaper capital and better interest rates.
As this type of financing arrangement became more popular, it became increasingly difficult for companies to find counterparties with exactly the opposite needs. In order to centralise supply and demand, financial institutions began to act as intermediaries. In doing so, they improved the original product (parallel loans) to swaps.

How big is the swap market?

The word swap comes from the English verb “to swap”. In finance, swap means an exchange of flows (and sometimes capital). Financial institutions were the first to realise the huge potential of the swaps market. In order to satisfy the growing demand, an interbank market was created. In the wake of this, several financial institutions became market makers (or dealers) to organize the market and bring liquidity to market participants. The role of a market maker is to offer bid and ask prices in a continuous manner. The financial institutions involved in the swap market have also come together in an association called the International Swap Dealers Association (ISDA). As a result, swaps became the first OTC market to have a standardised contract, further accelerating their development. With this success, the ISDA contract quickly became the standard for other OTC derivatives markets, allowing ISDA to expand its area of influence. The latter will be renamed the International Swaps and Derivatives Association. The ISDA ‘s work turned out to be an unprecedented success in the financial world. According to figures from the Bank for International Settlements (BIS), more than 75% of the outstanding amounts in the OTC markets involve swaps.

The GDP worldwide is about ten times less than the total known outstanding amounts in the OTC derivatives markets! The reason for this discrepancy is probably the almost systematic use of leverage in transactions involving derivatives.

Interest rate swaps

Interest rate swaps are a must in the OTC derivatives markets, with the notional amount outstanding in OTC interest rate swaps of over $400 trillion. In their most basic form (plain vanilla swaps), they provide a very simple understanding of how swaps work.
A plain vanilla swap is a financial mechanism in which entity A pays a fixed interest rate to entity B, and entity B pays a floating interest rate to entity A, all in the same currency. With this mechanism, it is possible to transform a fixed interest rate into a floating rate, and vice versa. It should be noted, however, that the plain vanilla is not the only type of interest rate swap. The definition of all interest rate swaps is as follows: an interest rate swap is a transaction in which two counterparties exchange financial flows in the same currency, for the same nominal amount and on different interest rate references. This definition obviously includes plain vanilla (a fixed rate against a floating rate in the same currency), but also other types of interest rate swaps (e.g. a floating rate against another floating rate in the same currency).

Currency Swaps

Currency swaps are the oldest family of swaps. A currency swap is a transaction in which two counterparties exchange cash flows in different currencies for the same nominal amount. Unlike interest rate swaps, in the case of currency swaps there is an exchange of the nominal amount at the beginning and end of the swap. Currency swaps can be classified into four categories, depending on the nature of the rates used:

Counterparty A (fixed rate) versus counterparty B (fixed rate)

Counterparty A (fixed rate) versus counterparty B (floating rate)

Counterparty A (floating rate) versus Counterparty B (fixed rate)

Counterparty A (floating rate) versus Counterparty B (floating rate)

This type of swap can reverse the currencies of two debts denominated in different currencies and also the type of interests (fixed or floating). In other words, companies use it to transform an interest payment in euros into an interest payment in dollars for instance, and a fixed interest into a floating interest for example.

Equity and commodity swaps

Interest rate and currency swaps are by far the most common families of swaps used by market participants. However, there are other types of swaps, notably equity swaps and commodity swaps. Since indices are made up of a set of stocks, equity swaps work in a similar way to index swaps. It is a matter of exchanging an interest rate (fixed or variable) against the performance of a stock or an index. Swaps have also been put in place for the commodity market. A commodity swap allows a counterparty to buy (or sell) a given quantity of a commodity at a future date, at a price fixed in advance, and to sell (or buy) a given quantity of a commodity at a future date, at a price varying according to supply and demand in the market.

Let us consider company A, that owns a certain amount of gold. The value of this asset is not stable, as it varies according to the price of gold on the markets. In order to protect itself against this over a specific time period, company A can simply ask its bank to arrange a swap in which the company exchanges (“swaps”) the variable price of its gold stock against a price fixed in advance. The mechanism for this type of swap is quite similar to the mechanism for equity swaps, which we discussed previously.

We could think of infinitely more types of swaps, as it has become a very common way to hedge against risk. Perhaps the most famous one would be the Credit Default Swap (CDS), which is a credit derivative that allows its buyer to protect himself against the risk of default of a company. In return, the buyer of the CDS pays a periodic premium to the seller of the CDS. The CDS has played an important role in the 2008 financial crisis, but this story deserves an article of its own.

Useful resources

ISDA

About the author

This article was written in May 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

How to compute the present value of an asset?

May 15, 2021 by William LONGIN

How to compute the present value of an asset?

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 have to repay the amount borrowed €90.90 and the interests €9.10, that is a total cash flow of €100 (that you will pay with the €100 that you are supposed to receive in one year). This refers to the concept of time value of money, best illustrated by the following quote: “Remember that time is money” – Benjamin Franklin (1748).

How is present value computed?

The formula for the present value (PV) of a cash flow occurring at time t, denoted by CF_t, 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 €100 obtained in 1 year, 5 years and 10 years with a discount rate of 10%. Present value shows that money received in the future is not worth as much as an equal amount received today.

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

Present value of a series of cash flows

Application 1: Computation of the present value of a stock

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

For a stock, the series of cash flows corresponds to the dividends paid by the firm to its stockholders at the end of each period t (DIV_t) and the price P_T at which the stock is supposed to be sold at time T (the horizon of the investor). The present value (PV) is then equal to the discounted value of this series of cash flows at the discount rate r.

Present value of the series of cash flows for a stock

Let us take the example of the valuation of a stock paying a dividend every year. The expected cash flows for dividends is €4 in Year 1, €4 in Year 2, €5 in Year 3, €5 in Year 4, €7 in Year 5 (end of year). The expected resale price in Year 5 is €110 (end of year). Using a discount rate of 10%, the present value of this stock is equal €94.41.

In practice, there are three steps to compute the present value of a stock:

Step 1: Estimate the expected value of future dividends and of the future price
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 bond

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

Present value of the series 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 5%, payment of interests on a yearly basis at the end of the year, and maturing in 5 years. The annual interest is computed as follows: 0.10*1,000 = €100. The last payment corresponds to the interest of the last year (€50) and the reimbursement of the initial capital (€1,000). The series of cash flows is then given by +50, +50, +50, +50, +1,050. Using a discount rate of 5%, the present value of this bond is equal €1,000.

In practice, there are three steps to compute the present value of a bond:

Step 1: Find the characteristics of a bond to compute the cash flows associated to the bond
Step 2: Estimate the discount rate given the risk characteristics of the bond
Step 3: Compute the present value

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 the future investments by the firm.

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.

▶ William LONGIN My experience as a junior financial analyst at ACE

▶ Maite CARNICERO MARTINEZ How to compute the net present value of an investment in Excel

▶ Jérémy PAULEN How to compute the IRR in Excel

▶ Sébastien PIAT Simple interest rate and compound interest rate

About the author

Article written in May 2021 by William LONGIN (EDHEC Business School, Global BBA, 2020-2024).

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

August 19, 2024May 13, 2021 by Raphaël ROERO DE CORTANZE

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

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) 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

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

Vincent Matalon (February 7, 2021) Raid sur le cours boursier de GameStop : des investisseurs amateurs racontent pourquoi ils se sont pris au jeu France Info

About the author

Article written in June 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

How do "animal spirits" shape the evolution of financial markets?

May 13, 2021 by Raphaël ROERO DE CORTANZE

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

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – 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

Academic articles and books

Ackerman, F. (2000) Still Dead After All These Years: Interpreting the Failure of General Equilibrium Theory Working paper.

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

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.

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

Press

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

Videos

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

About the author

Article written in May 2021 by Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Producer Price Index

May 6, 2021 by Bijal GANDHI

Producer Price Index

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 US.

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.

Useful resources

About the author

Article written in May 2021 by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022).

Consumer Price Index

May 6, 2021 by Bijal GANDHI

Consumer Price Index

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.

Useful resources

About the author

Article written in May 2021 by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022).

Hedge funds

April 18, 2025May 2, 2021 by Akshit GUPTA

Hedge funds

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.

Useful resources

Lasse Heje Pedersen (2015) Efficiently inefficient – How smart money invests & market prices are determined. Princeton University Press.

▶ Youssef LOURAOUI Introduction to Hedge Funds

▶ Shruti CHAND Financial leverage

▶ Akshit GUPTA Initial and maintenance margins in stocks

About the author

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

Value investment strategy

February 16, 2025May 2, 2021 by Akshit GUPTA

Value investment strategy

This article written by Akshit Gupta (ESSEC Business School, Master in Management, 2019-2022) presents the strategy of Value Investing.

Introduction

Value investment strategy is an investment style where investors look for shares that are undervalued by the market. In the companies that are undervalued, the current share price of that company is less than its intrinsic value. Intrinsic value refers to the stocks real value calculated using financial analysis metrics. The financial analysis is based on many factors including the company’s financial performance, free cash flows, future growth potential, historical performance, ratio analysis, market share and the quality of their management. The strategy is a part of fundamental investment style where investors actively seek capital appreciation and dividend returns and have a long-term investment plan.

The value investment strategy is the opposite of growth investment strategy and is considered to be a defensive strategy. A growth investment strategy is an investment style where investors look for companies, industries, sectors, or markets that are rapidly growing and have the future potential to grow at a higher-than-average rate compared to its market or industry average.

A defensive strategy involves buying quality – stocks that possess minimum risk and good returns. Dividend income is crucial for a value investor. A value investor holds onto his/her position in a company until the market realizes the true value of that company, and enjoys the stream of dividend income the company has to offer.

The investors practicing value investment strategy actively look for companies that have good long-term fundamental value. The idea behind the strategy is to buy undervalued stocks, hold the position till the stock prices reach their real or potential level and then exit the position.

Benjamin Graham is regarded as the father of value investment strategy. He is known for authoring many famous books on value investing including ‘The intelligent investor’ in the late 1940’s. He introduced the concepts such as the intrinsic value and the requirement of safety margin when investing in value stocks to the wide audience. Safety margin refers to the difference between the stock’s intrinsic value and the current market price. The more the difference between the two values, the higher the margin of safety the investor has. The high safety margin makes the investment less risky for the investor.

Indicators to practice value investment strategy

An investor practicing value investment style takes into consideration various financial and non-financial metrics based on the fundamentals of a company to compute the intrinsic value of the stock. The non-financial metrics largely depend on the investors experience and personal outlook. It can include management’s credibility, corporate strategy, focus on innovation, etc.

The most commonly used financial tools include:

Financial statements

For a value investor, it is important to study and analyze the financial statements of a company to compute different ratios to understand the company’s financial performance. The ratios that an investor looks for include:

Price- Earnings ratio: Price to earnings ratio is a fundamental analysis tool that helps an investor to determine how much the current market price of a company is compared to its current earnings per share. A value investor compares the price – to – earnings ratio of a company to the P/E ratio of other firms operating in the same sector to analyze if the stock is underpriced or not.
Price-book ratio: The P/B ratio is calculated by dividing the company’s current market price to its total book value. The book value of a company is equal to the company’s total assets minus its total liabilities. The P/B ratio of less than 1 means that the company’s current market price is less than its book value, thus the share is undervalued by the market.
P/E-growth ratio: Price/earnings to growth (PEG) ratio is calculated by dividing the price/earnings ratio of a company by its expected future growth rate. This ratio provides more comprehensive information about the company’s valuation. An PEG ratio of less than 1 signifies that the company’s current price is less than its future expected earnings growth rate. Such a company is considered as undervalued by the market.
Debt-assets ratio: Debt to assets ratios is calculated by dividing the company’s total debt by its total assets as per the balance sheet. The companies that have a ratio of less than 1 have a sound debt position in their balance sheet and have low chances of default. The company also possesses low risk which is an added advantage for the value investors.

DCF analysis

The value investors also carry out Discounted Cash flow (DCF) analysis to compute the present intrinsic value of the company based on their expected future cash flows. The value investors carry out this analysis since they believe that the present intrinsic value of a company is primarily dependent on its ability to generate good cash flows in the future. The DCF analysis takes into account the time value of money and is calculated by making projections about the free cash flows the company will have in the future and computing a discount rate which is usually the weighted average cost of capital.

Market efficiency

Market efficiency refers to the degree to which all the relevant information about an asset is incorporated in the market prices of that asset. Fama (1970) distinguished three forms of market efficiency: weak, semi-strong, and strong according to the set of information considered (market data, public information, and both public and private information).
In the strong form of the market efficiency hypothesis, the current market price of an asset incorporates all the publicly available information as well as the private or insider information.

The value investment strategy works against the efficient market hypothesis as the investors practicing this strategy always look for stocks that are undervalued or overvalued to execute trades. But value investors improve market efficiency by buying undervalued stocks (pushing the stock price up towards its fundamental value) and selling overvalued stocks (pushing the stock price down towards its fundamental value).

Example of value investors: Warren Buffet

Warren Buffet also referred to as ‘a man who values simplicity and frugality’, is a well-known believer and preacher of value investment strategy. He is a fellow student of Benjamin Graham and most of his investment decisions strongly focus on the principles of value investing and have a mid-term to long-term investment duration.

Some of the famous value stocks held by Warren Buffet, as of writing of this article (30/04/2021), includes:

Source: https://www.cnbc.com/berkshire-hathaway-portfolio/

Useful Resources

Investopedia article: Introduction to value investing

Corporate finance institute article: A guide to value investing

Relevance to the SimTrade Certificate

The concepts about value investment strategy can be understood in the SimTrade Certificate:

About theory

By taking the Trade orders course, you will know more about the different types of orders that you can use to buy and sell assets in financial markets.
By taking the Market information course, you will understand how information is incorporated into market prices and the associated concept of market efficiency.

About practice

- By launching the Sending an Order simulation, you will practice how financial markets really work and how to act in the market by sending orders.

By launching the Efficient market simulation, you will practice how information is incorporated into market prices through the trading of market participants and grasp the concept of market efficiency.

About the author

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

Understanding financial derivatives: forwards

May 2, 2021 by Alexandre VERLET

Understanding financial derivatives: forwards

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.

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!

Useful resources

ISDA

About the author

This article was written in May 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2019-2022).

Working in finance: trading

May 2, 2021 by Alexandre VERLET

Working in finance: trading

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – 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

Goldman Sachs Sales and Trading

About the author

This article was written in May 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

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