Why do companies issue debt?

Why do companies issue debt?

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) provides insights into why companies issue bonds.

A company can finance its activities in different ways: by internal financing (self-financing) and by external financing comprising debt and equity. Often, internal funds are not sufficient. The company must therefore make a choice between raising debt and raising equity. So, it is necessary to ask what might lead a company to prefer one over the other.

The advantages of debt over equity for a company

Debt is often preferred to equity because it is structurally less costly for the following reasons:

– The interest on the debt is tax deductible. The debt therefore costs the interest minus the tax savings (assuming that the company makes profit and pays taxes…).

– Investing in stocks is riskier than investing in bonds because of a number of factors. For instance, the stock market has a higher volatility of returns than the bond market, capital gains are not a guarantee, dividends are discretionary, stockholders have a lower claim on company assets in case of company default. Therefore, investor expect higher returns to compensate it for the additional risk.  Thus, for the company, financing itself through debt will be less expensive than through equity.

– The remuneration of the debt is not strictly proportional to the increase of the risk taken by the company, because there are multiple ways for lenders to take guarantees: leasing, mortgage….

Debt has other advantages over equity:

Debt can be used to gain leverage. It provides a leverage effect for shareholders who contribute only part of the sums mobilized in the investment. This effect is all the more important when the interest rate at which the debt is subscribed is low and the economic profitability of the investment is high.

Raising equity dilutes ownership of existing stockholders. When a company sells equity, it gives up ownership of its business. This has both financial and day-to-day operational implications for the business. Debt does not imply such a dilution effect.

There is a practical benefit for using debt. Issuing debt is easier than issuing equity in practice.

Finally, the terms of repayment of principal and interest payments are known in advance. This allows companies to anticipate future expenses.

The disadvantages of debt over equity

First, unlike equity, debt must be repaid at some point. This is because equity financing is like taking a share in the company in exchange for cash. Thus, where cash outflows are required to pay interest on debt and repay principal, this is not useful for equity.

Moreover, in equity financing, the risk is carried by the stockholders. If the company fails, they will lose their stake in the company. In contrast, in debt financing, creditors often require assets to be secured. Thus, if the company goes bankrupt, they can take the collateral.

Finally, the debt capacity of a company is limited. Indeed, the more debt a company takes on, the higher the risk of default. Thus, creditors will ask an already highly leveraged company for higher interest rates to compensate for the risk they are taking. Conversely, equity financing allows companies to improve their capital structure, and thus present better debt ratios to investors.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY The rise in corporate debt

   ▶ Rodolphe CHOLLAT-NAMY Corporate debt

   ▶ Louis DETALLE A quick review of the DCM (Debt Capital Market) analyst’s job…

About the author

Article written in June 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Credit Rating Agencies

Credit Rating Agencies

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains how credit rating agencies work.

What are Credit Rating Agencies?

Credit Rating Agencies are private companies whose main activity is to evaluate the capacity of debt issuers to meet their financial commitments. The historical agencies (Moody’s, Standard & Poor’s and Fitch Ratings) hold about 85% of the market. But national competitors have emerged over the years, such as Dagong Global Credit Rating in China. Nonetheless, there is little competition in this market as the barriers to entry are very high. The rating agencies’ business model is based on remuneration paid by the rated entities, consulting activities, and the dissemination of rating-related data.

The rating gives an opinion (in the form of a grade) on the ability of an issuer to meet its obligations to its creditors, or of a security to generate the capital and interest payments in accordance with the planned schedule. The rated entities are therefore potentially all financial or non-financial agents issuing debt: governments, public or semi-public bodies, financial institutions, non-financial companies. The rating may also relate not to an issuer in general, but to a security.

S&P, Moody’s, and Fitch rating scales S&P, Moody's, and Fitch rating scales
Source: internet.

Rating agencies are key players in the markets. Indeed, ratings are widely used in the regulatory framework on the one hand, and also in the strategies of many investors. For instance, to be eligible for central bank refinancing operations, securities must have a minimum rating. Similarly, the management objectives of many investors are based on ratings: for example, a mutual fund may have as one of its objectives to hold 80% of assets issued by issuers rated at least “BBB”. Credit risk monitoring indicators in corporate and investment banks are also based on ratings.

Credit Rating Agencies: judges & parties during the subprime crisis?

Rating agencies played a crucial role in securitization (“titrisation” in French), a financial technique that transforms rather illiquid assets, such as real-estate loans, into easily tradable securities. The agencies rate both the securitized credit packages and the bonds issued as counterparts according to the different risk levels.

The securitization technique appeared in the 70’ in the US, and allowed banks to grant more loans. During the 1990’ and 2000’, banks used securitization as a way to remove from their balance sheet the loans they granted. Indeed, banks would package loans in vehicles labelled as “Asset Backed Securities” (securities which the collateral is an asset). Banks would then sell these securities, or sell the risk associated with these securities. In the case of subprimes, the loans were packaged inside vehicles called “Mortgage Backed Securities”, as these securities had as counterpart the mortgage loans. There was a shift from the previous “originate-to-hold” bank model (where banks originated the loans and kept them in their balance sheet) to the new “originate-to-distribute” model (where banks originated the loans and then took them out of their balance sheet).

Michel Aglietta explains that in the case of securitized loans (such as MBS), the rating agencies rate and are at the same time stakeholders in the securitization. Indeed, the constitution of the product and the rating are completely intertwined. “Without the rating, the security has no existence”. The investment banks that structure and market the product and the agencies work together to determine the specificities of each loan packages or “pools” and obtain the desired rating.

It is now recognized that rating agencies often overrated the securitized packages compared to the intrinsic risk they were carrying. By granting high grades to many securitized packages (the highest being AAA), they have contributed to the formation of a speculative bubble. In addition, when the housing market collapsed, the rating agencies reacted too late and downgraded MBS abruptly, which inevitably worsened the crisis. For example, 93% of the MBS rated AAA marketed in 2006 had their grade scaled down to “junk bond” ratings (BB+/Ba1 and below) later on.

Rating agencies have been accused of conflict of interest, as they are paid by those they rate. The emails revealed by the US Senate Investigations Subcommittee in April 2010 during its work on the Goldman Sachs affair reveal a system in which the marketing teams of structured products of investment banks tended to choose the agency most inclined to give the most favorable rating. Furthermore, the Senate subcommittee found that rating decisions were often subject to concerns about losing market share to competitors.

Key concepts

Mortgage loan

A mortgage loan has the specificity of putting the purchase property (a house for instance) as the counterpart of a loan. In the case of a payment default, the property is seized.

Related posts on the SimTrade blog

▶ Jayati WALIA Quantitative Risk Management

▶ Jayati WALIA Credit risk

▶ Rodolphe CHOLLAT-NAMY Credit analyst

▶ Jayati WALIA My experience as a credit analyst at Amundi Asset Management

Useful resources

La Finance pour Tous

Aglietta M. (2009) La crise : Pourquoi en est arrivé là ? Michalon Editions.

Ministère de l’Economie et des Finances Quel rôle ont joué les agences de notation dans la crise des subprimes ?

Marian Wang (2010) Banks Pressured Credit Agencies, Then Blamed Them Later on Blog.

About the author

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

The Internal Rate of Return

The Internal Rate of Return

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) explains the financial concept of internal rate of return (IRR).

What is the Internal Rate of Return?

The Internal Rate of Return (IRR or “TRI” – “taux de rendement interne” in French) of a sequence of cash flows is the discount rate that makes the Net Present Value (NPV or “VNP” or “VAN” for “valeur nette présente” or “valeur actuelle nette” in French) of this sequence of cash flows equal to zero.

Screenshot 2021-05-31 at 21.59.49

In order to calculate the IRR, two methods can be used. First of all, use the Excel “IRR” formula on the sequence of cash flows, which will automatically display an approximate value for the IRR. Nonetheless, if Excel is not available for performing the IRR calculation, you can use the dichotomy method (which is indeed used by Excel). The dichotomy method uses several iterations to determine an approximation of the IRR. The more iterations are performed, the more accurate the final IRR output is. For each iteration, the table below assesses whether the NPV using the “Average” discount rate is positive or negative. If it is negative (resp. positive), it means the IRR is somewhere in between the “Lower bound” (resp. “Upper bound” and the “Average”) and the next iteration will thus keep the same “Lower bound” (resp. use the “Average” as the new lower bound) and use the “Average” as the new “Upper bound” (resp. keep the same “Upper bound”). After 10 iterations, the table displays an IRR of 18,457%, which is an approximation to the nearest hundredth of the 18,450% IRR calculated with the Excel formula.

Screenshot 2021-05-31 at 22.08.50

The IRR criterion

In the same way as the NPV, the IRR can be used to evaluate the financial performance of:
A tangible investment: the IRR criterion can be used to evaluate which investment project will be the most profitable. For instance, if a firm hesitating between Project A (buying a new machine), Project B (upgrading the existing machine) and Project C (outsourcing a fraction of the production), the firm can calculate the IRR of each project and compare them.
A financial investment: whether it is a bank investment or a private equity investment (purchase of a company) the IRR criterion can be used to sort different projects according to their financial performance.

Disaggregating the IRR

Investors and especially Private Equity firms often rely on the IRR as one measure of a project’s yield. Projects with the highest IRRs are considered the most attractive. The performance of Private Equity funds is also measured through the IRR criterion. In other words, PE firms use the IRR to select the most profitable projects and investors look at the IRR of PE funds when choosing to which PE firms’ fundraising campaign, they will participate in.

Nonetheless, IRR is the most important performance benchmark for PE investments, the IRR does not go into detail. Indeed, disaggregating the IRR can help better understand which are the different components of the IRR:

  • Unlevered IRR components:
    • Baseline return: the cash flows that the acquired business was expected to generate without any improvements after acquisition.
    • Business performance: value creation through growth by improving the business performance, margin increase and capital efficiency improvements.
    • Strategic repositioning: value creation through by increasing the opportunity for future growth and returns (innovation, market entries etc.).
  • Leveraged IRR: PE investments heavily rely on high amounts or debt funding (hence the wide use of Leverage Buy-Out or LBO). Debt funding allows to resort to less equity funding, thus mechanically increasing the IRR of the investment.

Each of these components can have different proportions in the IRR. As an example, we can consider two PE funds A and B displaying the same IRR of 30%. After disaggregating each fund’s IRR, we come up with the following table, showing the weight of each IRR component in the total IRR (or “Levered IRR”). From this table, we understand that Fund A and Fund B have very different strategies. Fund A focuses in its PE operations on improving the business performance and carrying out strategic repositioning’s. Only 23% of the total IRR comes from financial engineering. In contrast, Fund B draws most of its performance from financial engineering, while only 23% of the total IRR comes from the unlevered IRR.

Screenshot 2021-05-31 at 22.09.00

Through this example we understand that PE funds and firms can have very different strategies, while disclosing the same IRR. Thus, disaggregating the IRR can reveal the positioning of PE funds. Finally, disaggregating the IRR also allows to assess whether PE funds are true to the strategy they display: for instance, a fund can be specialized in strategic repositioning and business performance improvements on the paper, but drawing most of its value creation through financial engineering.

Related posts on the SimTrade blog

   ▶ Jérémy PAULEN The IRR function in Excel

   ▶ Léopoldine FOUQUES The IRR, XIRR and MIRR functions in Excel

   ▶ William LONGIN How to compute the present value of an asset?

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

   ▶ Sébastien PIAT Simple interest rate and compound interest rate

Useful resources

Prof. Longin’s website Calcul de la VNP et du TRI d’une séquence de flux (in French)

Prof. Longin’s website Méthode de dichotomie pour le calcul du TRI (in French)

McKinsey A better way to understand internal rate of return

About the author

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

Corporate debt

Corporate debt

Rodolphe Chollat-Namy

In this article, Rodolphe Chollat-Namy (ESSEC Business School, Grande Ecole – Master in Management, 2019-2023) introduces you to corporate debt.

Investors seek to determine how the different characteristics of a bond can influence its intrinsic value in order to know whether it is a good investment or not. To do this, they will look at the theoretical value of a bond, i.e. its present value. How can this be determined? How to interpret it?

Composition of a company’s debt

The debt of a company is composed of short-term liabilities and of long-term liabilities.

Short-term liabilities: accounts payable, deferred revenues, wages payable, short-term notes, current portion of long-term debt.

Long-term liabilities: Bonds payable, capital leases, long-term loans, pension liabilities, deferred compensation, deferred income taxes.

Let us have a look to the long-term liabilities:

  • Bonds payable: A bond payable is a form of long-term debt issued by the company.
  • Capital leases: A capital lease is a contract entitling a renter to the temporary use of an asset.
  • Long-term loans:  A long-term loan involve borrowing money over a specified period with a pre-planned payment schedule.
  • Pension liabilities: A pension liability is the difference between the total amount due to retirees and the actual amount of money the company has on hand to make those payments.
  • Deferred compensation: Deferred compensation is an arrangement in which a portion of an employee’s income is paid out at a later date after which the income was earned.
  • Deferred income taxes: Deferred income taxes result from a difference in income recognition between tax laws and the company’s accounting methods.

When looking at a company’s debt, analysts often look at net debt. It is equal to the sum of the short-term liabilities and of the long-term liabilities minus the cash and the cash equivalents, that are liquid investments with a maturity of 90 days (certificates of deposit, treasury bills, commercial paper, …). It is a metric that measures a company’s ability to bay all its debts if they were due today.

 

For example, assume that a company has a line of credit of $5,000, a current portion of long-term debt of $25,000, a $60,000 long-term bank loan, and $40,000 in bonds. Moreover it has $10,000 in cash and $5,000 in Treasury bills.

The short-term debt would be equal to $5,000 + $25,000 = $30,000

The long-term debt would be equal to $60,000 + $40,000 = $100,000

And the cash and cash equivalents would be equal to $10,000 + $5,000 = 15,000

So the net debt of the company would be equal to $115,000.

Debt Ratios

Nevertheless, an absolute value will not give us much indication of the health of the company. In order to understand the company’s indebtedness, we need to compare the amount of debt with other metrics. To do this, we will use what are called ratios.

We will focus here on three important ratios: the debt-to-equity ratio, the EBIT-to-interest expenses ratio and the debt-to-EBITDA ratio.

Debt-to-equity ratio (D/E)

The D/E ratio, also known as gearing, is a ratio that measures the level of debt of a company in relation to its equity. Simply put, it tells us about the financial structure of the company.

Capture d’écran 2021-05-30 171132

Changes in long-term liabilities have more influence on the D/E ratio than changes in short-term liabilities. Thus, investors will use other ratios if they want information on short-term liabilities.

The higher the ratio, the more indebted the company is. The risk is therefore higher. Between 0 and 0.1, the ratio is theoretically excellent. Above 1, the ratio is theoretically bad.

Beware, this ratio has its limitations. First of all, the reading of this ratio depends on the industries. Capital intensive industries, such as TMT or oil and gas, will tend to have higher ratios. It is therefore necessary to compare the ratios of companies in the same sector. On the other hand, a low D/E ratio can also mean that a company is afraid to invest. In the long run, this can present a risk of downgrading compared to its competitors.

It is therefore important to keep in mind, and this is also true for other ratios, that it is one indicator among others and that it cannot be perfect. It is important to put it into context and to compare comparable companies.

Interest Coverage ratio (ICR)

The ICR is the ratio of financial expenses to operating income. It measures a company’s ability to pay the interest on its debt.

Capture d’écran 2021-05-30 171146

A low ICR means that less profit is available for interest payments and that the company is more vulnerable to rising interest rates.

Usually, the ICR is considered low when it is below 3. However, it varies according to the type of industry. On the other hand, we can also look at the trends that are emerging. A falling ICR is worrying for investors.

Debt-to-EBIDTA ratio

This ratio measures the company’s ability to repay its debt with the money generated by its activity. It tells us how many years of profit it would take to pay off the entire debt. It is often referred to as leverage.

Capture d’écran 2021-05-30 171157

Analysts often use this ratio, which is easy to calculate. The lower the ratio, the healthier the company. A good ratio is between 2 and 4. However, again, it depends on the industry.

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY Why do companies issue debt?

   ▶ Rodolphe CHOLLAT-NAMY Corporate debt

   ▶ Louis DETALLE A quick review of the DCM (Debt Capital Market) analyst’s job…

About the author

Article written in May 2021 by Rodolphe Chollat-Namy (ESSEC Business School, Grande Ecole – Master in Management, 2019-2023).

Bond risks

Bond risks

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond risks.

Holding bonds exposes you to fluctuations in its price, both up and down. Nevertheless, bonds offer the guarantee of a coupon regularly paid during for a fixed period. Investing in bonds has long been considered one of the safest investments, especially if the securities are held to maturity. Nevertheless, a number of risks exist. What are these risks? How are they defined?

Default risk

Default risk is the risk that a company, local authority or government fails to pay the coupons or repay the face value of the bonds they issued. This risk can be low, moderate or high. It depends on the quality of the issuer.

For a given product, the default risk is mainly measured by rating agencies. Three agencies share 95% of the world’s rating requests. Moody’s and Standard & Poor’s (S&P) each hold 40% of the market, and Fitch Ratings 14%. The highest rated bonds (from Aaa to Baa3 at Moody’s and from AAA to BBB- at S&P and Fitch) are investment-grade bonds. The lowest rated bonds (Ba1 to Caa3 at Moody’s and BB+ to D at S&P and Fitch) are high yield bonds, otherwise known as junk bonds.

It should be noted that the opinions produced by an agency are advisory and indicative. Moreover, some criticisms have emerged. As agencies rate their clients, questions may be asked about their independence and therefore their impartiality. The analysis done aby rating agencies is most of the time paid by the entities that want their product to be rated.

In addition, companies issuing bonds are increasingly using the technique of “debt subordination”. This technique makes it possible to establish an order of priority between the different types of bonds issued by the same company, in the event that the company is unable to honor all its financial commitments. The order of priority is senior, mezzanine and junior debt. The higher the risk is, the higher the return is. It should also be noted that bonds have priority over equity.

To highlight the level of risk of an issuer, one can compare the yield of its bonds to those of a risk-free issuer. This is called the spread. Theoretically, it is the difference between the yield to maturity of a given bond and that of a zero-coupon bond with similar characteristics. The spread is usually measured in basis points (0.01%).

Liquidity risk

Liquidity risk is the degree of easiness in being able to buy or sell bonds in the secondary market quickly and at the desired price (i.e. with a limited price impact). If the market is illiquid, a bondholder who wishes to sell will have to agree to a substantial discount on the expected price in the best case, and will not be able to sell the bonds at all in the worst case.

The risk depends on the size of the issuance and the existence and functioning of the secondary market for the security. The liquidity of the secondary market varies from one currency to another and changes over time. In addition, a rating downgrade may affect the marketability of a security.

On the other hand, it may be an opportunity for investors who want to keep their illiquid bonds. Indeed, they usually get a better return. This is called the “liquidity premium”. It rewards the risk inherent in the investment and the unavailability of funds during this period.

Interest rate risk

The price of a bond fluctuates with interest rates. The price of a bond is inversely correlated to interest rates (the discount rate used to compute its present value). Indeed, the nominal interest rates follow the key rates. Thus, if rates rise, the coupons offered by new bonds will be higher than those offered by older bonds, issued with lower rates. Investors will therefore prefer the new bonds, which offer a better return, which will automatically lower the price of the older ones.

The interest rate risk is increasing with the maturity of the bond (more precisely its duration). The risk is low for bonds with a life of less than 3 years, moderate for bonds with a life of 3 to 5 years and high for bonds with a life of more than 5 years. However, interest rate risk does not impact investors who hold their bonds to maturity.

Inflation risk

Inflation presents a double risk to bondholders. Firstly, if inflation rises, the value of an investment in bonds will necessarily fall. For example, if an investor purchases a 5% fixed-rate bond, and inflation rises to 10% per year, the bondholder will lose money on the investment because the purchasing power of the proceeds has been greatly diminished. Secondly, high inflation can lead central banks to raise rates in order to tackle it, which, as we can see above, will depreciate the value of the bond.

To protect against this, some bonds, floating-rates bonds, are indexed to inflation. They guarantee their holders a daily readjustment of the value of their investment according to the evolution of inflation. However, these bonds have a cost in terms of return.

As with interest rate risk, the risk increases with the maturity of the bond. Also, the risk rises as the coupon decreases. The risk is therefore very high for zero-coupon bonds.

Currency risk

An investor can buy bonds in a currency other than its own. However, as with any investment in a foreign currency, the return on the bond will depend on the rate of that currency relative to the investor’s own currency.

For example, if an investor holds a $100 US bond. If the EUR/USD exchange rate is 1.30, the price of the bond will be €76.9. If the euro appreciates against the dollar and the exchange rate rises to 1.40, the price of the bond will be €71.4. Thus, the investor will lose money.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Bond valuation

Bond valuation

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023) introduces you to bond valuation.

Investors seek to determine how the different characteristics of a bond can influence its intrinsic value in order to know whether it is a good investment or not. To do this, they will look at the theoretical value of a bond, i.e. its present value. How can this be determined? How to interpret it?

Present value of a bond

The price of a bond is equal to the present value of the cash flows it generates. The holder of a bond will, by definition, receives a set of cash flows that will be received over a period of time. These flows are not directly comparable. A euro at time t1 does not have the same value as a euro at time t2. It is therefore necessary to determine the present value of future cash flows generated by the bond. This is calculated by multiplying these flows by a discount factor.

The discount rate chosen for this operation is determined by observing those already applied on the market to bonds comparable in duration, liquidity and credit risk. The convention is to discount all flows at a single rate, even if this does not reflect reality.

The present value of a bond is equal to the sum of the present value of the nominal amount and the present value of future coupons.

Capture d’écran 2021-05-30 165852

Where:

  • C = coupon payment
  • r = discount rate
  • F = face value of the bond
  • t = time of cash flow payment
  • T = time to maturity

This formula shows that the present value of the security varies with the discount rate. In addition, the longer a bond has to mature, the greater the impact of discounted income on the value. This is known as the bond’s sensitivity.

Note that this formula includes the accrued coupon. This is known as the <i>gross</i> price. Most often the price in question is the price at the coupon footer. This is known as the clean price.

Now, let us see an application of this formula:

Consider a 2-year coupon bond with a 5% coupon rate and a nominal value of €1,000. We assume that coupons are paid semi-annually. A 3% discount rate is used. What is its present value?

Capture d’écran 2021-05-30 165911

The result is PVbond = €1,038.54

Yield To Maturity (YMT)

The YTM (“taux de rendement actuariel” in French) represents the rate of return on a bond for someone who buys it today and holds it to maturity. This is equivalent to the internal rate of return (IRR) of an investment in a bond if the investor holds the bond until maturity, with all payments made as scheduled and reinvested at the same rate.

To calculate the yield to maturity of a bond, the compound interest – in other words “interest on interest” – method is used. This method takes into account the fact that the interest from holding a bond is added back to the principal each year and itself generates interest.

The YTM is the rate that equates the price of the bond with the present value of the future coupons and the final repayment.

We therefore have the following relation:

Capture d’écran 2021-05-30 165928

Where y corresponds to the YTM.

Example

Let us take an example:

Consider a 3-year coupon bond with a 10% coupon rate and a nominal value of €1,000. We assume that the present value of the bond is €980. What is the yield to maturity?

To find out the yield to maturity, you have to solve the following equation:

Capture d’écran 2021-05-30 165947

The YMT is 10.82%.

If a bond’s coupon rate is less than its YMT, then the bond is selling at a discount. If a bond’s coupon rate is more than its YMT, then the bond is selling at a premium. If a bond’s rate is equal to its YTM, then the bond is selling at par.

Related posts on the SimTrade blog

   ▶ Rodolphe CHOLLAT-NAMY Introduction to bonds

   ▶ Rodolphe CHOLLAT-NAMY Government debt

   ▶ Rodolphe CHOLLAT-NAMY Corporate debt

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Rodolphe CHOLLAT-NAMY Bond risks

Useful resources

longin.fr Evaluation d’obligations à taux fixe

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, i>Grande Ecole – Master in Management, 2019-2023).

Consumer Confidence Index

Consumer Confidence Index

Bijal Gandhi

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

This reading will help you understand the meaning, calculation, and importance of consumer confidence index.

Introduction

The consumer confidence index (CCI) is a statistical estimation that measures the current and future economic conditions. This indicator provides estimates based on households’ expectations and view of their financial situation like employability, saving capacity, consumption, etc.

It is a barometer that mainly measures the optimistic/pessimistic nature of the consumers regarding their future financial situation. The CCI is based on the concept that when consumers are optimistic about the future, they are likely to spend more currently and stimulate the economy but if the consumers are pessimistic about the future, then they are likely to save more in the present and hence this could lead to a recession. This index tells you about the optimal levels of the households about the economy and their ability to find jobs.

Measuring Consumer Confidence Index

The Consumer Confidence Index measures the degree of optimism/pessimism of the households for the future state of the economy by measuring household current saving and spending patterns. While the Consumer Confidence Index is measured differently in every economy based on various underlining factors, we talk about how it is measured in the U.S. economy to provide an understanding of its calculation process.

In the U.S. economy, the Conference Board calculates the Consumer Confidence Index. It was first calculated in 1985 and is now used as a benchmark to assess the CCI. The value of CCI is calculated monthly based on the results of a household survey of (1) consumers’ opinions on the current conditions as well as their (2) future economic positions. The former constitutes 40% of the index, while the latter constitutes the remaining 60%.

When the confidence increases, consumers spend more money in the present time ,and as a result, indicates the sustainability of an economy. And when the confidence decreases, consumers are prone to save more in the present time, and as a result, indicates the possibility of future economic turmoil.

Each month, the Conference Board conducts a survey for 5,000 U.S. households the survey participants are asked to answer each question in any of the three forms as positive, negative, or neutral. The survey is comprised of five questions about the following:

Present Situation Index

  • Current business conditions
  • Current employment conditions

Expectations Index

  • Business situation for the next six months
  • Employment situation for the next six months
  • Total family income situation for the next six months

A relative value is calculated separately for each question, it is then compared to the relative value from the 1985 survey. This comparison of the relative value is used to calculate the “index value” for each question.

Finally, the average of all five index values forms the final consumer confidence index. In the U.S. Economy, this data is calculated for the economy as a whole. In the following graph, we can see the impact of the corona virus pandemic on the consumer confidence index in April 2020.

Bijal Gandhi

Source: The Conference Board

Interpreting Consumer Confidence Index

The consumer confidence index measures the spending/savings pattern of the consumers currently and their response to the economy’s future growth prospects.

Higher index value means that the consumers have confidence in the future of the economy and its growth and as a result will be spending more currently. On the contrary, a lower index value means that consumers have low confidence in the future of the economy and as a result will be likely to save more in the present. Therefore, the consumer confidence index does not only help to interpret the household’s opinion on the future of the economy’s growth but also helps businesses, banks, retailers, and government to factor in and adapt to the changes in the household’s future consumption/saving patterns.

For example, if the consumer confidence index shows a consistent decrease in its value, it means that the consumers are currently saving more and, in the future, as well. As a result, consumers will be less willing to spend. Based on these manufacturers’ can adapt to their production of retail goods, banks can interpret a decrease in the lending activity and credit card usage, the government can adapt its fiscal or monetary policies to stimulate the economy. On the contrary, if the consumer confidence index shows a consistent increase in its value it means that the consumers are willing to spend more currently and, in the future, because they have confidence that the economy will boost. As a result, the manufacturers can increase their supply of non-essential goods and luxury goods, banks can expect the increase of withdrawal from the consumers saving accounts, etc.

The consumer confidence index is a lagging indicator, as mentioned by many economists. This means that the indicator is not necessarily good at predicting future economic trends. On the contrary, it is more like the index follows the future economic conditions after they have occurred. For example, even after a regressive period is over, the impacts will remain. There will still be an increased unemployment rate in the economy. This simply means that the consumer confidence index is more like the aftershocks of an earthquake that already happened in the economy.

CCI therefore helps get an idea of the consumer spending/saving pattern and the degree with which it will increase/decrease. An increase in spending can increase the growth of businesses and therefore result in higher earnings in stock market prices for businesses. Hence, investors are more likely to buy stocks if the consumer confidence index rises. As a result, the stock market may move drastically during the publication date of the confidence index.

Useful resources

About the author

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

Purchasing Managers’ Index

Purchasing Managers’ Index

Bijal Gandhi

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) elaborates on the concept of Purchasing Managers’ Index

This read will help you understand the formulation of PMI and it’s importance for each of the stakeholders.

Introduction

The Purchasing Managers’ Index (PMI) is a statistical estimation used to determine the economic directions in which the manufacturing and service sectors are moving forward. The PMI consists of a diffusion index that locates whether the market conditions for a particular sector are expanding, remaining the same, or contracting. The main goal of this index is to provide information about the present and future business conditions to decision-makers, analysts, investors, and the government.

The Purchasing Managers’ Index is an economic indicator formulated via surveys conducted for businesses in a particular sector.

PMI is formulated by three main institutions:

  • Institute for Supply Management (ISM): This institute originated the manufacturing and non-manufacturing metrics produced for the United States.
  • Singapore Institute of Purchasing and Materials Management (SIPMM): This institute formulates the Singapore PMI.
  • IHS Markit Group: This institute formulates metrics based on ISM’s metrics for more than 30 countries worldwide.

Calculation of PMI

The Purchasing Managers’ Index is formulated by several different surveys of purchasing managers at businesses in a different sector but mainly revolving around manufacturing and service sectors. All the surveys are amalgamated into a single numerical result depending on several possible answers to each question.

The calculation mentioned below is the methodology of the PMI being calculated and released by the Institute for Supply Management (ISM). The PMI is formulated from a monthly survey sent to senior executives at more than 400 companies in 19 primary industries (which are selected and weighted via their contribution to the U.S. GDP). The PMI is formulated around five main survey areas: (1) new orders, (2) inventory levels, (3) production, (4) deliveries, and (5) employment. All the survey areas are equally weighed while computing the PMI. This always consists of questions about business conditions regarding the sector and if any possible changes are occurring, whether be expanding, stagnant, or contracting.

The Purchasing Managers’ Index is an index indicating whether the economic conditions are better or worse for the companies surveyed by comparing it to the previous PMI. The methodology used to calculate the PMI assigns weight to each common element. The common element is multiplied by the following for a certain situation: multiplied by 1 for improvement, multiplied by 0.5 for stagnation, and multiplied by 0 for deterioration.

The PMI is calculated as:

PMI = (P1 x 1) + (P2 x 0.5) + (P3 x 0) where,

P1 = % of answers indicating an expansion
P2 = % of answers indicating no change
P3 = % of answers indicating a contraction

The PMI is a number ranging between 0 and 100. The formulated PMI is then compared to the previous month and if the PMI is greater than 50 represents an improvement/expansion while a PMI which is less than 50 represents a contraction/deterioration. A PMI equal to 50 represents no change/stagnation. It is also important to note that the greater the difference from the midpoint of 50, the greater is the expansion/contraction.

Importance of PMI

The PMI is turning out to be one of the most tracked indicators of business activity across the globe. It provides a good picture of how an economy is functioning particularly in the manufacturing sector. It is a good representative of the boom-and-bust cycles in the economy and hence it is closely administered by investors, businesses, traders, and financial professionals including economists. Furthermore, the PMI acts as a leading indicator of economic activity. It is important to various entities as explained below.

For Manufacturers

The PMI and its relevant data formulated every month by the ISM are crucial decision-making tools for managers in various roles ranging from different sectors. For example, if a smartphone manufacturer makes their production decisions based on the expected new orders from customers in the future months. These new orders drive the management’s purchasing decisions about multiple components and raw materials. Therefore, the PMI helps manufacturers in predicting the possibility for an expansion or unexpected contraction in their sector and them to make decisions for an anticipated future.

For Suppliers

The PMI also facilitates suppliers in making their decisions. A supplier from the manufacturing sector would follow the PMI to predict the market to estimate the amount of future demand for its products. PMI’s ability to inform about supply and demand, in turn, helps the supplier adjust the prices that they can charge. For example, if the manufacturer’s new orders are growing, it might result in increased customer prices and as a result, accept a price increase from its suppliers as well. On the contrary, if the new orders are declining, the manufacturers might reduce their prices and as a result demand lower prices for the parts that they procure from suppliers.

For Investors

Investors can also utilize the data from the PMI to their advantage because the PMI acts as an indicator of economic conditions. The direction in which the PMI tends to follow is usually preceded by changes in the trends of major economic activities and outputs such as the GDP, Industrial Production, and Employability. Therefore, paying attention to the value of PMI and its movement can result in profitable foresight for the investors.

For Government

The Purchasing Managers’ Index is an important indicator for economic growth. It is used by international investors who try to formulate an opinion on the economic growth and hence consider PMI as a leading indicator for the GDP’s growth or deterioration. Central banks also utilize the results of PMI to formulate monetary policies.

Why should one be concerned about PMI?

PMI is a good indicator to provide a direction in which the economy is moving forward. If you are a potential employee, it will help you determine the increase or decrease in employability in an economy. If you are an investor, PMI helps you determine changes in the macro fundamentals of the economy and their impact on the equity market. If you are a business owner, it could help formulate and guide in making more informed and certain decisions related to the sourcing of raw materials, inventory levels, etc.

The following graph from tradingview.com depicts the PMI from 2017 to 2021. The PMI ranges between the value 0 and 100 with values below 50 showing contraction and values above 50 showing expansion in the economy. As of April 2021, the PMI was 60.70 as depicted in the chart below.

Bijal Gandhi

Source: www.tradingview.com

Related posts on the SimTrade blog

   ▶ Bijal GANDHI Economic Indicators

   ▶ Bijal GANDHI Leading and Lagging Indicators

   ▶ Bijal GANDHI GDP

   ▶ Bijal GANDHI Interest Rates

   ▶ Bijal GANDHI Inflation Rate

Useful resources

Institute for supply management

Trading View

About the author

Article written in May 2021 by Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Credit Rating

Credit Rating

Bijal GANDHI

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) elaborates on the concept of Credit Rating.

This reading will help you understand the meaning, types, and importance of credit rating.

Introduction

Credit rating is the measurement of ability of the entity that seeks to borrow money to repay its financial obligation. Credit rating is based on the earning capacity of an entity as well as the history of the repayment of their past obligations. The entity seeking to borrow money can be an individual, a corporation, a state (at a national or federal level for some countries like the US), or a government agency. Credit ratings are used by banks and investors as one of the factors to determine their decision to lend money or not. Banks would develop their own credit analysis to decide to lend or not while investors would rely on the analysis by rating agencies to invest in credit products like commercial papers or bonds.

Rating agencies

The credit agency calculates the credit rating of an entity by analyzing its qualitative and quantitative attributes. Information can be procured from internal information directly provided by the entity such as financial statements, annual reports, etc. as well as external information such as analyst reports, published news articles, overall industry, etc.

A credit agency is not a part of the deal and therefore does not have any role involved in the transaction and, therefore, is assumed to provide an independent and honest opinion on the credit risk associated by a particular entity seeking to raise money through various means.

Now, three prominent credit agencies contribute 85% to the overall rating market:
1. Moody’s Investor Services
2. Standard and Poor’s (S&P)
3. Fitch Group

Each agency mentioned above utilizes a unique yet similar rating style to calculate credit ratings like described below,

Bijal Gandhi

Types of Credit Rating

Credit rating agencies use their terminology to determine credit ratings. Even so, the terminology is surprisingly similar among the three credit agencies mentioned above. Furthermore, ratings are grouped into two main categories:

Investment grade

These ratings indicate the investment is considered robust by the rating agencies, and the issuer is likely to complete the terms of repayment. As a result, these investments are usually less competitively priced when compared to speculative-grade investments.

Speculative grade

These investments are of a high-risk nature and hence offer higher interest rates to reflect the quality of the investments.

Users of Credit Rating

Credit Ratings are used by multiple entities like the following:

Institutional investors

Institutional investors like pension funds or insurance companies utilize credit ratings to assess the risk associated to a particular investment issuance, ideally with reference to their entire portfolio. According to the rate of a particular asset, it may or not include it in its portfolio.

Intermediaries

Credit ratings are used by intermediaries such as investment bankers, which utilize these ratings to evaluate credit risk and therefore derive pricing for debt issues.

Debt Issuers

Debt issuers like governments, institutions, etc. use credit ratings to evaluate their creditworthiness and to measure the credit risk associated with their debt issuance. These ratings can furthermore provide prospective investors in these organizations with an idea of the quality of the instruments issued by the organization and the kind of interest rate they could expect from such instruments.

Businesses & Corporations

Business organizations can use credit ratings to evaluate the risk associated with certain other organizations with which the business plans to have a future transaction/collaboration. Credit ratings, therefore, help entities that are interested in partnerships or ventures with other businesses to evaluate the viability of their propositions.

Understanding Credit Rating

A loan is a debt, which is the financial obligation with respect to its future repayment by the debtor. A credit rating helps to distinguish between debtors who are more liable to repay the loan compared to debtors who are more likely to be defaulters.

A high credit rating indicates the repayment of the loan by the entity without any possible defaults. A poor credit rating indicates the possibility of the entity defaulting the repayment of loans due to their past patterns with respect to loan repayments. As a result of the strong emphasis on credit rating, it affects an entity’s chance of being approved for a loan and receiving favorable terms for that loan.

Credit ratings apply to both businesses and the government. For example, sovereign credit ratings apply to the national government whereas corporate credit ratings apply for cooperation. On the other hand, credit scores apply only to individuals and are calculated by agencies such as Equifax, Experian, and TransUnion for the citizens of the United States.

Credit ratings can be short-term or long-term. A short-term credit rating reflects the history of an entity’s rating with respect to recent loan repayments and therefore poses a possibility for this borrower to default with its loan repayment when compared to entities with long-term credit ratings.

Credit rating agencies usually assign alphabet grades to indicate ratings. For example, S&P Global has a credit rating scaling from AAA (excellent) to C and D. They consider a debt instrument with a rating below BB to be a speculative-grade or junk bond, indicating they are more likely to default on loans.

Importance of Credit Ratings

Credit ratings for entities are calculated based on due diligence conducted by the rating agencies. While a borrowing entity will aim to have the highest possible credit rating, the rating agencies aim to take a balanced and objective view of the borrowing entity’s financial situation and capacity to honor/repay the debt. Keeping this in mind, mentioned below are the importance of credit ratings for various entities:

For Lending Entities

Credit ratings give an honest image of a borrowing entity. Since no money lender would want to risk giving their money to a risky entity with a high possibility of default from their part, credit ratings genuinely help money lenders to assess the worthiness of the following entity and the risk associated with that entity, therefore helping them to make better investment decisions. Credit ratings act as a safety guard because higher credit ratings assure the safety of money and timely repayment of the same with interest.

For Borrowing Entities

Since credit ratings provide an honest review of a borrower’s ability to repay a loan, borrowers with high credit ratings find it easier to get loans approved by money lenders at interest rates that are more favorable to them. A considerable rate of interest is very important for a borrowing entity because higher interest rates make it more difficult for a borrower to repay the loan and fulfill their financial obligations. Therefore, maintaining a high credit rating is essential for a borrower as it helps them get a considerable amount of relaxation when it comes to a rate of interest for the loan issued to them. Finally, it is also important for a borrower to ensure that their credit rating has a long history of high rating. Just because a credit rating is all about longevity. A credit rating with a long credit history is viewed as more attractive when compared to a credit rating with a short credit history.

For Investors

Credit ratings play a very crucial role when it comes to a potential investor’s decision to invest or not in a particular bond. Now, investors have different risk natures associated with them. In general, investors, who are generally risk-averse in nature, are more likely to invest in bonds with higher credit ratings when compared to lower credit ratings. At the same time, credit ratings help investors, who are risk lovers to differentiate between bonds that are riskier due to the lower credit ratings and invest in them for higher returns at the risk of higher defaults associated with them. Overall, credit ratings help investors make more informed decisions about their investment schemes.

Related posts on the SimTrade blog

   ▶ Jayati WALIA Credit risk

   ▶ Bijal GANDHI Interest Rates

   ▶ Rodolphe CHOLLAT-NAMY Credit analyst

   ▶ Aamey MEHTA My experience as a credit analyst at Wells Fargo

   ▶ Jayati WALIA My experience as a credit analyst at Amundi Asset Management

   ▶ Louis DETALLE My professional experience as a Credit Analyst at Société Générale

Useful resources

S&P Global Ratings

Moody’s

Fitch Ratings

About the author

Article written in May 2021 by Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

Bond Markets

Bond markets

Rodolphe Chollat-Namy

In this article, Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023) introduces you to bond markets.

The bond market allows the financing of medium and long-term needs of States, local authorities and companies. In return, it offers opportunities to invest medium and long-term financing capacities. In order to understand the bond market, it is necessary to distinguish two markets. The primary market, where bonds are issued, and the secondary market, where they are traded. What are their characteristics?

The primary market

When an organization issues new bonds, it uses the primary bond market, where its securities are acquired by various investors.

The issue price of a bond is expressed as a percentage of the face value of the security. If the issue price is 100%, the price is said to be at par.  If the issue price is above 100%, the price is said to be above par. If the issue price is below 100%, the price is said to be below par.

The nominal interest rate is used to calculate the coupon that will be paid to the bondholder. The interest rate at the issuance date depends on the default risk of the issuer reflecting its financial quality. This default risk is usually evaluated by rating agencies (S&P, Moody’s, Fitch).

There are two principal ways to issue bonds: syndication and auction.

Syndication

Syndication is the most common way to issue debt, widely used by companies, governments and other organizations. Syndication is when several financial institutions join together to ensure the placement of a bond with investors in order to reduce their risk exposure.

In a syndication, there are two types of financial institution: the lead bank, which arranges the transaction and manages the loan syndication, and the so-called “junior” banks, which participate in the transaction without setting the terms.

There are two types of syndication. “Full commitment” is where the lead bank commits to providing the company with the capital it needs and then subcontracts part of the financing to the other members of the syndicate to limit its exposure. “Best effort” is when the amount of the loan is determined by the commitments that the banks are willing to make in a financing transaction.

Auction

Auction is used by governments only. It is their preferred method of issuing sovereign debt. It allows the acquisition of a debt security through an auction system.

The auction can be “open”, i.e. all direct participants in public securities auctions (credit institutions, management and intermediation companies, etc.) have the possibility of acquiring part of the security put up for auction. It can also be “targeted”, i.e. the issue is reserved only for the primary dealers – banks or other financial institutions that has been approved to trade securities – of the issuing State.

A few days before the planned date of an auction, the State makes an announcement, confirming, postponing or cancelling the operation. It also gives the characteristics of the securities to be issued, i.e. the type of securities, the maturity and the amount it wishes to raise. Buyers can then submit several bids, each specifying the desired quantity and price. The issue lines are then auctioned to the highest bidders. The higher the demand is, the lower the issue rate is.

Auction is used because it provides investors, among other things, with transparency and free competition on an investment product with an attractive benefit in relation to a low risk level.

The secondary market

Once issued, a bond can be traded on the secondary bond market. It then becomes a tradable financial instrument, and its price fluctuates over time.

On entering the market, a bond will compete with other bonds. If it offers a higher return than other bonds for the same risk, the bond will be in demand, which will drive up its price. For the most part, transactions are conducted over the counter (OTC). Buyers and sellers interrogate several “market makers” who give them buying or selling prices, and then choose the intermediary who makes the best offer.

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the CAC40 for stocks. The most common American benchmarks are the Barclays Capital Aggregate Bond Index and Citigroup BIG.

A bond is quoted as a percentage of its face value. Thus, if it is trading at 85% of its nominal value of €1,000, it is quoted at €850. In addition, the bond is quoted at the coupon footer, i.e. without the accrued coupon.

The accrued coupon is the interest that has been earned but not yet paid since the most recent interest payment. It is calculated as follows: accrued coupon = (number of days/365) x face rate – with the face rate being the rate on the basis of which interest is calculated at the end of a full year for the nominal value of the bond -.

To better understand this mechanism, let us take an example:

Consider a 6% bond with a nominal value of €1,000, with an entitlement to dividends on 12/31 (coupon payment date). It is assumed that the bond is worth €925 on 09/30.

Gross annual interest: 1,000 x 6% = €60.

The accrued coupon on 09/30 is: 60 x 9/12 = 45 €.

Quotation at the foot of the coupon: 925 – 45 = €880.

Percentage quotation: 880 x 100/ 1000 = 88%.

The quoted price will be: 88%.

In the market, bondholders are subject to risks (interest rate risk, exchange rate risk, inflation risk, credit risk, etc.). We will come back to this in a future article.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond risks

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

Article written in May 2021 by Rodolphe CHOLLAT-NAMY (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2023).

Financial products marketing

Financial products marketing

Ashima Malik

In this article, Ashima MALIK (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021) explores the marketing of financial products.

Financial product marketing refers to a set of marketing solutions that address the needs of financial companies. The marketing of a highly efficient financial product uses digital methods to promote new financial products and increase brand awareness. Fortunately, financial services companies are increasingly recognizing the limitless power of digital channels in marketing their new financial products. The recent Digital Trends in Financial Services and Insurance survey of 700 top industry leaders confirms this.

Why Digital? Because technology and gadgets are on the sidelines, digital mobilization is about building a more compelling customer experience and building trust. There are many platforms available for us to go digital including social media, mobile app, ad campaigns, etc.

Marketing channels

There are many reasons to get involved with social media. When it comes to social media, we have to think about how to do it better than to try to do everything but not do it right. Setting up accounts with top social networking sites and / or engaging with the ones that make the most sense in your industry. For starters, it is a good idea to post on Facebook, YouTube, Instagram, Twitter, and LinkedIn. Social media is an ideal platform for marketing a financial product because it cuts across to everyone. Once the target audience has been identified, we can post the right content to the right audience engagement channels. As a financial services company it is important for the marketing team to understand where customers prefer to participate in social media.

Also, it is almost impossible for financial services companies to reach their target audience without mobile marketing. In a financial services company, a website should be optimized for mobile use, because a large percentage of customers, and potential customers, do business on the go.

Challenges

One of the biggest challenges for financial companies using digital marketing is that the words used in relation to financial services can be confusing and difficult for customers and the prospects for understanding them. And that is a major challenge when it comes to creating digital content that can engage people and make them feel invested in new financial products and services. It is very important for you to create valuable content that can appeal not only to Millennials, but also to your customers’ general interests and aspirations for information such as their lifestyles, wants, and needs.

In the financial services sector, one cannot underestimate the digital revolution if what we want is to use effective financial product advertising. Any financial product marketing plan should start by understanding that simple, clear, and relevant content is a way to engage your customers. Armed with this knowledge and a well-developed digital strategy for financial services, we can bring your customers closer and enable them to invest more in the company.

Useful resources

Econsultancy And Adobe: 2021 Digital trends – Financial Services & Insurance in Focus

Related posts on the SimTrade blog

   ▶ Cynthia LIN Financial products marketing in neobanks

   ▶ Samantha MARCUS Brands and marketing in the financial services sector

About the author

Article written in May 2021 by Ashima MALIK (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021).

Inflation & deflation

Inflation & deflation

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) describes the main mechanisms at the origin of inflation and deflation episodes, providing historical examples.

Inflation

Definition

Inflation is a movement of increase in the general price level (all products and not a few products) in an economy. It is a self-sustaining movement over several years. Measuring inflation is complex. Historically, inflation has been calculated by monitoring the evolution of a fixed basket of day-to-day products (such as milk, bread, etc.).

If your local supermarket suddenly increases its prices, it is not inflation: it is a microeconomic and located event that is the consequence of a human decision. In the same way, a sudden price increase following a tax increase is not considered as inflation.

Maintaining a level of inflation is one of the objectives of the Central Banks, which manipulate interest rates to reach their inflation target (2% for the European Central Bank). Indeed, low inflation is often beneficial for the economy, as it guarantees monetary and economic stability, and in particular helps to avoid deflationary spirals.

The origin of inflation

Firstly, inflation can be the result of imbalances between supply and demand:

  • Demand increases faster than supply (Keynesian approach): inflation occurs when the use of the means of production is at a maximum (it is not possible to produce more) and imports are unable to compensate the lack of domestic supply. The excess aggregate demand pushes up the prices as supply cannot follow.
  • A sudden fall in supply: in Germany in 1922, bad crops and a 30% drop in the industrial production in 1923 created a wave of hyperinflation as the supply couldn’t cope with the demand.

Secondly, inflation can be the result of evolution of productive constraints and price movements:

  • Wages increase more rapidly than the productivity of labor: companies increase their prices to maintain their margins, which creates inflation. William Baumol (American economist – the Baumol law) explained in 1966 that wage increases in less productive sectors rise in parallel with wage increases in more productive sectors. These increases, which are not justified by productivity arguments, result in inflation.
  • An increase in the production price per unit (for instance in the case of a sharp increase in the price of commodities) can result in inflation if companies can increase their prices to maintain their margins.

Finally, the expectations of economic agents can amplify the effect of inflation. If they expect a high inflation, the number and amount of transactions will increase, as they try to get rid of cash rapidly (in case of hyperinflation, the currency can lose its value very quickly), which will amplify inflation. It is the mechanism of “flight from money”.

The post WW1 German hyperinflation

Screenshot 2021-05-22 at 15.53.04
The stage of hyperinflation is reached when the rise in prices exceeds 50% per month. After WW1, the Treaty of Versailles imposed reparations on Germany. Quickly after, the fear that Germany would not be able to pay its reparations and debts spread. As a consequence, the value of the mark decreased in comparison to other European currencies. At the same time, the German government artificially injected money while Germany experienced a sharp decrease. These three phenomena translated into inflation, which was accelerated by the mechanism of “flight from money”. The average monthly rise in prices went beyond 300%. Germany managed to get out of this inflationary episode thanks to drastic measures: the introduction of a new currency, the capping of governmental money injection in the economy, austerity measures and debt rescheduling.

Deflation

Definition

Deflation is not to be confused with disinflation: disinflation is characterized by a decrease in the rate of inflation, whereas deflation happens when the prices decrease. Deflation is downward trend in the general price level over several years and similar to inflation, it is cumulative and self-sustaining. Deflationary episodes are much less common than inflationist periods.

The origins of deflation

Deflation mainly comes from imbalances between demand and supply:

  • Demand collapses compared to supply: Keynes explains that a collapse in private investment and savings can lead to a decrease in prices and salaries, as firms will try to sell their unsold products and maintain their margin. Due to wage decreases, consumption is depressed, which reduce the demand and pushes companies to further lower prices.
  • Supply increases suddenly: a sudden decrease in the price of commodities, labor cost or an acceleration of productivity gains can lead to disinflation, and eventually to deflation as firms will be able to decrease their prices. In this case, it is possible for deflation and growth to coexist, especially if productivity gains are high enough.

The Japanese deflation

In this two-decades deflationary episode, structural factors combined with macroeconomic events. In terms of structural factors, the increase in relocations to China, the sharing of added value to the detriment of employees and the aging of the population created a situation of weak and sluggish demand. In 1984, the Oba-Sprinkle agreements (which imposed a deregulation) lead to a continuous appreciation of the yen, which translated into an increased profitability of financial investments and therefore an influx of foreign capital. Fearing a speculative bubble, the Bank of Japan raised its key interest rate abruptly in 1992. The bubble burst, causing an economic slump. Households and banks became very cautious, leading the country into a dynamic of price decreases for over 20 years. Japan gradually emerged from this deflationary episode thanks to the reflationary policy conducted by Shinzo Abe since 2012.

Key concepts

Reflation policy

Reflation policy is the act of stimulating the economy by increasing the money supply or reducing taxes, seeking to return the economy to its long-term trend. This is the opposite of disinflation, which aims to bring inflation back to its long-term trend.

Useful resources

Solow and Samuelson (1960), Analytical aspects of anti-inflation policy, The American Economic Review.

Kaldor (1985) The scourge of monetarism.

Baumol (1966) Performing Art: The Economic Dilemma.

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

About the author

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

Understanding financial derivatives: futures

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.

Related posts on the SimTrade blog

   ▶ Alexandre VERLET Understanding financial derivatives: options

   ▶ Alexandre VERLET Understanding financial derivatives: forwards

   ▶ Alexandre VERLET Understanding financial derivatives: swaps

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

Classic brain teasers from real-life interviews

Alexandre VERLET

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!

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   ▶ Alexandre VERLET Working in finance: trading

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

Understanding financial derivatives: swaps

Alexandre VERLET

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

Related posts on the SimTrade blog

   ▶ Alexandre VERLET Understanding financial derivatives: options

   ▶ Alexandre VERLET Understanding financial derivatives: futures

   ▶ Alexandre VERLET Understanding financial derivatives: forwards

   ▶ Akshit GUPTA Currency swaps

About the author

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

How to compute the present value of an asset?

How to compute the present value of an asset?

William Longin

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

What is present value?

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

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

How is present value computed?

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

Present value of a cash flow

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

Present value of a cash flow

Download the Excel file to compute the present value of a cash flow

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

Present value of a series of cash flows

Application 1: Computation of the present value of a stock

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

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

Present value of the series of cash flows for a stock

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

Excel file to compute the present value of a stock

Download the Excel file to compute the present value of a stock

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

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

Application 2: Computation of the present value of a bond

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

Present value of the series of cash flows for a bond

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

Excel file to compute the present value of a bond

Download the Excel file to compute the present value of a bond

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

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

How to properly compute cash flows?

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

Who is using present value?

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

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

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

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

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

Related posts

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

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

   ▶ Jérémy PAULEN How to compute the IRR in Excel

   ▶ Sébastien PIAT Simple interest rate and compound interest rate

About the author

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

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

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

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

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

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

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

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

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

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

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

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

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

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

A cohabitation of rationality and “animal spirit”

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

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

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

Key concepts

Walsarian auction

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

Related posts on the SimTrade blog

   ▶ Shruti CHAND WallStreetBets

   ▶ Raphaël ROERO DE CORTANZE Gamestop: how a group of nostalgic nerds overturned a short-selling strategy

   ▶ Alexandre VERLET The GameStop saga

Useful resources

Academic articles and books

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

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

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

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

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

Press

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

Videos

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

About the author

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

Producer Price Index

Producer Price Index

Bijal Gandhi

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

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

What is Producer Price Index?

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

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

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

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

Bijal Gandhi

Understanding Producer Price Index (PPI)

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

1. Industry Level Classification

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

2. Commodity Classification

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

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

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

Example of the use of Producer Price Index (PPI)

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

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

Benefits of Using Producer Price Index

1. Accurate Measuring of Inflation

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

2. Predictive Value on Retail Changes

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

3. Contract Negotiations

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

Related posts on the SimTrade blog

Useful resources

About the author

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

Consumer Price Index

Consumer Price Index

Bijal Gandhi

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

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

What is Consumer Price Index?

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

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

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

Calculation of CPI

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

Bijal Gandhi

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

Bijal Gandhi

Determining the Market Basket

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

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

Uses of the Consumer Price Index

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

Limitations of the Consumer Price Index

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

Limitations in measurement of the CPI

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

Related posts on the SimTrade blog

Useful resources

About the author

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

Hedge funds

Hedge funds

Akshit Gupta

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

Introduction

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

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

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

Benefits of a hedge funds

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

Fee structure

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

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

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

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

Types of strategies used by hedge funds

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

Long/Short equities

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

Event driven strategy

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

Relative value strategy

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

Distressed securities

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

Major hedge funds in the world

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

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

Risks associated with hedge funds

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

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

Useful resources

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

Related posts

▶ Youssef LOURAOUI Introduction to Hedge Funds

▶ Shruti CHAND Financial leverage

▶ Akshit GUPTA Initial and maintenance margins in stocks

About the author

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