The return of inflation

August 2, 2021 by Alexandre VERLET

The return of inflation

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explains how inflation could become an issue again for the first time in 40 years.

Inflation is not something we usually worry about. In fact, few understand what inflation is about beyond the fact that it is characterized by a rise in prices. But since inflation has been around for 40 years without causing any problem, it seems to be absolutely not dangerous and perfectly controlled by central banks. Problem is, the Covid-19 crisis and the economics policies launched by governments and central banks in response are unprecedented. Moreover, an excess of inflation can be a major problem for developed economies: the UK in the 1970’s was Europe’s sick man and had to revolutionize its economy the hard way in order to get out of its stagflation spiral.

So why are we talking about a 40 year old subject? Because for several weeks now, markets have been worried about a sustained return of inflation. Fantasy for some, harsh reality for others: the scenario of a sustainable return of inflation is far from unanimous among economists. None of them, however, disputes the appearance of signals favorable to an at least temporary rise in prices, even if the extent of the phenomenon is debated. Indeed, the latest figures from the United States speak for themselves: in April, prices there rose by 4.2% over one year. This is the first time since September 2008 that the markets have been particularly nervous in recent days. In the euro zone, inflation, although more moderate (+1.6% year-on-year), also seems to be accelerating as economies are recovering from the crisis.

What is inflation and what is causing it to return?

To put it simply, inflation is the sustained rise of general prices over a period of time. It is calculated using a basket of products in which their weight in the GDP is taken into account so the basket represents the economy as a whole. The causes of inflation can be derived from a simple phenomenon: the imbalance between supply and demand of good. In our case, all the ingredients were in place for a rise in prices. Initially, the end of the Covid-19 epidemic in China and the roll-out of the vaccination campaign, particularly in the United States, contributed to the sudden rebound in global demand. But the supply side was not able to keep up with the movement and meet all the needs, since supply chains and production processes are still disorganized. Adding to that, some countries remain closed, and global supply chains cannot be restarted overnight after more than a year of pause. As a result, bottlenecks have developed in some sectors and manufacturers are now facing shortages of raw materials. Companies must also adapt their production processes under the Covid-19 regulation, and all this has a cost.This automatically leads to higher production costs, which companies pass on in their prices.

Beyond the tensions on the goods and services market, other signals are worrying the markets across the Atlantic. Starting with Joe Biden’s three stimulus plans, which will involve almost 30% of US GDP. These massive plans, which are flourishing both in the United States and in Europe, are encouraged by the central banks’ accommodating policy and their unlimited power of money creation which, through asset purchases, allow governments to go into debt at lower cost. But by injecting so much money to stimulate demand, the Fed and the White House are taking the risk of putting the US economy in a state of overheating which could lead to a surge in prices in the US and, by contagion, in Europe. This is the principle of the quantitative theory of money developed by the economist Milton Friedman in 1970 when he stated that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be generated only by an increase in the quantity of money faster than the increase in output. The other phenomenon fueling fears of a sustained acceleration in prices is the tightness in the US labor market. Some sectors are facing a shortage of labor, including low-skilled workers, which could restart the “wage-price loop”. Several companies, including McDonald’s and Amazon, have already announced a significant increase in their minimum wage and attractive hiring bonuses to attract new candidates to the United States.

How would the return of the inflation impact us?

If it does not exceed a certain level, inflation is not necessarily harmful to the economy and can even be good for some. Keep in mind that the European Central Bank is aiming for an inflation rate close to but below 2% per year. The markets fear the return of inflation, but everyone is waiting for this inflation. Since 2008, the world entered a phase of low inflation but also of risk of deflation. While rising prices cause consumers to lose purchasing power in the short term, they often result in higher wages in the medium term. Not least because the French minimum wage is indexed to inflation, as are a number of social benefits. And an increase in the minimum wage most often results in an increase in the lowest wages, as explained by INSEE in a study on wages in France. In addition, employee representatives usually use inflation as a reason to obtain wage increases during annual negotiations in the company. If the employer accepts an increase at least equal to that of prices, then the purchasing power of employees remains stable. But one of the main winners from an acceleration of inflation is the state. When prices rise across the board, tax revenues increase. Another positive consequence is that inflation increases the capacity to repay public debt, since it increases nominal GDP and thus reduces the debt/GDP ratio. The same mechanism applies to all borrowers. At least if wages keep pace with inflation over time. Let us take the case of an employee earning 2000 euros per month. This person has taken out a fixed-rate loan with a monthly payment of 500 euros. Let us also assume an inflation rate of 2% for three consecutive years. Assuming that wages increase at the same rate, the employee will receive 2122 euros per month three years later but will still have to continue to repay 800 euros. His debt ratio would then fall from 32% to 30%. It would then be easier for him to repay his loan. The opposite is true for savers. When inflation is higher than the rate of return on savings, which is the case for the Livret A, the real return becomes negative. This means that the capital invested loses value. Finally, civil servants or pensioners can also be the big losers of a return of inflation if their income is not revalued in line with inflation, as has been the case in recent years. Provided that it is not excessive, inflation is not always a bad thing and is even often synonymous with growth. The question is therefore to know how much inflation will be and whether it will be sustainable.

In the current context, the prospect of uncontrolled inflation cannot be ruled out. The pre-existing equilibrium was not one of non-existent inflation, but one of well-anchored inflation expectations. The extremely accommodating fiscal and monetary policies are now threatening that balance.

If private agents start to doubt the willingness and ability of their central bank to defend price stability, then expectations may be derailed and a return to normal inflation would require huge sacrifices. To prevent expectations from deteriorating further, the central bank would be forced to absorb liquidity by a reverse quantitative easing, which would cause a rise in long-term rates and a contraction in economic activity. As a consequence, the ability of States to take on debt would become severely limited, which would threaten the sustainability of post-covid recovery plans.

Should we worry about the future because of inflation?

The inflation threat should be definitely be treated seriously by central banks. Nevertheless, the scenario of an uncontrolled inflation remains unlikely, especially in Europe where the stimulus package were far from the size of Biden’s plan. Firstly, the rise in prices in the United States is largely temporary. The shortage of raw materials and labor will eventually fade, so the resulting inflation should do the same. Secondly, the inflation figures observed in April should be put into perspective as they reflect a catch-up phenomenon. Indeed, demand had fallen at the same time last year due to the confinement, which had also pushed prices down. It should also be noted that the increase in prices in the US is highly sectorised: one third of the monthly inflation in April was linked to the evolution of second-hand car prices. And if we exclude volatile prices such as energy and food, US inflation reached 3% over one year. For their part, central banks such as the US Fed point out that a number of deflationary elements have not disappeared, starting with unemployment, which puts the risk of wage inflation into perspective. If inflation anticipations are still strong enough to offset those two trends, central banks will have to raise key rates to cool the economy in order to limit price increases. It would then be the end of the years of “free money”, and that is something that will impact all of us as potential borrowers. So keep an eye on economic indicators over the next few months!

About the author

Article written in August 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).

Understanding financial derivatives: options

August 2, 2021 by Alexandre VERLET

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

A historical perspective on options

The history of options is surrounded by legends.. This story is linked to human’s desire to control the unpredictable, sometimes to protect himself from it, often to profit from it. This story is also that of a flower: the tulip. At the beginning of the seventeenth century, in the Netherlands, the tulip was at the origin of the first known speculative bubble. Furthermore, this was historically the first time that options contracts were used on such a large scale. The possibility of profiting from the rise in the price of tulips by paying only a small part of the price aroused great interest on the part of speculators, thus increasing the price of the precious flower tenfold. Soon the price of the tulip reached levels completely unrelated to its market value. Then, suddenly, demand dried up, causing the price to fall even faster than the previous rise. The crisis that followed had serious consequences and confirmed Amsterdam’s loss of world leadership in finance to the benefit of London, which had already taken over the Dutch capital as the world’s center for international trade. Educated by the Dutch experience, the British became increasingly sceptical about options, so much so that they eventually banned them for over a century. The ban was finally lifted towards the end of the 19th century. It was also at this time that options were introduced in the United States.

The American options market entered a new dimension at the end of the 20th century. Indeed, 1973 was a pivotal year in the history of options in more ways than one. In March 1973, a floating exchange rate regime was adopted as the standard for converting international currencies, creating unprecedented instability in the currency market. This was also the year of the “first oil shock”. Also in 1973, the Chicago Board Options Exchange (CBOE), the first exchange entirely dedicated to options, opened its doors. The same year saw the birth of the Options Clearing Corporation (OCC), the first clearing house dedicated to options. Finally, 1973 saw the publication of the work of Fischer Black and Myron Scholes. This work was completed by Robert Merton, leading to the Black-Scholes-Merton model. This model is of capital importance for the evaluation of the price of options.

What’s an option?

There are two types of option contracts: calls and puts. Since these contracts can be both bought and sold, there are four basic transactions. Thus, in options trading, it is possible to either go long (buy a call contract, buy a put contract), or to be short (sell a call contract, sell a put contract). An option contract can therefore be defined as a contract that gives the counterparty buying the contract (the long) the right, but not the obligation, to buy or sell an asset (the underlying) at a predetermined price (the strike price), date (the maturity date) and amount (the nominal value). It is useful to note that the counterparty selling the contracts (the short) is in a completely different situation. This counterparty must sell or buy the underlying asset if the transaction is unfavorable to it. However, if the transaction is favorable, this counterparty will not receive any capital gain, because the counterparty buying the contract (the long) will not have exercised its call option. To compensate for the asymmetry of this transaction, the counterparty selling the option contracts (the short) will receive a premium at the time the contract is initiated. The selling counterparty therefore has a role similar to that of an insurance company, as it is certain to receive the premium, but has no control over the time of payment or the amount to be paid. This is why it is important to assess the amount of the premium.

The characteristic of an option contract

Options contracts can have as underlying assets financial assets (interest rates, currencies, stocks, etc.), physical assets (agricultural products, metals, energy sources, etc.), stock or weather indices, and even other derivatives (futures or forwards). The other important feature of an option contract is its expiration date. Options contracts generally have standardized expiry dates. Expiry dates can be monthly, quarterly or semi-annually. In most cases, the expiration date coincides with the third Friday of the expiration month. In addition, options whose only possible exercise date is the maturity date are called European options. However, when the option can be exercised at any time between signing and expiration, it is called an American option. Ultimately, what will drive the holder of an option contract to exercise his right is the difference between the underlying price and the strike price. The strike price is the purchase or sale price of the underlying asset. This price is chosen at the time the option contract is signed. The strike price will remain the same until the end of the option contract, unlike the price of the underlying asset, which will vary according to supply and demand. In organised markets, brokers usually offer the possibility to choose between several strike prices. The strike price can be identical to the price of the underlying asset. The option is then said to be “at-the-money” (or “at par”).

In the case of a call, if the proposed strike price is higher than the price of the underlying, the call is said to be “out of the money”.

Are you “in the money”?

Let’s take an example: a share is quoted at 10 euros. You are offered a call with a price of 11 euros. If we disregard the premium, we can see that a resale of the call, immediately after buying it, will result in a loss of one euro. For this reason, the call is said to be “out of the money”. On the other hand, when the strike price offered for a call is lower than the price of the underlying asset, the call is said to be “in the money”. Another example: the stock is still trading at 10 euros. This time you are offered a call with a strike price of 9 euros. If you disregard the premium, you can see that you earn one euro if you sell the call immediately after buying it. This is why this call is called “in the money”. Note that our potential gain of one euro is also called the “intrinsic value” of the call. Of course, the intrinsic value is only valid for “in the money” options. For puts, it is the opposite. A put is said to be “out of the money” if its strike price is lower than the price of the underlying asset.

Finally, a put is said to be “in the money” if its strike price is higher than the price of the underlying asset. If you are one of those people who think that you can make money with options by simply buying and selling calls or puts “in the money”, I have bad news for you! In reality, the premiums of the different contracts are calculated in such a way as to cancel out the advantage that “in the money” contracts offer over other contracts.

Useful resources

ISDA

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).

The NFTs, a new gold rush?

July 31, 2021 by Alexandre VERLET

The NFTs, a new gold rush?

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explores the latest tech trend, which could revolutionize the art market and so much more.

These three letters are on everyone’s lips right now: NFT (for non-fungible token). But have you figured out what it’s really about? Let’s get into that special world of art, blockchain and people rich enough to buy a single tweet or jpg image. Jack Dorsey, CEO of Twitter, has put his very first tweet up for sale; the current auction is at $2.5 million (about €2 million). Sound like a lot? Canadian artist Grimes (and companion of the whimsical Elon Musk) has put up for sale an entire collection of digital works for nearly 6 million, while the most expensive single work sold to date is an animation showing Donald Trump, naked, being mocked by a blue bird. Its price? $6.6 million. But let’s get back to the basics and technique by detailing what an NFT, or non-fungible token, actually is.

Fungible vs non-fungible

First of all, let’s explain what a fungible element is and how it differs from a non-fungible element. The dictionary gives the following definition of the word “fungible”: things that are consumed by use and can be replaced by things of the same kind, quality, and quantity (e.g., commodities, cash).This means that it is something that has a value, but can be replaced by an equivalent of the same nature. For example, a coin that has no traceability, no serial number and will have the same value as a similar coin. Conversely, a non-fungible item cannot be replaced or substituted. For example, imagine a plane ticket: it is an object that can be consumed (in the sense that it can be bought), but its number, the fact that it is linked to a name and a particular seat on a given flight prevents it from being substituted for any other plane ticket.

What is a NFT (non-fungible token)?

An NFT applies this principle by adding a cryptographic layer based on an ERC (Ethereum Request for Comment) blockchain. This means that an NFT can be registered and exchanged just like an Ethereum (the second largest cryptocurrency after Bitcoin). This unique virtual token can then be used as a certificate for anything and everything, whether it is a real or digital good. Only its holder will be able to justify its possession, while it is possible to check the path of this token throughout its life. An NFT allows you to justify a purchase and prove its authenticity, whatever you have bought. Even a simple tweet, which may one day go down in history and be worth billions of dollars. The very principle of the blockchain ensures the encryption of information and its security, making each NFT unfalsifiable with today’s technical possibilities.

What can you buy with an NFT?

Technically, an NFT can be used as a certificate for anything. A famous painting, an official pair of sneakers… but where NFTs really come into their own is for digital assets. It’s easy to prove you own a painting or a pair of shoes, it’s harder to prove you bought a tweet from Jack Dorsey. But above all, it is a real revolution in the art world since any digital creation can now be identified and recognized as a unique work, thus immediately taking on value, like anything else that is unique. Some things, such as memes, can thus be considered as unique works.

Why buy a virtual image when you can copy it?

A question that often comes up is that of copying. What is the point of buying a 6.6 million dollar video or a single image when they are available everywhere on the net and can be downloaded and admired without any problem? Simply for the art and the joy of owning something unique. In a few seconds, you can find a reproduction of the Mona Lisa on Google Images and there is nothing to stop you from printing it and displaying it in your living room. However good your printer is, you will never own THE Mona Lisa by Leonardo da Vinci. Speculation and the principle of supply and demand do the rest and allow some works to be exchanged for several millions. And this is only the beginning.

The limits of NFTs

In front of this picture of the future that is being painted in real time before our eyes, there are a few fences linked to technical, ethical and legal limits. The biggest one being the cost of the blockchain. The Ethereum blockchain is currently particularly energy-intensive, which makes it expensive to use. From an ecological, ethical and economic point of view, relying on an ERC chain today is a miscalculation. “Today. Cryptocurrencies and blockchain in general are still in their infancy and the arrival of Ethereum 2.0 (a version that completely changes the principle of this blockchain in order to simplify and fluidify its operation expected in the next few years) could well solve these problems. Whatever you think about NFTs being a good investment or not, you will probably hear about them a lot in the coming years.

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).

Cryptocurrencies

July 31, 2021 by Alexandre VERLET

Cryptocurrencies

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) explores explores the latest and most fashionable investment trend.

They are everywhere on the news, in (young) people’s daily conversations, and probably in a corner of your head if you have already invested a bit of money in them. Cryptocurrencies are a daily drama, as it allows people to make or lose big money in record time. Everyone’s heard of it, but few people actually understand where cryptos come from and how they work. You may not necessarily need that to invest in them in the short term, as simply following Elon Musk on twitter might be a quicker and more efficient way to predict its evolution. But in the long run, and to understand the impact it will have on society, you need to know what’s going on. For some, it might become an actual currency in the coming years and will compete with the national currencies. For others, regulation will eventually tame cryptos and people will therefore lose interest in them. What’s for sure is that a public debate will arise at some point, and you might as well have the keys to understand cryptos so you can forge your own opinion. So here we go.

What is a cryptocurrency?

In a nutshell, it’s a virtual currency. What makes it a completely different and original currency is that it is not centrally managed; in other terms, it is the user who has full control over the cryptocurrency in their possession (peer-to-peer). This process is done through the implementation of Blockchain technology: the latter is a distributed and decentralized data storage and transmission technology at its core. The most frequently used analogy is that of a ledger that is accessible to all, indestructible and unpublishable once the data is embedded in the system. Like cryptocurrency, the Blockchain also relies on peer to peer to operate in a decentralized manner. Note that Blockchain can be used for much more than cryptocurrency; being a database, this technology represents a potentially huge evolution in the way we (businesses) deal with data. However, it was with the advent of Bitcoin, the first of many cryptocurrencies, that the distributed blockchain was seen as a potential successor to existing storage technology. The main cryptocurrencies are Bitcoin- the world’s most widely used and legitimate cryptocurrency-, Ethereum – founded in 2015 and known for its enhanced architecture using “smart contracts”-, Litecoin – released in 2011, similar to Bitcoin but with a higher programmed supply limit (84 million units vs 21 million).

Where do cryptos come from?

Before cryptos as we know them were invented, some early cryptocurrency proponents already shared the goal of applying cutting-edge mathematical and computer science principles to solve what they perceived as practical and political shortcomings of “traditional” currencies. It goes back to the 1980s when an American cryptographer named David Chaum invented a “blinding” algorithm that allowed for secure, unalterable information exchanges between parties, laying the groundwork for future electronic currency transfers. Then, the late 1990s and early 2000s saw the rise of more conventional digital finance intermediaries, such as Elon Musk’s Paypal. But no true cryptocurrency emerged until the late 2000s when Bitcoin came onto the scene. Bitcoin is widely regarded as the first modern cryptocurrency, because it combined decentralized control, user anonymity, record-keeping via a blockchain, and built-in scarcity. It all began in 2008, when Satoshi Nakamoto (an anonymous person or group of people) published a white paper about the Bitcoin. Nakamoto then released Bitcoin to the public. In 2010, the very first Bitcoin purchase was made: an Internet user exchanged 10,000 Bitcoins for two pizzas. At today’s prices, that would be the equivalent of about 500 million euros: that’s a lot of money for a pizza. By late 2010, dozens of other cryptocurrencies started popping out as more and more people started to mine and exchange cryptos. It grew in legitimacy when it became accepted as a means of payment by major companies, such as WordPress, Microsoft or Tesla. As of May 2021, the cryptos’ market cap is $2 trillion.

How do cryptos work?

There are several concepts that you should know about in order to get how cryptos work. Cryptocurrencies use cryptographic protocols, or extremely complex code systems that encrypt sensitive data transfers, which make cryptos them virtually impossible to break, and thus to duplicate or counterfeit the protected currencies. These protocols also mask the identities of cryptocurrency users.Then the crypto’s blockchain records and stores all prior transactions and activity, validating ownership of all units of the currency at all times. Identical copies of the blockchain are stored in every node of the cryptocurrency’s software network — the network of decentralized server farms, run by miners, that continually record and authenticate cryptocurrency transactions. The term “miners” relates to the fact that miners’ work literally creates wealth in the form of brand-new cryptocurrency units. Miners serve as record-keepers for cryptocurrency communities, using vast amounts of computing power, often manifested in private server farms owned by mining collectives that comprise dozens of individuals. The scope of the operation is quite similar to the search for new prime numbers, which requires tremendous amounts of computing power. Miners’ work periodically creates new copies of the blockchain, adding recent, previously unverified transactions that aren’t included in any previous blockchain copy — effectively completing those transactions. Each addition is known as a block, which consist of all transactions executed since the last new copy of the blockchain was created. Sincce the cryptocurrencies’ supply and value are controlled by the activities of their users and highly complex protocols built into their governing codes, not the conscious decisions of central banks or other regulatory authorities, which is why cryptos are said to be decentralized. Although mining periodically produces new cryptocurrency units, most cryptocurrencies are designed to have a finite supply — a key guarantor of value. Generally, this means miners receive fewer new units per new block as time goes on. For instance, if current trends continue, observers predict that the last Bitcoin unit will be mined sometime around 2150.

Why are cryptocurrencies so successful?

You may be wondering why crypto-currencies are gaining so much momentum today. With no intrinsic value, and no commodity to fall back on, economically speaking it makes no sense for this market to reach such an astronomical price. There are two rationales that often come up in the argument for cryptocurrencies. On the one hand, the anonymity via cryptography provided by blockchain technology: as there is very little regulation in this industry yet, one can end up with astronomical amounts of money without necessarily having to pay taxes on it, as there is no centralized body to follow what is going on. The second reason is more sociological: since there are people mining and trading cryptocurrencies, the logic is that they must have value. The consequence is that other people join the rush, and so on until it becomes a global phenomenon. You could call it a crowd movement, or a 21st century digital gold rush.

But these two reasons don’t necessarily answer the question of why Bitcoin and all these other cryptocurrencies are valuable. To get a clear answer, we need to go back to the basics of economics: any value applied to a commodity or currency is subjective. That is, if we, as individuals, see value in it, the commodity in question has value. The snowball effect resulting from a group of people’s growing interest in a commodity is at the origin of any bubble, and from that point of view cryptos are a massive bubble. Which does not mean that it is a bad investment: after all, a bubble is a bubble when it blows up, but it might never happen.

Summary

To sum up, if you want to invest in cryptocurrencies, there are a couple of things you should consider. First, if you’re aiming for the long-term (if you believe cryptocurrencies will keep increasing in value as “deflationary currencies”) or the short-term (pure speculation). Second, you should examine the specific characteristics of the cryptos and see which best fits you in terms of anonymity, growth potential and liquidity. Last but not least, follow the latest regulation announcements on cryptos, such as central banks or governments comments on cryptos, which are a pretty good indicator of the crypto’s evolution on both the long and short term.

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021).

Inflation and the economic crisis of the 1970s and 1980s

July 31, 2021 by Alexandre VERLET

Inflation and the economic crisis of the 1970s and 1980s

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) goes back on the inflation issue of 1970’s/1980’s and the lessons it teaches us for the 2020’s.

In the developed capitalist countries, the fight against inflation became the top priority of economic policy in the 1970s. Georges Pompidou’s famous formula: “better inflation than unemployment” was buried for good. Inflation can be defined as the continuous and self-sustaining rise in the general price level. It is the result of a monetary struggle conducted by the various economic agents to maintain or increase their income or their capital: it has winners and losers. For economic decision-makers, inflation is a “sweet poison”: on the one hand, it is a factor of growth (by stimulating investment and consumption, and at the same time favoring production and employment); on the other hand, it is a danger for this same growth if the rise in prices gets out of hand (trade deficit, capital flight, ruin of savers). By what mechanisms does the inflationary growth of the 1960s give way to the rapid stagflation of 1973-1986?

Low inflationary growth was at the heart of the virtuous circle of the Trente Glorieuses

The Second World War and the post-war period were times of great inflationary pressure due to the large-scale expenditure by governments to finance the war effort, economic reconstruction and the establishment of the welfare state. France struggled with the problems of currency and price stability. Germany had the lowest inflation of the OECD countries since the monetary reform of 1948 and the priority given to a strong currency. Some countries, such as France, had chronic inflation. The debate raged in the years 1945-1952: a man like Mendès-France resigned from the government in 1945 to protest against monetary and budgetary laxity, stating that “distributing money to everyone without taking it from anyone is to maintain a mirage… “(extract from his letter of resignation, June 6, 1945). The growth of the 1950s and 1960s was generally not very inflationary in the developed countries: the Bretton Woods agreements ratified the stability of exchange rates around the dollar, the only reference currency convertible into gold. However, it was not until 1958 that European currencies regained their convertibility. Wartime periods remained inflationary: the Korean War (1950-53), for example, during which there was a rise in the price of raw materials, an increase in public spending in the United States and an increase in the circulation of dollars. From the beginning of the 1950s, once reconstruction had been completed, to the beginning of the 1960s, inflation fluctuated between 1 and 4% per year in the industrial countries. Moreover, Keynesian economic policies aimed to stimulate demand through deficit spending, which created inflation, and then to contain the pressure of demand when tensions were too great, so that inflation was limited. The alternation of stimulus (inflation) and austerity (deflation) took the form of the stop-and-go policy that characterized Great Britain and the United States in the 1950s. Consequently, in a period of full employment, a certain amount of “natural” unemployment is accepted in order to avoid too much pressure on wages and therefore on prices, as demonstrated by the British economist A.W. Philllips (Economica Journal, 1958). Inflation is in this perspective a lesser evil: it is seen as a painless way of financing growth: in fact, it works in favor of companies that go into debt, it has a favorable effect on their financial profitability. In a country such as France, it makes it possible to arbitrate social conflicts by defusing profit/wage tensions (the government negotiates both wage increases and low-cost credit).

The 1960s: the “inflationary spiral” begins to get out of control

From 1961-62 onwards, the developed industrial countries experienced an acceleration in price increases: a significant and lasting rise in inflation, from 3 to 5% until the early 1970s. During this period, there was no significant reduction in unemployment and even a slight increase in the number of job seekers: is this the end of the jobless era? In any case, the Phillips curve seemed to apply more and more poorly to the economic situation. There are several causes for this. Firstly, the growing importance of budget deficits: due to the use of deficit spending in the Keynesian logic; due to the implementation of the welfare state and social programs: for example, in the United States, the New Frontier programs of J.F. Kennedy and the Great Society of L. Johnson. Secondly, the deterioration of the international monetary system: devaluation of the pound sterling, crisis of the dollar at the end of the 1960s. Lastly, the wage increases outstripped productivity gains, which were slowing down: the “crisis of Fordism”: in other words, inflation through wage costs.

The 1973 and 1979 oil shocks

As seen previously, the 1970’s inflation is a consequence of economic phenomena already observed in the 1960’s. However, the two oil shocks were game changers. This time we are talking about cost inflation: the cost of energy supply is at stake, with the price of a barrel of oil multiplying by more than 11 in 1973 and 1979. This explains why inflation continues even when demand is lacking, when there is stagflation and part of the production capacity is unused. During classical crises, overproduction results in a general fall in the price level and a collapse of production, as shown by the Great Depression of the 1930s. On the contrary, during the crisis of the 1970s, prices rose continuously after the two oil shocks of 1973 and 1979, while production was very unstable (after a collapse in 1973-1974, it picked up again in 1975-1976). Inflation was now high: from an average of around 5% per year in the early 1970s, it rose to double-digit figures between 1973 and 1975, and again between 1979 and 1982.

The economic consequences of inflation

The crisis is industrial and commercial: companies’ profits collapse because of rising costs; their international competitiveness is severely damaged because of the relative rise in prices. The crisis is social: the unemployment curve follows that of inflation, but without showing any real inflection between 1973 and 1982: it calls into question the Phillips curve analysis, as there is a simultaneous rise in unemployment and inflation. The number of unemployed in the OECD rose from 10.1 million in 1970 to almost 33 million in 1983, which roughly corresponds to a tripling. European countries seem to be particularly affected: unemployment has multiplied by almost 4 in the same period. The crisis is also financial. On a national scale, part of the population is ruined by rapid inflation (savers, rentiers, farmers, employees), while another part makes significant gains (speculators). On an international scale, the debt of Third World countries literally exploded: from 130 billion dollars in 1973 to more than 660 billion dollars in 1983. Currencies tend to depreciate, which causes a generalized rise in prices: galloping inflation becomes global (Mexico for example). What’s more, Keynesian policies further reinforced the symptoms that had been combated, and were strongly criticized by the monetarist movement. Double-digit inflation makes Keynesian anti-crisis policies ineffective. For example, with an inflation rate of 13.5% in 1980 in France, the inflationary policy of President F. Mitterrand had disastrous effects on the competitiveness of French firms: it wiped out their margins, caused them to lose market share and finally penalized foreign trade. The fight against inflation became the main objective of monetarist policies. For Mr. Friedman, it is necessary to return to Phillips’ interpretation: it applies in a transitory way in the history of capitalism, when economic agents cannot predict or anticipate the rate of inflation. It is no longer a question of explaining inflation by the state of the labor market, but the opposite: it is the inflation anticipated by consumers that explains the tensions on the labor market; he shows that Keynesian recipes increase inflation through money creation without any effect on employment (because consumers anticipate it, consume less, which translates into a reduction in employment among producers). More inflation leads to more unemployment and, in an open economy, a decrease in the competitiveness of companies. The 1970’s crisis sheds light on how inflation works and to what extent the Phillips curve model can be applied to real-world situations. This useful to remember in a time when inflation is coming back for the first time in thirty years.

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021).

Throwback to the Karlsruhe vs ECB fight, one year ago

July 31, 2021 by Alexandre VERLET

Throwback to the Karlsruhe vs ECB fight, one year ago

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) explores the legal thriller of 2020, in which the opposition between German orthodoxy and the flexible monetary policy came to light.

On May 5th 2020, the Constitutional Court of Karlsruhe released a decision. It stated that the government debt purchase programme performed by the European Central Bank was not in line with the ECB’s mandate under the European treaties. This decision came at a critical time when the ECB implemented a second large-scale quantitative easing programme in response to the Covid-19 economic crisis. You might have just heard the story in the media, but such an event is a key element of 2020’s economic and financial news, as the future of the ECB and the quantitative easing programme are at stake here.

Which part of the ECB’s action is being criticised by the German constitutional court?

Basically, the quantitative easing programme and its public debt paybacks are being targeted in the legal decision. Let us recall what the ECB did exactly. On 22 January 2015, the European Central Bank announced the implementation of an Expanded Asset Purchase Programme (APP or EAPP). This programme provided for asset purchases amounting to €60 billion per month in the secondary market. It aims to provide monetary support to the economy at a time when the ECB’s key interest rates have reached their zero lower bound, by easing financing conditions for companies and households. Investment and consumption should ultimately contribute to a return of inflation to levels close to 2%, in line with the objective of the ECB’s mandate. It should be noted that this programme is distinct from the Outright Monetary Transactions (OMT) initiated in 2012, the primary objective of which is financial stability by reducing the cost of financing for euro area countries. On 4 March 2015, in the context of the EAPP, the ECB Governing Council established a substantial sub-programme of purchases of Member States’ securities, the Public Sector Purchase Programme (PSPP). The PSPP provides for each national central bank to purchase eligible securities from public issuers in its own country according to the capital key for the ECB’s capital subscription. This sub-programme is by far the largest component of the ECB’s unconventional quantitative easing (QE) policy, accounting for almost 84% of the ECB’s net purchases in July 2019, with the remainder split between the other three sub-programmes – the asset-backed securities purchase programme (ABSPP – 8%), the covered bond purchase programme (CBPP3 – 1%) and, since March 2016, the corporate sector purchase programme (CSPP – 7%). 90% of purchases under the CSPP are made in domestic sovereign bonds and 10% are allocated to supranational issuers (international organisations, development banks, etc.).

A highly political decision

The recent decision by the Constitutional Court in Karlsruhe echoes the case brought by German businessman Heinrich Weiss at the start of the PSPP in 2015, which accused the ECB of overstepping its mandate by financing eurozone states – particularly the less creditworthy ones. The Karlsruhe court referred the case to the Court of Justice of the European Union (CJEU) in 2017, which found that the PSPP did not infringe the ECB’s prerogatives. In its decision of 5 May 2020 , the Constitutional Court in Karlsruhe now considers itself competent to rule on the non-compliance of the ECB programme, to contradict the CJEU and to question the Bundesbank’s participation in the PSPP. There is a political significance to this decision, which reflects a real split between Germany and the ECB since the European sovereign debt crisis. The Karlsruhe decision should therefore be understood as the latest disagreement between the traditional German and ECB views, which have been increasingly diverging since 2011. Initially, the ECB’s structures were modelled on the Bundesbank, both in terms of its political independence and its hierarchical mandate. Price stability is the ECB’s primary objective, enshrined in Article 127 of the TEU. To achieve this, its strategy combines both quantitative monetary targeting – again a legacy of the Bundesbank – and inflation targeting. The TEU also provides that “without prejudice to the primary objective of price stability, the ESCB [European System of Central Banks] shall support the general policies in the Union”; the ECB’s mandate thus does not exclude the possibility of a policy whose secondary effects support the growth and employment objectives defined by the Member States. Indeed, the ECB’s bulletins and communiqués show that growth and employment are constant concerns, and the sovereign debt crisis and the arrival of Mario Draghi endorsed a broader interpretation of the ECB’s mandate.The growing divergence between the Bundesbank and the ECB was marked by the recurrent clashes between Mario Draghi, the new ECB head from 2011, and Jens Weidmann, who was appointed President of the Bundesbank in the same year. Jens Weidmann was appointed by Angela Merkel following the resignation of Axel Weber, who was known for his sharp criticism of the debt buyback programme for fragile eurozone states, which would have cost him the ECB presidency for which he was a candidate. Considered at the time of his nomination as less dogmatic than his predecessor, Jens Weidmann nevertheless continued the fight of his predecessor and systematically criticised the ECB’s debt buyback programmes. Shortly after Axel Weber’s resignation, Jürgen Stark, the ECB’s chief economist, had himself resigned in protest at the accommodating policy then being pursued by Jean-Claude Trichet, considering that “a fiscal stimulus would only increase the level of debt and therefore only increase these risks”.

What could explain the German exception?

Germany is the Euro Zone’s most powerful member, so it is one of the few countries that can actually rebel agains the ECB. But France never did, so there is a clearly a German exception linked to Germany’s economic culture and financial history. When the ECB announced the resumption of quantitative easing on 12 September 2019, the dissension became even stronger. Sabine Lautenschläger, one of the six members of the ECB’s Executive Board, resigned shortly after Christine Lagarde, recently appointed as successor to Mario Draghi, indicated that she wanted to continue her predecessor’s policy. In an interview with the German tabloid Bild in September 2019, the Bundesbank President openly criticised the resumption of quantitative easing; the article in question was also made famous by its illustration depicting Mario Draghi as Count Dracula ready to “suck the blood of German savers”. Interestingly, concern about the adverse effects of lower rates on savers is a constant in German concerns, as is the sovereign debt of fragile eurozone states. German households save on average more than 18% of their income in 2019, one of the highest rates in Europe. From 2015 to 2020, the real interest rate was -0.9% in the eurozone, which may explain German dissatisfaction with the negative rate effects partly caused by quantitative easing. German public opinion was therefore unfavourable to the resumption of the programme in September 2019. In addition to this, there were some high-profile decisions, such as the Munich Savings Bank, which at the same time decided to pass on these negative rates to some of its customers’ deposits. It is therefore these concerns combined with the trauma of the sovereign debt crisis that have pushed German opinion towards support for a more orthodox monetary policy, which the Karlsruhe ruling has materialised, and all the more so after the announcement of the large-scale €750bn Pandemic Emergency Purchase Programme on 18 March 2020 by the ECB.

Is Karlsruhe right about the ECB not respecting its mandates?

Through the PSPP, the ECB fulfills its second objective of supporting Member States’ economic policies by enabling convergence of inflation rates but also convergence of the long-term interest rates of the euro area Member States and a more sustainable public debt path than in the absence of the PSPP (see above): in short, the fulfillment of the convergence criteria. In particular, the PSPP has led to a significant reduction in Member States’ sovereign bond yield spreads (see sovereign bond yield spreads graph): the standard deviation of different sovereign bond interest rates has fallen from almost 5% in 2015 (and 3% in 2016) to 1% in 2018 and 2019. So the ECB’s action via the PSPP and the PEPP seems today to live up to expectations from an economic point of view. Nevertheless, Karlsruhe considers that there is a potential violation of European treaties because the ECB and the European court of justice – which approved the PSPP in December 2018 – did not provide evidence that proportionality had been duly considered. Karlsruhe cites easier financing conditions for member states or the banking system, and ‘penalizing’ savers, but the court seems to ignore that the PSPP’s effects are not any different from those of other ECB instruments. Either the PSPP does not violate the proportionality principle, or all ECB instruments do. What’s more, if for instance, in considering an interest rate rise to counter inflationary pressures, the ECB found this would produce losses for bondholder or increase unemployment, then the ECB’s would be considering objectives that are explicitly out of its mandate. What the German court reproaches the ECB is rather paradoxical and the economic basis of the legal decision is weak , but it definitely show that there is a need for a redefinition of the ECB’s mandate. It could become a non-hierarchical dual mandate, more similar to the US Federal Reserve model. The ECB would thus have a clear function of pursuing a price stability objective combined with a full employment objective. The mandate could be materialized not by the definition of a monetary target, the evolution of the monetary aggregate M3 and inflation, as it currently is, but by the establishment of an implicit nominal anchor on the so-called “neutral” rate theoretically allowing the euro area to reach its potential growth. Nevertheless, such evolution of the ECB’s mandate will have to wait until the end of the Covid-19 crisis, and nothing has prevented the Bundesbank from implementing the ECB’s policy since Karlsruhe released its decision one year ago. Adding to that, the possible return of inflation might jeopardize the sustainability of further quantitative easing programmes. To be continued..

About the author

Article written in July 2021 by Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021).

Women in Finance

May 17, 2021 by Alexandre VERLET

Women in Finance

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) explores the potential causes and solutions of women’s underrepresentation in the financial sector.

It is no secret to anyone that women are largely underrepresented in the world of finance. It might not sound really surprising to anyone, since a woman in France still had to obtain her husband’s permission to open a bank account and exercise a profession less than 60 years ago- and yet France is doing relatively well in terms of gender parity in finance compared to other countries. What is astonishing, however, is to observe how slowly the financial sector has been opening up to women compared to the progress of gender equality in society. While many sectors are running late, especially when it comes to gender quality in highly ranked positions, finance is losing the race to parity by far.

The difficulty to consider the financial industry as a whole

It would not make sense to simply set as a target a 50% parity in the financial sector, because it would not prevent strong inequalities to remain. For instance, a survey conducted by the French Association of Financial Management found that women accounted for a third of the workforce overall, which is a rather low number but does not adequately reflect the issue that the financial industry has with women. Indeed, most women in those number work in internal control, compliance and communication, positions which are essential to the functioning of the financial industry but are not at the core of the finance activity, where jobs are usually more highly regarded and salaries much higher. When looking at firms that encompass mostly “core” finance jobs, the figures are incredibly low: hedge funds, venture capital and private equity funds, respectively 11%, 9% and 6% occupy senior positions.

What are the specific reasons for women’s underrepresentation in finance?

There are several reasons that could explain why finance is so robust to parity. A key aspect of the issue that can be easily quantified is the lack of women with quantitative backgrounds, an essential qualification for financial jobs, which makes parity mathematically impossible as there are just not enough women applying to finance positions. The trend is definitely not going in the sense of parity since the number of women majoring in finance is decreasing in the US, and surveys show that less than half of women in finance are satisfied with their careers. Nevertheless, the latter should not obscure the fact that it is not all about getting: a study from McKinsey found that while parity was close to being respected in the business degrees of the most prestigious American universities and at entry level in the major banks, only 19% of women occupied positions of power: something must definitely be happening in-between. Both self-censorship and stereotypes are probably part of the equation, as well as some form of “path dependency” where women might be reluctant to set foot in positions overwhelmingly masculine. The same could be said of many sectors, but the fact that finance is a restricted club in many ways probably emphasized the aforementioned reasons.

What can be done to promote women in finance?

According to PWC, gender equality in finance senior positions will not happen before 2085. Surely, some things have to be done to speed it up. There is a growing research consensus pointing to the fact that diverse board of directors take better decisions than less diverse ones. Christine Lagarde, ECB president even said that if “Lehman Brothers had been Lehman Sisters, the world might well look a lot different today”. She recently insisted on the importance of quotas to counter self-censorship from women, saying that all along her career as a leader, she saw hundreds of young men come to ask for pay raise but hardly ever any women. Quotas are not always an efficient measure when it comes to diversity, but one might argue that a club as sclerotic as top finance positions need strong and immediate change. Regarding self-censorship or the lack of self-confidence, many organizations like 100 women in finance or WIBF try to promote successful women in finance, and Girls Who Invest even offers a summer program to intensively train women for finance interviews at different levels.

On the long run, promoting girls in quantitative degrees is essential, but it is a much bigger issue than just that of women in finance, as research suggest that the gender inequality in maths results is the product of a social phenomenon that roots back to secondary school.

To conclude, I strongly encourage women interested in finance and reading those lines to attend the numerous events “Women at [insert investment bank]”, which are tailored to tackle the problems mentioned in this article.

Useful resources

Academic research

Adams R.B and V. Ragunathan (2017) Lehman Sisters Working paper.

Longin F. and E. Santacreu-Vasut (2019) Is Gender in the Pocket of Investors? Identifying Gender Bias Towards CEOs with a Lab Experiment ESSEC Working paper.

Websites

Longin F. and E. Santacreu-Vasut Gender & Finance

About the author

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

Understanding financial derivatives: futures

May 17, 2021 by Alexandre VERLET

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

Where do futures come from and how are they different from forwards?

Sometimes, derivatives get so complex that finance can seem quite disconnected from real-world economics. Nevertheless, futures were originally introduced for a very practical reason: for farmers to hedge against their crops’ price volatility. Research suggests that the first know examples of futures contracts dates back to the 1700’s in Osaka, Japan. Rice was widely used as a currency – even the Samurai warriors were paid in rice, but with no central control whatsoever. Imagine a currency with no central bank to control it, and whose quantity in circulation is also vulnerable to bad harvests. Growing pressure the Samurai class, whose relative income had dropped compared to the merchant class, led to the creation of the Dojima Rice Exchange, the first trading market for futures in history.
That allows us to introduce what futures are, and how they are different from forwards. A futures contract is defined as a firm commitment between two counterparties to buy or sell a specific quantity of an asset (the underlying) on a given date (the maturity date) and at a price agreed in advance. Wait, isn’t it the exact same definition as a forward contract?
Yes, but forwards are traded OTC (over-the-counter), while futures are only traded on organised markets, usually futures exchanges. That is the only actual difference, but this difference leads to others. Organised markets are structured in such a way as to optimise their operation as much as possible and to increase liquidity. This is achieved through standardisation. As we have seen, the maturities of futures contracts are standardised. By grouping the end dates of contracts at a few annual dates, the exchanges ensure a large volume of trading at these precise times, thus increasing the probability that each participant will find a counterparty. The problem of liquidity does not really arise for forwards, because the counterparty is known in advance. As a result, the maturity dates of forwards are much more flexible, as the two participants can make arrangements as they see fit. In the case of forwards, the credit risk depends on the financial strength of the counterparty. Another fundamental feature of organised markets is the use of a clearing house. It serves as a counterparty to the holders of futures contracts. This system also makes it possible to eliminate, or at least limit, the credit risk In the case of forwards, the credit risk depends on the financial strength of the counterparty. Since futures contracts were key in the emergence of organised markets and clearing houses, you will find a more detailed explanation of what clearing houses actually do at the end of this article.

What is being traded?

The main category of futures contracts are by far interest rate futures, followed by index futures, currency futures and commodities futures. Commodities futures were the only type of future from the 18th century to the 1970’s, with the gold futures and the oil futures as the star products. Inside those markets, some products are much more popular than others: the most traded futures are S&P 500 futures, 10 years Treasury notes and crude oil futures. Let us zoom on index futures to understand the actual difference between forwards and futures. Index forwards basically do not exist, while index futures are way more popular than equity futures. Stock market indices have been considered by investors as the barometers of the markets, as they are composed of a set of stocks, usually the largest capitalisations in a market. However, indices have a disadvantage in that they cannot be bought directly. It is true that indices were designed more as indicators than as assets to be traded. Theoretically, it is possible to buy an index by building up a portfolio with all the stocks in the index in question as components. However, this is not practical, if only because of the prohibitive brokerage fees involved. The alternative is to buy an index fund, or Index Tracker, or ETF (Exchange-Traded Fund). An index fund is an investment fund that tracks the performance of a stock market index. In the world of futures, buying an index futures contract is as simple as buying a stock futures contract. This is possible because of the nature of futures. As we have seen, when trading a futures contract, it is not necessary to own the underlying asset, as only the gain (or loss) in value is traded. Knowing that this gain or loss is itself a function of the rise or fall of the underlying asset, it is understandable that it is as easy to design index futures as it is to design stock futures. In fact, it is more even more convenient for an investor to buy an index futures contract than to buy a stock futures contract. Since the CME8 introduced the first S&P 500 Index futures contract in 1982, index futures have been a success. Even today, S&P 500 futures are the most widely traded futures contract in the world, although futures contracts exist for most of the known indices.. The popularity of index futures contracts has resulted in increased volumes and therefore liquidity of these contracts, which would be impossible in the case of index forwards.

Futures and organized markets

But let’s go back to the history of futures, which is crucial to understand how financial markets are organised today. It was in the United States that a new page in the history of futures was written after the Dojima Rice Exchange. The country gained its independence in 1776 and from then on experienced exceptional growth, driven in particular by a very dynamic agricultural sector. In this context, one city in particular stood out: Chicago. The city was strategically located in the heart of the Great Lakes region, known as the “breadbasket of America”. Chicago quickly became the epicentre of the raw materials trade in the United States. It was with this in mind that the Chicago Board of Trade (CBOT) was created in 1848. This exchange was created in particular to facilitate and secure the exchange of futures contracts. It was the first exchange of its kind in the world, but it would not be the last. Fifty years later, the forerunner of what would become the Chicago Mercantile Exchange (CME) in 1919 was founded. New York was not to be outdone, as in 1882 the New York Mercantile Exchange (NYMEX) also opened its doors. These three exchanges (CBOT, CME and NYMEX) are now combined into a single entity within the CME Group. In Europe, the futures market will initially be organised around three strong centres. The London International Financial Futures and Options Exchange (LIFFE), Eurex and Euronext. Eurex is the result of the merger of the Deutsche Terminbörse (DTB) and the Swiss Options and Financial Futures Exchange (SOFFEX). Euronext is the result of the merger of the French, Dutch, Belgian and Portuguese stock exchanges. But the merger/acquisition phenomenon did not stop there. In 2006, the New York Stock Exchange (NYSE) absorbed Euronext, followed by LIFFE a year later. The combination will give rise to NYSE Euronext, which will itself be acquired in December 2012 by the Intercontinental Exchange (ICE). In the rest of the world, the main exchanges are the Tokyo Financial Exchange (TFX) in Japan and the Bolsa de Valores, Mercadorias & Futuros BOVESPA (BM&FBOVESPA) in São Paulo, Brazil.

Going deeper into the clearing house system

Basically, a clearing house is a financial entity whose objective is to eliminate counterparty risk. It is the buyer of all sellers and the seller of all buyers. Its role is to manage the different positions of its clients. It also determines the amount of the security deposit and triggers margin calls. In detail, a clearing house has four main roles: single counterparty, position management, risk management and delivery of the underlying. The single counterparty is achieved by acting as a substitute for the buyer and seller to guarantee the successful completion of transactions. If our counterparty defaults, we still get paid, since in this system our real counterparty is the clearing house. The position management means the clearing house receives and records all transactions. It also makes sure that there is a seller opposite each buyer. This is called reconciliation. It generates a confirmation for each transaction. It also calculates the balance of each open position. In addition, it ensures that the risk management system works properly. The Risk management role is when the clearing house asks its members to pay a deposit for each position, the amount of which it determines unilaterally. It also determines the limit of the maintenance margin, the threshold at which the margin call is triggered. This margin call makes it possible to reconstitute the margin deposit. However, in extreme cases, these arrangements may be insufficient to cover the losses of an insolvent counterparty. To mitigate this type of situation, the clearing house has an additional guarantee fund. This fund is paid for by the clearing house’s clients and is usually pooled with other funds. In addition, the clearing house has an additional guarantee fund to compensate for this type of situation. Lastly, the delivery of the underlying: in principle, a clearing house does not directly manage delivery. However, it is the clearing house that gives the order to the central depository to carry out the settlement or delivery, once it has ensured that each of the counterparties got his products or cash. This brings us to another link in the chain: the central depository. A confusion is generally made between clearing houses and central depositories. In Europe, LCH Clearnet is the main clearing house. It was formed in 2003 from the merger between the main British clearing house, The London Clearing House, and the main French clearing house, Clearnet. In contrast, Euroclear or Clearstream are International Central Securities Depositories, or ICSDs. Euroclear, originally created by the bank J.-P. Morgan & Co, is very active in most European countries. In order to limit Euroclear’s monopoly on the European custody market, Germany decided in 1971 to create an institution known today as Clearstream.

To conclude, futures and forwards are very similar in some ways, but the fact that futures are only traded on organised markets changes many things, especially since it is the futures themselves that made necessary the creation of financial markets as we know them.

About the author

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

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).

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).

The GameStop saga

April 24, 2021 by Alexandre VERLET

The GameStop saga

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains the GameStop saga. Why does the app “Robinhood” bears its name so well? Did hedge funds actually kneeled down before a bunch of Reddit users? What is a short squeeze? Let’s find out!

Speculation on GameStop

For some, it is a massive collusion that dangerously overvalued a firm, for others, forum users beat the greedy Wall Street hedge funds at their own game and allowed millions of ordinary millennials to make money. GameStop, which is now being referred to as the MOASS (the Mother of All Short Squeezes), is a financial drama that challenged Wall Street players and public regulators and a premise of the major shifts that amateur investing will impose upon financial markets. It all started on the Reddit forum called “WallStreetBets” in early January 2021, where amateur investors were merely sharing hinches and posting memes about their latest profits or losses. It became much more than that the day some users started to take personally the short selling of GameStop, a video games firm that had been a part of their teenage years and that they considered seriously undervalued. That was the spark that triggered a massive buy trend on the GameStop stock, to both support GameStop and to make money out of the big funds that seemed to always win on the markets. Then, a speculation bubble grew as the media started to report what was happening, amateur investors betting that millions of others would join the party, making money out of it and beating the hedge funds at their own game. The GameStop share rose from around $20 in early January to $480 in late January, a 2,300% increase that caused the short-selling hedge funds in what is known as a short squeeze position.

Figure 1. GameStop share price.

Source: Source: Google Finance.

Short selling

In order to understand what a short squeeze is, you must first get familiar with the concept of shorting. The simplest definition of shorting a stock would be to bet against that stock, meaning that one anticipates the stock price will drop at some point and wishes to make a profit out of that fall. Usually, an investor can either buy or sell a stock to respectively bet it will go up or down, but selling a stock implies the investor owns that stock. Although that sounds rather obvious, selling without owning a stock at all is actually possible – it is known as a “naked short”-, but it is theoretically illegal to do so in the USA. What investors do when they want to bet against a stock but do not own it, which is by far the most common case, is to place a “covered short”, meaning they borrow the stock from a broker in exchange for a commission, sell it for its current market price at time t, and buy it later once the price has fallen, say, at t+1. The current market price at time t minus the market price at time t+1 minus the broker’s commission is the investor’s profit. That is what happens when the investor is right. When he or she is wrong, things get trickier. Investing on financial markets is by definition risky, but buying shares only exposes the investor to lose the money invested. On the other hand, short-selling exposes to a loss that is theoretically limitless: a share price is bounded by 0 for a caller, but could rise to levels that could send the short seller to bankruptcy. That is what the short squeeze is all about: if the share price at time t+1 is much higher than at time t, buying the shares would mean a massive loss for the investor.

Now, the obvious question would be: why on earth would an investor sell at time t+1 and expose himself to massive losses, and not just wait for the share price to go down later? The first reason is that the investor pays fees to the broker that work like an adjustable interest rate, meaning the price rise will also drive the brokers fees up to the point that the investor might lose big, especially if he or she has to wait long enough for the price to go back to its selling price (and even lower than that to compensate the broker’s fees paid in-between). Second, the regulator, in our case the clearing house, ensures the solvability of investors by demanding they either refund their margin account or liquidate assets to make sure they are able to face their financial obligations towards the broker – this process is known as a “margin call”. The short squeeze happens when the investor is forced to buy back the shares he borrowed and sold initially, at a price that is much higher, which further drives the share price up in the case of a big investor.

In the case of GameStop, the short sellers were indeed big investors, with at least the two hedge funds Melvin Capital and Citron Capital short squeezed only a couple of weeks after the frenzy began. Since those investors short sold the stocks for around 20$, you can easily imagine that being forced to sell around 350$ costed huge amounts of money to those firms- up to $5 billion. What is brand new about GameStop, is the fact that the short squeeze was orchestrated by a group of amateur investors with no connections in Wall Street and using a public internet forum. The fact that it happened in 2021 is not so random. In recent years, social networks laid the ground for collusion at large scale, “free” trading apps such as Robinhood made investing as easy as a game, and the lockdowns imposed in 2020 boosted amateur investing activity. Considering the dreadful reputation of hedge funds, particularly since the 2008 crisis, such news was welcomed with much enthusiasm on the internet and beyond.

Political issues and future challenge for regulators

Consequently, when GameStop trading was frozen on the investing apps, the issue became political: “People on Wall Street only care about the rules when they’re the ones getting hurt. It’s time for SEC and Congress to make the economy work for everyone” said US Senator Sherrod Brown (Chairman of the Senate Banking Committee). Investor populism gained support on both sides of the political scene, as exemplified by the similar positions held by the Democrat AOC and the Republican Ted Cruz in favor of the amateur investors. Unfortunately, the reality is more complex than just GameStop being a victory for the democratization of finance where the mob overthrows the big players who run Wall Street. The SEC is currently investigating where the profits of the short squeeze went, and ironically a significant part of it might have been generated by innovative hedge funds who anticipated the trends by tracking forums and app data. Therefore, if financial markets keep attracting amateur investors people in the coming years, and they most likely will, a huge challenge awaits financial regulators. Meanwhile, AMC and Blackberry’s shares have been the next targets of the Reddit traders, and there is no doubt that the MOASS will engender many more financial dramas. To be continued…

GameStop – Power to the players GameStop - Power to the players

Source: GameStop

Useful resources

WallStreetBets

Robinhood

GameStop (GME) (Yahoo Finance)

About the author

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

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