Inflation & deflation

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

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).

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).

Producer Price Index

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

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

What is Producer Price Index?

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

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

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

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

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

• Economic Indicators
• Leading and Lagging Indicators
• GDP
• Interest Rates
• Inflation Rate

Useful resources

• FRED economic Data
• U.S. Bureau of Labor Statistics

About the author

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

Consumer Price Index

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

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

What is Consumer Price Index?

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

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

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

Calculation of CPI

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

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.

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

• Economic Indicators
• Leading and Lagging Indicators
• GDP
• Interest Rates
• Inflation Rate

Useful resources

• FRED economic Data
• CPI calculation

About the author

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

Understanding financial derivatives: forwards

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

What’s a forward?

A forward is a derivative that is rather simple to understand. To illustrate the principle, let’s say you own a farm that you want to sell since you’re fed up with living in the countryside. However, you will have to wait until harvest time (i.e. a year) to get the best price (around 100,000 euros). But bad weather can ruin your plans. To protect yourself against these risks, you can use a financial product: a forward contract!

With a forward contract, you will be able to fix your selling price today (105,000 euros), but you will only receive the money in a year’s time, when you sell the farm. This is an ideal solution that solves all your problems at once. If you look at it another way, the risk that the price of your farm will fall in a year’s time is no longer borne by you, but by the natural or legal person with whom you have concluded the forward contract; this is also known as the counterpart. So, whether the price of your farm rises to 120,000 euros or falls to 80,000 euros, your forward contract guarantees that you will be able to resell it at 105,000 euros in a year’s time. However, you have a small question: why did you sign a contract for 105,000 euros when the farm is valued at 100,000 euros?

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

Yes, in the world of money, time has a price. That’s why you get interest when you put money into your savings account, and that’s why you pay interest (usually at a higher rate) when you borrow money from your bank. For the same reason, in your forward contract, the amount you will receive in one year is 100,000.(1+0.05)1, or 105,000 euros, if we assume an interest rate of 5%.

To summarise, a forward contract can be defined as a firm commitment between two counterparties to buy or sell a specified quantity of an asset (the underlying) at a given date (the maturity date) and at a price (the strike price) agreed in advance.

Let’s take a closer look at this definition. We have the term “firm commitment”, which distinguishes forwards from another family of derivatives: options, where the commitment is optional. We can also note the term “underlying”, a clue that we are in the presence of a derivative product which, as its name indicates, is derived from another asset. The maturity date distinguishes our forward contract from a spot contract, in which the transaction is carried out immediately (the stock market is an example of a spot market). But this definition does not allow us to distinguish forwards from other contracts that are very similar to them, namely futures contracts. Indeed, the main difference between forwards and futures is that forwards are traded over-the-counter, or OTC, while futures are traded on organised markets.

The forwards market

The origin of forwards is very old, as they do not require the establishment of an organised market. Today, they occupy an important place in the range of financial instruments used by market operators. In fact, the forwards market has been globalised, but it is mainly concentrated in large financial institutions.

In theory, a forward contract is negotiated between two participants with opposing needs. In practice, however, the transaction is usually between a client and a broker, with the broker indirectly linking parties with opposing needs. The brokers here are often the large global banking institutions. Clients are financial institutions, multinationals, governments, and non-governmental organisations. Despite the common perception, derivatives can be of real use to companies. For example, to fix the price of a future sale or order, a company may use a forward contract. This is because forwards, like other derivatives, were originally designed as insurance or, more precisely, as a hedge against market risks. But, of course, they can also be used as powerful speculative instruments

Foreign exchange forwards

As we have seen, forwards are widely used in the foreign exchange market. And there is a historical reason for this. In 1971, President Richard Nixon decided to put an end to the fixed exchange rate system that had been put in place in 1944 after the war. This decision led to an unprecedented increase in volatility (price variation) in the currency market. Increased volatility means increased bonuses but also increased risks, which means that instruments are needed to reduce or even neutralise these risks.

This is where currency forwards come in. Imagine that you have just been promoted to the head of a company. On your first business trip, you manage to secure $600 million in orders. The problem is that you won’t receive the money for six months. In the meantime, a change in the EUR/USD exchange rate could wipe out your already tight margins. The solution? A currency forward, obviously! Let’s assume that the current EUR/USD rate is 1.2. Through your bank, you set up an exchange rate forward for an amount of 600 million dollars (i.e. 500 million euros). Six months later, the EUR/USD exchange rate has risen to 1.3 and your client pays you the 600 million dollars as stated in the contract. However, since the EUR/USD rate is 1.3, the 600 million dollars is now worth only 450 million euros, instead of 500 million euros. Fortunately, you have been careful, and the currency forward will save you from losing EUR 50 millions.

Equity forwards and index forwards

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

Interest rate forwards

Interest rates are not to be outdone. Indeed, there are forwards on interest rates. They work in much the same way as equity forwards.

However, Forward Rate Agreements (FRAs) are interest rate forwards that fix an interest rate today for a period of time starting at a future date. In terms of volume, these contracts surpass all the forwards we have discussed so far. So let’s take a look at FRAs, which, along with interest rate swaps, are the most widely used derivatives in the financial markets of any kind. But first, let’s try to understand what an FRA is and where it can be useful.
Let’s assume that you want to buy a flat in London. You have just found a particularly interesting property. Unfortunately, it will not be available for sale for another three months. What’s more, you want to finance this acquisition with a loan that you will repay in the short term, i.e. in six months. It should be noted that the UK has just gone through a serious economic crisis, which has led the central banks to reduce interest rates to a particularly low level. But the economic situation is improving rapidly and the financial press is now reporting an imminent rise in interest rates.

In short, we need to take out a loan in three months’ time, at today’s interest rate. We want to repay the loan in six months. The three months of waiting and the six months of repayment mean that our financing package is spread over nine months. This is exactly what a three-by-nine FRA is all about, where you borrow money in three months and pay it back in six months at today’s interest rate. However, it is very important to note that in the financial markets, the interest rates used are usually market rates, or reference rates. The LIBOR rate is the most widely used for this purpose. LIBOR, which stands for London Interbank Offer Rate, is the interest rate at which international banks based in London lend the dollar to other banks. These banks are said to be exchanging Eurodollars. All dollar currencies traded outside the United States are referred to as Eurodollars.

Other types of forwards

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

Useful resources

ISDA

Related posts on the SimTrade blog

   ▶ Verlet A. Understanding financial derivatives: options

   ▶ Verlet A. Understanding financial derivatives: futures

   ▶ Verlet A. Understanding financial derivatives: swaps

About the author

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

Unemployment Rate

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

What is the unemployment rate?

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

Types of unemployment

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

Structural unemployment

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

Frictional unemployment

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

Cyclical unemployment

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

How to calculate the unemployment rate?

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

Alternative measures of calculation

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

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

Source: Federal Reserve Bank of St. Louis

Related posts on the SimTrade blog

• Economic Indicators
• Leading and Lagging Indicators
• GDP
• Interest rates
• Inflation rate

Useful resources

• U.S. Bureau of Labor Statistics
• International Labour Organization

About the author

Article written in April 2021 by Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022). Bijal has two years of experience in the financial markets and is currently working as a financial analyst at Mega Biopharma.

Interest rates

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

This read will help you understand the impact of rising and falling interest rates and their relationship with the stock and the bond markets.

Definition of Interest Rates

Interest rate is the cost charged by the lender to the borrower for the amount borrowed. The buzz over interest rate is real as it has a huge impact on not just the stock markets but also the overall economy. It is therefore important to understand how the interest rates are set and influenced by different factors.

Economic policy

The primary goal of any nation would be to attain maximum levels of employment, stability in prices, and economic growth. To achieve these goals, the Central Bank uses the interest rates as a switch to either curb inflation or achieve growth. The federal funds rate is the rate at which banks borrow money from each other overnight. The federal body sets the target for the federal funds rate and any deviations from this target has a ripple effect over the entire economy and thereby on the stock markets. The graph below portrays the trajectory of the effective federal funds rate from 1998 to 2018.

Impact of rising interest rates

In the US, the Federal Reserve increases the federal funds rate in order to make borrowing money more expensive for banks. The Central Bank manages this through open market operations using government securities like Treasury bills, notes and bonds. It sells the Treasury securities in order to increase the interest rates. The banks therefore would charge a higher rate to their customers. With an increase in interest rates, the consumers will now have less money to spend due a decrease in their disposable income (due to a higher cost to obtain credit). An increase in interest rates may impact the demand for goods and services. The prices may fall and thereby help the federal body curb inflation. A further rise will start impacting businesses directly. This is because businesses borrow money from banks for their operations. Rise in interest rates will discourage business spending which may not just slow down the growth of one company but the entire economy. The negative impact on the revenues and profits of a company will eventually reflect in the stock prices.

Source: Federal Reserve & Balance.com

Impact of falling interest rates

Apart from the interest rate at which the banks borrow from one another, the Central Bank also set the reserve requirements for the banks. The reserve requirement is the percentage of deposits a bank is obliged to keep on hand each night. The Fed can also lower the reserve requirements in case it wants to encourage lending to businesses and households in the economy. Similarly, during a slump in the economy, the federal reserve may also stimulate activity by cutting down the federal funds rate. An increase in the borrowing by businesses would act as a catalyst for growth. This is because businesses would enjoy operations, expansions, and acquisitions at a cheaper rate. A lower interest rate will also result in higher consumer spending. The revenues and profits for businesses will rise thereby impacting the stock prices positively.

Relation between interest rates and stock market prices

A higher interest rate would mean higher debt costs for companies, which may result in a decrease in the projected future cash flows for stockholders. This will lower the stock price of that company and if similar situations occur in other companies in the economy, the whole stock market may decline. Not just the existing debt costs, but an interest rate hike may also discourage borrowing for expansionary measures. However, this may not be the case with all sectors. Some sectors like the financial industry may benefit from an increase in the interest rate as they can now charge more for lending. The impact cannot just be financial but also psychological. A reduction in the stock prices may also set off a bout of panic selling due to fear and uncertainty. The investors and businesses may lose confidence and would now not be willing to make any risky investments.

Relation between interest rates and bond market prices

Bond prices and interest rates have an inverse relationship: as interest rates rise, bonds prices fall and vice versa. This is because with an increase in interest rates, the cost of borrowing will also increase resulting in a decrease in demand for existing bonds which yield lower returns. Similarly, with a decrease in interest rates, companies will now issue new bonds at lower interest rates for their projects. The demand for high yielding bonds will increase and so would the prices of these bonds. The longer the maturity of a bond, the more the bond value would be subjected to fluctuations. Short-term bonds are less affected by the interest rate changes. Long-term bonds are more affected by the interest rate changes. Technically, this effect is captured by the duration measure of a bond.

Conclusion

Interest rates not just affect businesses and investors but also all individuals of the nation. They play a major role in deciding the fate of both investments and the economy and therefore it is important to understand its role and impact.

Related posts on the SimTrade blog

• Economic Indicators
• Leading and Lagging Indicators
• GDP

Useful resources

• Effective Federal Funds Rate
• Federal Funds Target Rate

About the author

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

Gross Domestic Product (GDP)

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

This read will help you understand in detail the calculation, components, variations, and drawbacks of GDP.

Gross Domestic Product

Gross domestic product refers to the total monetary value of all finished goods and services produced within a geographical region during a specific period. The final value of the product is taken into consideration instead of the product components to avoid double-counting. The GDP is calculated for a country on an annual basis through data gathered from surveys and trade flows. The calculation is generally undertaken by the country itself and occasionally by the UN agencies like the World Bank and IMF. As discussed in Economic Indicators post, the GDP is helpful in estimating both the value of an economy and its growth rate.

Measuring GDP

The GDP is primarily calculated through the following three approaches. All three methods would yield the same results if computed correctly.

The Expenditure Approach

As the name suggests, this approach calculates the total spending by different participants in the economy. Therefore, the following formula is used:

where C represents consumption, G government spending, I investment, and (X-M) exports net of imports. Consumption is the largest and the most significant component of the GDP calculation. Consumers spend on goods and services and their willingness to spend reflects their level of confidence in the economy. Government spending refers to the sum of government consumption plus the total amount invested/spent to generate benefits for the residents. Investment by businesses is the sum of all the money invested in business activities or capital expenditures made to boost the businesses in an economy. Net exports are the total value of exports less the total value of imports. In the U.S., the Bureau of Economic Analysis (BEA) adopts the expenditure approach to calculate the GDP. The following is a snapshot of the U.S. GDP for Q3, 2020.

Source: Federal Reserve Bank of St. Louis.

The Income Approach

The income approach is based on the accounting logic that the total expenditures in an economy should be equal to the total income generated by the production of all the goods and services in that economy. Here, the assumption is that all revenues eventually go to either one of the four factors of production such as land, labor, capital, or entrepreneurship. Therefore, all the income generated through these factors like rent, wages, return on capital and corporate profits are summed and adjusted with taxes and depreciation.

The Production Approach

The total value of output generated by all the industries in an economy is summed in order to derive the GDP through the production approach. The cost of intermediate goods used in the production of this output is deducted from this value to avoid double-counting. Therefore, the gross value added is basically the total output less intermediate consumption.

Real GDP vs Nominal GDP

• Real GDP refers to the inflation-adjusted GDP. It is important to remove the effects of inflation on GDP to make GDP comparable with the previous years. If not, then the real GDP would seem to be increasing while not the case. A price deflator is used to determine the change in prices since the base year.
• Nominal GDP refers to the GDP calculated by considering the current market prices in the economy. It is basically the raw measurement which includes price changes over the years. The nominal GDP is the most used while comparing GDP between countries. The currency market exchange rates are used to convert the local currencies into U.S. dollars. Below, we can see that the U.S., China, Japan, Germany, and India dominate the market share of the world economy when measured by the Nominal GDP.

Source: World Bank.

Variations of GDP

GDP growth rate

The GDP growth rate is the percentage change in the GDP from one period to another. It compares one year/ quarter to another and helps policymakers take informed decisions. A negative growth rate for consecutive years suggests that the economy is contracting which further signals a recession. A very high growth rate is an indication of inflation. According to economists, a growth rate of approximately 2% is ideal for sustainable economic growth.

GDP per capita

GDP cannot be directly compared from one country to another due to the difference in the population size. One of the methods to make GDP comparable would be to use GDP per capita. In GDP per capita calculation, the total GDP is divided by the number of residents in the country. This helps in direct comparison of the standard of living of the residents of two or more nations. The real GDP per capita would be one of the optimal methods as it eliminates the effects of inflation and exchange rates as well. The following graph is the per capita growth rate of China from 1980 to 2019.

Source: Datacommons.org

GDP and PPP (Purchasing power parity)

To make GDP comparable, it is also necessary to adjust for differences of the local currency and the exchange rate. The purchasing power parity method is used to make cross-country comparisons using the real outputs, living standards and real income.

GDP and Investing

Even though a lagging indicator, the GDP is a very important economic indicator for investors. This is because the GDP data aids investors in making comparisons and adjustments for their asset allocation. Being a direct indicator of the condition of the economy, it helps investors make well informed decisions even for their funds in other developed and developing nations. The GDP report is a good source of information and data related to inventory, corporate profits, and operating cash flows of different sectors of the economy. Also, investors can make rough estimations of the equity market value through the ratio of total market capitalization to GDP. To conclude, GDP provides a good decision-making framework for investors.

Criticisms of GDP

Even though very useful, GDP has its own share of drawbacks. The major drawback is that it does not consider the value generated through informal and illegal trade. The activities in the black market are unaccounted for and therefore this results in underestimating the actual output. Also, unpaid work and services like volunteering are not considered, even though they have a significant impact on the economy.

Another major flaw could be that it ignores the environmental costs of producing the output. The impact on the well-being of society and the costs attached to the same are ignored while calculating the GDP. Similarly, every expense or income by the government or individual is included irrespective of whether they were productive or not. Therefore, even the unproductive output regularly contributes to the GDP growth rate.

Related posts on the SimTrade blog

   ▶ Bijal GANDHI Economic Indicators

   ▶ Bijal GANDHI Leading and Lagging Indicators

Useful resources

Investopedia World Economy

The balance GDP Definition

About the author

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

Growth Investment strategy

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents the strategy of Growth Investing.

Introduction

Growth investment strategy is an investment style where investors look for companies, industries, sectors, or markets that are rapidly growing and have the future potential to grow at a higher-than-average rate compared to its market or industry average. It is a part of a fundamental investment style where investors look for stocks that can provide short/long term capital appreciation on their investments rather than mere dividend earnings.

The growth investment style is the opposite of value investment style and is considered to be an offensive strategy. Value investment strategy is an investment style where investors look for shares that are undervalued by the market. It is rather a defensive strategy where the investors are conservative in approach ad have low risk appetite. An offensive strategy refers to an investment style where investors are actively looking to build up their portfolios by capital appreciations and earn higher than average returns.

A growth investor is not affected by the company’s current or historical earnings but strictly takes into consideration the company’s future growth potential before investing his/her money.

In general, growth investing is less concerned about dividend payments or stable cash inflows and is not preferred by investors who have a low-risk appetite. The income generated by companies having more-than-average growth rates are reinvested in the business to expand their growth potential and are not distributed as dividends to the shareholders. So, the growth investors look for capital appreciations over the period rather than having stable cash inflows.

For example, a growth investor Mr. X maintains a portfolio A of high growth stocks. The companies that Mr. X target are generally young companies with small market capitalization (between $300 million to $2 billion) and which have the potential to grow exponentially over the coming years. The minimum return expectation of Mr. X hovers around 15%-20% p.a.

However, the portfolio generated an annual return of 22% while the benchmark index saw an annual return of 14%. When the rate is compounded annually, a growth investor expects to double his/her money in a period of 5-6 years.

Indicators to practice Growth investment strategy

Although there is no certain set of indicators that can help an investor judge a company’s future growth potential, an investor practicing growth investment style looks for certain fundamental factors of a company before investing his money. Some of the most commonly used growth investment indicators are:

• Projected future earnings – A growth investor pay close attention to the projected future earning potential of a company rather than focusing on the current or historical earnings. The aim of a growth investor is to buy stocks of a company which presents strong future growth which is generally higher than the average market growth rate.
• Return on Equity – Return on equity is a good fundamental analysis tool that helps growth investors to determine how efficiently a company is using the shareholder’s equity to generate profits. The ROE multiple is calculated by dividing the company’s net profits after tax by the total shareholders equity. A growth investor prefers a company with a ROE multiple which is at least stable or increasing and generally higher than the industry or market average.
• Earnings per share – The earnings per share (EPS) is an important fundamental analysis tool that is calculated by dividing the company’s earnings by the total number of shareholders. A growth investor prefers a company which has seen a steady increase in the EPS growth over the years.
• Price/Earnings ratio – Price to earnings ratio is a fundamental analysis tool that helps an investor to determine how much the current market price of a company is compared to its current earnings per share. A growth investor compares the price – to – earnings multiple of a company to the average industry P/E multiple to understand the growth potential of a company compared to its industry’s growth.
• Price/Earnings to Growth ratio – Price/earnings to growth (PEG) ratio is calculated by dividing the price/earnings ratio of a company by its expected future growth rate. This multiple provides more comprehensive information about the company’s future potential.

In the current era, startups are considered to be a very hot space for investors practicing growth investment strategy on their portfolios. Although, the current earnings of the startups might be zero or negative, they hold true growth potential and can provide exponential returns on the investments made by growth investors.

Some of the typical industries that growth investors prefer to invest in include technology and healthcare services. Both the sectors have the power to provide revolutionary and cutting-edge products to the market. The prices for stocks of such companies can sharply rise in a short period of time, making them a trending place for growth investors.

Related posts ont eh SimTrade blog

   ▶ All posts about financial techniques

   ▶ Akshit GUPTA Asset management firms

   ▶ Akshit GUPTA Momentum Trading Strategy

Useful Resources

Corporate finance institute A guide to growth investing

About the author

Article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).