Understanding financial derivatives: forwards

Understanding financial derivatives: forwards

Alexandre VERLET

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.

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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

Unemployment Rate

Bijal Gandhi

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.

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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.

Bijal Gandhi
Source: Federal Reserve Bank of St. Louis

Related posts on the SimTrade blog

Useful resources

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.

Inflation Rate

Inflation Rate

Bijal GANDHI

In this article, Bijal GANDHI (ESSEC Business School, Master in Management, 2019-2022) explains in detail about the inflation Rate.

This read will help you understand the causes for inflation, the pros and cons of inflation and finally how to control inflation.

What is inflation?

Inflation in simple terms means an increase in the cost of living. It is basically an economic term which means that an individual must spend more money now than before to buy the same goods or services. The percentage increase in the prices over a specified period can be termed as the inflation rate. As the prices increase, the purchasing power of each unit of the currency decreases. The change in the price level of a well-diversified basket of goods and services can help estimate the decline in the purchasing power. This basket should include commodities, services, utilities, and everything else that humans need to lead a comfortable life. Therefore, the calculation of inflation is a complex process. It is measured in several ways depending upon the goods and services included in the calculation.

Deflation is the opposite of inflation and it indicates a general decrease in the prices of goods and services. It occurs when the inflation rate is lesser than 0%.

Types of inflation

Inflation rates can be divided into the following categories depending upon their characteristics,

  • Creeping inflation means that the prices have increased by 3% or less during a year.
  • Walking inflation refers to an increase in prices between 3-10% a year. It is destructive in nature and is harmful for the economy.
  • Galloping inflation causes an absolute havoc in the economy as the prices rise by 10% or more.
  • Hyperinflation is a rare phenomenon which occurs when the prices rise by 50% or more.

What are the three causes of inflation?

The rise in prices is most associated with the rise in demand. But there are several other mechanisms that result in an increase in the money supply of an economy. These mechanisms can be classified into the following three types,

Demand-pull effect

The demand-pull effect refers to the situation in which the demand exceeds the supply for goods and services. This may occur due to an increase in the money supply and credit, stimulating the overall demand. The consumers are willing and able to pay higher prices for a product thereby leading to a price rise.

Cost-Push Effect

A cost-push effect occurs when the supply is restricted while the demand is not. The supply could be restricted due to several factors like the scarcity of raw materials, the increase in the prices of production inputs, pandemics, etc. These additional costs may result in a higher cost for the finished product or reduce supply. In any case, the prices would rise resulting in inflation.

Built-in Inflation

The built-in inflation is a result of the cause-effect relationship. It is based on the people’s expectations of inflation in the coming years. The laborers and workers will demand a higher wage if they expect that the prices of goods and services will rise. Thereby increasing the cost of production. This will further result in an increase of the prices of goods and services again.

Measure of inflation

The Consumer Price Index (CPI) evaluates the change in the average price of a selected basket of goods and services over time. This predetermined basket mainly includes necessities like food, medical care, and transportation. The change in price of each component is calculated over a period and averaged to its relative weight in the basket. It is a widely used measure for both the inflation and effectiveness of the government’s policy. In the US, the CPI reports are published on a monthly and yearly basis by the U.S. Bureau of Labor Statistics. The value of inflation can be calculated over a period between two dates using the following methodology:

Formula for inflation

If you wish to know the purchasing power of a certain sum of money from one period to another, you can input data in this Inflation Calculator by the U.S. Bureau of Labor Statistics and see the results. This calculator uses the same methodology and CPI data as mentioned above.

Is inflation good or bad?

Inflation can be either good or bad depending upon the situation of individuals. For example, individuals holding cash or bonds would not like inflation as the purchasing power of their holdings would decrease. Individuals with investments in assets like real estate, commodities, etc. would appreciate inflation as the real value of their holdings will increase.

Central banks often struggle in maintaining an optimal level of inflation. Spending is encouraged over saving as increased spending will help boost economic activities. This is because it would be profitable for individuals to spend now instead of later if the purchasing power of money is expected to fall. For example, in the U.S., the Federal Reserve aims for a target rate of inflation of 2% YoY. A very high inflation rate can have catastrophic consequences. For example, Venezuela, which was suffering from hyperinflation (1087%) in 2017, collapsed into a situation of extreme poverty and uncertainty. Individuals who depend upon savings or fixed income are affected the most. This is because the interest rates in their savings accounts in the banks are lesser than the inflation rate, thereby making them poorer. Similarly, lower-income families are highly affected if the rise in their wages does not keep up with the rise in the prices. A high inflation also pressurizes governments to take actions to financially support the citizens as the cost-of-living increases.

Bijal Gandhi

Similarly, a deflation situation is not healthy as well. Consumers may put off spending as they may expect a fall in the prices. The reduced demand for goods and services will result in slow economic growth. This could further result in a recession-like situation with increased unemployment and poverty.

How to control inflation?

As discussed in the Interest rates post, the financial regulators of a country shoulder the responsibility of maintaining a stable and steady inflation rate. In the US, the Federal Reserve communicates inflation targets well in advance to keep a steady long-term inflation rate. This is because price stability helps businesses plan well ahead in future and know what to expect. The central banks through the monetary policy actions controls the money supply. For example, they adopt methods like quantitative easing to either counter deflation or to maintain the targeted inflation rate.

One powerful way for individuals would be to increase their earnings either through demanding a higher pay or promotions to keep up with inflation. Other options include investing in the stock market. Stocks are a good way to hedge against inflation. This is because a rise in the stock price will be inclusive of the effects of inflation. Another alternative would be to invest in instruments indexed to the inflation. Treasury Inflation Protected Securities (TIPS) and Series I Bonds are examples of such instruments.

Useful resources

U.S. Bureau of Labor Statistics

Investopedia Inflation Rate

The Balance How to measure Inflation

Related posts on the SimTrade blog

   ▶ Bijal GANDHI Economic Indicators

   ▶ Bijal GANDHI Leading and Lagging Indicators

   ▶ Bijal GANDHI GDP

   ▶ Bijal GANDHI Interest Rates

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

Interest rates

Bijal GandhiIn 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.

Bijal Gandhi

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.

Bijal GandhiSource: 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

Useful resources

About the author

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

GDP

Gross Domestic Product (GDP)

Bijal GANDHI

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:

Bijal Gandhi

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.

Bijal Gandhi
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.

Bijal Gandhi
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.

Bijal Gandhi 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).

Could the COVID-19 debt be wiped out?

Could the COVID-19 debt be wiped out?

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) discusses the current debate surrounding the cancellation of the covid debt.

In March 2020, the French President Emmanuel Macron announced during a televised speech that the French government would “mobilize all necessary means […] to save lives, whatever the cost”. In one year, the “whatever the cost” has resulted in a sharp increase of the French national debt from 100% of GDP in March 2020 to 120% in March 2021. In 2020, debt increases and money creation have taken on unprecedented proportions. The Federal Reserve in the US and the Eurosystem in Europe have injected nearly $3 trillion and $2 trillion respectively in the economy.

For many months now, economists in Europe have been calling for a cancellation of the “Covid-debt”. What are their arguments? Why do some refuse to consider this option? What could be the consequences of such a cancellation?

How does public debt work in Europe?

The Article 123 of the Treaty on the Functioning of the European Union forbids the European Central Bank (ECB) to finance and refinance directly the members of the Eurozone. The ECB can only acquire national debt securities such as treasury bills through the secondary market: it has to repurchase the securitizes from other investors which purchased them on the primary market in the first place (where the national debt securities were first emitted).

The European national debts are mainly held (75%) by other States and institutional investors such as banks and insurance companies. The remaining 25% are held by the ECB. The debate around the covid-debt cancellation is solely focused on the 25% held by the ECB. In effect, the very idea of cancelling some of the remaining 75% of debt hold by other States and investors is inconceivable (it would immediately undermine the European union credibility, which would increase the risk linked to national European state securities, thus increasing the cost of debt financing for European countries).

Why should the Covid debt be wiped out — and why it shouldn’t

In February, 150 economists from 13 European countries (such as Thomas Piketty or Gaël Giraud) explained in an opinion page published in Le Monde, that accumulated public debt had reached a level too high to be entirely paid out without a drastic austerity that would damage European economies. They highlighted the fact that raising taxes and/or reduce public spending would have devastating social consequences.

Furthermore, according to Thomas Piketty, as 25% of the European debt is hold by the Eurosystem, which group the ECB and national central banks (such as “Banque de France”), this is equivalent to consider that European countries hold 25% of their own debt. Hence the fact that these 25% of debt are a zero-sum game. He also argues that as “it is unlikely that the ECB […] will ever decide to put these securities back on the markets or to demand their repayment, the decision to no longer count them in the total public debt could be taken now”.

From this perspective, several right and left wing public figures (such as former minister Arnaud Montebourg or economist Alain Minc) advocate for a cancellation of these 25% of debt or a conversion into a perpetual debt with a zero-percent interest rate.

On the other side of the arena, according to those who are against the cancellation, it is forbidden to cancel the debt. Christine Lagarde herself (President of the ECB) has declared such a cancellation is “unthinkable” as it would be a “violation of [the article 123 of] the European treaty” which forbids the ECB to finance and refinance directly Eurozone states.

Furthermore, in the strictest sense, the debt of Eurozone countries is held by the Eurosystem. This implies that European national debt securities generate interests, which are paid back members of the EU. This cash-flow would be cut-off if the debt were to be cancelled or converted into a zero-interest long-term debt.

Finally, some economists like Jean Pisany-Ferry (who backed of the French President Emmanuel Macron during the last 2017 presidential campaign) and Henri Sterdyniak compare this cancellation solution to a “mystification” and a “fake theory”. Cancelling the debt would make the Eurozone States “neither richer nor poorer”. According to them, the 25% of debt held by the Eurosystem is a real debt. Thus, the Covid-debt issue should be addressed with “real economic arguments” like reducing public spending to avoid future macroeconomic imbalances, rather than using a “magic trick to hide public debts”.

What could be the consequences of such a cancellation?

The opponents to this option explain that a debt cancellation goes against the long-term goal of the Eurosystem of a having a controlled inflation rate. Indeed, when a country increases its debt, it receives the amount of money lent through money creation. Money creation is supposed to increase the inflation rate in the long run. Nonetheless, the reimbursement of a debt translates into money destruction. In a perfect world without inflation, the reimbursement of a debt destroys the exact amount of money created to issue the debt, resulting in no inflation effect. Cancelling the debt would thus remove the destruction phase of money creation, which could result in the long run in an increased inflation way above the targeted inflation.

Furthermore, cancelling the debt would undermine the ECB reputation. In another opinion page published in Le Monde newspaper, 80 economists explain that “the supposed alleviation from a cancellation would be quickly cancelled out by the risk premium that the markets would inevitably charge on the signatures of the euro zone member states”. In other words, the loss in credibility of the ECB implied by the cancellation of the debt would increase the interest rate of national Eurozone national securities, thus making the financing of public debt more expensive for Eurozone states and riskier for investors.

The advocates of debt cancellation reply that the risk of creating an uncontrollable inflation is minimal, as the amount of money released by the debt cancellation would be invested in the real economy and support investments, job creation etc. To the argument of loss of credibility, Thomas Piketty replies that an unprecedented situation (the Covid crisis) requires unprecedented means of action.

Amidst this debate, what appears to be certain is that the sharp increase in public debt doesn’t threat public finances in the short run. Nevertheless, this debate introduces relevant questions for the long term, especially in the Eurozone where it could question its model. Finally, if efforts have already been made in favor of developing countries notably by the International Monetary Fund (IMF), associations such as OXFAM call for the pure and simple cancellation of the debts of these countries in order to allow them to survive the Covid crisis.

Key concepts

Eurozone

The Eurozone is a monetary union of 19 member states of the European Union that have adopted the euro as their primary currency. The monetary authority of the eurozone is the Eurosystem. The eurozone is comprised of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.

Eurosystem

The Eurosystem is comprised of the ECB and the national central banks of the 19 member states that are part of the Eurozone. The national central banks apply the monetary policy of the ECB. The primary objective of the Eurosystem is price stability, followed by systemic stability and financial integration.

Useful resources

Sources: Le Monde, Les Echos, Oxfam, European Union Law

https://www.lemonde.fr/idees/article/2021/02/05/la-bce-peut-offrir-aux-etats-europeens-les-moyens-de-leur-reconstruction-ecologique-sociale-economique-et-culturelle_6068861_3232.html

https://www.lemonde.fr/idees/article/2020/06/12/la-bce-devrait-des-maintenant-annuler-une-partie-des-dettes-publiques-qu-elle-detient_6042636_3232.html

What to do with Covid debt?

https://eur-lex.europa.eu/legal-content/FR/TXT/HTML/?uri=CELEX:12008E123&from=FR

https://www.lemonde.fr/idees/article/2020/05/16/jean-pisani-ferry-annuler-la-dette-c-est-toujours-en-transferer-le-fardeau-a-d-autres_6039837_3232.html

Annuler la dette des pays pauvres : une mesure d’urgence face au coronavirus

https://en.wikipedia.org/wiki/Eurozone

https://www.ecb.europa.eu/ecb/orga/escb/eurosystem-mission/html/index.en.html

About the author

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

How has the 21st century revolutionized financing methods?

How has the 21st century revolutionized financing methods?

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) explains how the 21st century revolutionized financing methods.

In The Crisis in Keynesian Economics (1974), the British economist John HICKS described how the world economy shifted during the 20th century from the autoeconomy model to the overdrafteconomy model. An autoeconomy is an “equity” economy, dominated by self-financing and capital market financing. An overdrafteconomy is a “debt” economy, where financing is provided through debt by an intermediary (a bank or credit institution).

What were the reasons which led to this shift from autoeconomy to overdrafteconomy? Why do the evolution of markets and investment regulations during the second half of the 20th century question the typology described by John Hicks in 1974?

From the Industrial Revolution to the 1920s: the development of the autoeconomy model

In the beginning of the 19th century as the first wave of industrialization gained momentum across Europe and North America, the relative peace following the end of Napoleonic wars helped cut public spending. This period brought unparalleled increases in revenue, profit and cash flows, allowing both firms and governments to benefit from tremendous surplus and self-investing capacities. For instance, during the 19th century, the UK was able to reduce dramatically its public debt thanks to unprecedented budget surplus.

Meanwhile, financial markets were gradually asserting themselves as key players in financing the economy. Stock exchanges, which were until then mainly open government bonds, started to allow companies to seek additional financing. Companies started to combine more and more self-financing and capital market financing. The passion for the financial markets also affected the general public. In France in 1911, 45% of the inheritance in the bourgeoisie involved securities. In 1914 there were 2.4 million individual security holders (for a population of 42 million).

Until the end of the Roaring Twenties, the stock market was still very attractive. European governments financed the increase of public debt induced by the First World War through capital market financing. Even though the banking system was also developing in parallel, the financing of the economy remained dominated by financial markets and self-financing.

From the Wall Street Crash of 1929 to the 1970s: the shift towards the overdrafteconomy model

On Monday 28 October 1929 (Black Monday), the greatest sell-off of shares in US history was recorded. The Great Crash quickly spread to Europe, and with it a feeling of mistrust towards financial markets settled in. Following the 1929 crash, the first steps of banking regulation contributed to transitioning from the autoeconomy model to the overdrafteconomy model. Indeed, a separation was introduced between retail and investment banks, in order to reduce the impact of a future financial crisis on real economy (the Glass Steagall Act in 1933 in the US). In France, a deposit insurance scheme was introduced in 1934.

On the one hand, the loss of credibility of financial markets, and on the other hand the revival of banking regulation translated into a shift in financing methods. Numerous countries, such as France and Japan, used bank financing to finance the post World War II reconstruction. In most Western countries (except for the US and UK), companies and governments began preferring bank financing to capital markets financing and went into bank debt (hence the “overdraft” economy – where the economy spends more than it produces) to finance their activities.

Since the 1970s: the development of new financing methods

From the 1970s, two phenomena made financial markets appealing again, by making them more liquid and more accessible:

  • Financial deregulation: end of the stockbrokers’ monopoly, introduction of derivatives, abolition of regulations that hindered the free international movement of capital, etc.
  • Departitioning between national and international markets and between debt and stock markets.

Furthermore, the separation between retail and investment banks was abolished (in 1979 in the UK), allowing the emergence of banking behemoths (Citi Group in 1998, BNP Paribas in 2000). Banks did not lose out on these developments: they gradually established themselves as the central players in this new globalized finance.

Technical and regulatory innovations in the markets and the banking sector created financial globalization. This evolution was accompanied by a boom in the collective management of savings with the emergence of huge institutional investors. For instance, between 1980 and 2009 the amount of assets managed by pension funds was multiplied by 33.

Finally, the second part of the 20th century saw the development of new forms of financing. In 1958, in the US, new laws allowing the creation of investment firms, paved the way to private equity and venture capital, which financed the development of start-ups in Silicon Valley. The 1980s witnessed the emergence of the first Leverage Buy Out.

At beginning of the 21st century, crowdfunding through crowd equity (funding in exchange of a stake in the company) of crowd lending (funding in exchange of interests) added another new form of financing.

Thus, the 20th century witnessed the development of the forms of financing that we know today. The typology devised by John Hicks in 1974 appears now to be obsolete, as the means of financing abound, without one imposing itself as in the overdraft and autoeconomy models. Nevertheless, it allows us to understand how the events of the last century have built the globalized finance we know today.

Key concepts

Overdraft

An overdraft occurs when money is withdrawn from a bank account and the available balance goes below zero. In this situation, the account is said to be “overdrawn”. If there is a prior agreement with the account provider for an overdraft, and the amount overdrawn is within the authorized overdraft limit, then interest is normally charged at the agreed rate. If the negative balance exceeds the agreed terms, then additional fees may be charged and higher interest rates may apply.

Deposit insurance scheme

Deposit insurance or deposit protection is a measure implemented in many countries to protect bank depositors, in full or in part, from losses caused by a bank’s inability to pay its debts when due. Because banking institution failures have the potential to trigger a broad spectrum of harmful events, including economic recessions, policy makers maintain deposit insurance schemes to protect depositors and to give them comfort that their funds are not at risk. In the European Union, the current coverage limit is €100,000.

Useful resources

John Hicks (1974) The Crisis in Keynesian Economics.

Adeline Daumard (1973) Les fortunes françaises au XIXème siècle.

Pierre-Cyrille Hautcoeur, Paul Lagneau-Ymonet, Angelo Riva (2011) Les marchés financiers français : une perspective historique.

André Strauss (1988) Evolution comparée des systèmes de financement : RFA, Royaume-Uni et Japon.

Henri Bourguinat (1992) Finance internationale.

About the author

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

Growth investment strategy

Growth Investment strategy

Akshit GUPTA

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).

Fixed-income products

Fixed-income products

Jayati WALIA

In this article, Jayati WALIA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022) presents fixed-income products.

Introduction

Fixed-income products are a type of debt securities that provides predetermined returns to investors in terms of a principle amount at maturity and/or interest payments paid periodically up to and including the maturity date (also known as coupon payments). For investors, fixed-income securities pay out a fixed set of cashflows that are known in advance and are hence preferred by conservative investors with low-risk appetite or those looking to diversify their portfolio and limit risk exposure. For companies and governments issuing these securities, it is a mechanism to raise capital to fund operations and projects.

The most elementary type of fixed-income instrument is the coupon-bearing bond. The values of different bonds depend on the coupon size, maturity date and market view of future interest rate behaviours (or essentially bond market yields). For eg., prices of bonds with longer maturity fluctuate more by interest rate changes. Bonds are generally traded OTC unlike equity stocks that are traded via exchanges. The risk exposure of a bond can be gauged by their Credit Rating issued by rating agencies (S&P, Moody’s, Fitch). The least risky bonds have a rating of AAA which indicates a high measure of credit worthiness and minimum degree of default.

Fixed-income products can come in many forms as well which include single securities like treasury bills, government bonds, certificate of deposits, commercial papers and corporate bonds, and also mutual funds and structured products such as asset back securities.

Types of fixed-income products

Fixed-income products come in several structures catering to the needs of investors and issuers. The most common types are explored below in detail:

Treasury bills

Treasury bills (also called “T-bills”) are money market instruments that are issued by governments with a short maturity ranging from one month to one year. These bills are used to fund short-term financing needs of governments and are backed by the Treasury Department. They are issued at discounted value and redeemed at par value. The difference between the issuance and redemption price is the net gain or income for the investor. The T-Bills are generally issued in denomination of $1,000 per bill. For example, if you buy a T-bill issued by the US Department of Treasury with a maturity of 52 weeks at $990, you will redeem your T-bill at a price of $1,000 upon maturity.

Treasury notes and bonds

Treasury notes and bonds are a type of fixed-income security issued by governments with a medium or long maturity beyond one year. These bonds are used to fund permanent financial needs of governments and are backed by the Treasury Department. They come with predetermined interest payments. They are considered to be the safest investment since they are backed by the government. As a consequence, government bonds come with low returns. Government bonds are usually traded over the counter (OTC) markets. Technically, government bonds come in various forms: zero-coupon bonds, fixed payment and inflation protected securities.

Corporate bonds

Corporate bonds, as the name suggests, are issued by corporations to finance their investments. They generally come with higher yields as compared to the government bonds as they are perceived as more risky investments. The expected return for such bonds generally depends on the company’s financial situation reflected in its credit rating. Corporations can issue different types of bonds which includes zero-coupon bonds, floating-rate bonds, convertible bonds, perpetual bonds, and subordinated bonds.

Asset-backed securities

Asset-backed securities (ABS) is a kind of fixed-income product that comprises of multiple debt pools packaged together as a single security (also known as ‘securitization’) and sold to investors. The assets that can be securitized include home loans (mortgages), auto loans, student loans, credit card receivables among others. Thus the interest and principal payments made by consumers of the individual debts are passed on to the investors as the yield earned on the ABS.

Benefits of fixed-income products

For issuers

Generally, fixed-income products are issued by governments and corporations to raise capital for their operation.

For firms, the issuance of bonds in financial markets along with bank credit (two types of debt) allows firms to use leverage. Interests can also be deduced from income such that the firm will pay less taxes.

For investors

The investment in fixed-income products is considered to be a conservative strategy as it presents low returns (compared to stocks) but also provides a relatively low-risk exposure. Other benefits include:

  • Capital protection: Fixed income products carry less risk as compared to other asset classes such as stocks. These investments ensure capital preservation till the maturity of the investment and are preferred by investors who are risk averse and look for stable returns.
  • Generation of predetermined income: The income from fixed-income products is generated by means of interest or coupon payments. The income level for such products is predetermined at the time of investment and is paid on a regular basis (usually semi-annually or annually). Also, investors benefit from income tax exemption on investment in many fixed-income products.
  • Seniority rights: The holders of corporate bonds get seniority rights in terms of repayment of their capital if the company goes into bankruptcy.
  • Diversification: The fixed-income markets are less sensitive to market risk compared to the equity markets. So, the fixed-income products are considered to be less risky than the equity market investments and generally provides a fixed or stable stream of income. To manage the risk exposure for any portfolio, investors prefer investing in fixed income products to diversify their investments and offset any losses which may result from the equity markets.

Risks associated with fixed-income products

While fixed-income securities are considered to provide relatively low risk exposure, volatility in the bond market may still prove tricky. Bond value and interest rates have an inverse relationship and increase in interest rates thus affects the bond value negatively. Due to the fixed coupon rate and interest payments, fixed-income securities are highly sensitive to inflation rates as cashflows may lose value. There is also credit risk including potential default by the issuer. If an investor buys international bonds, she/he is always exposed to exchange risk due to the ever-fluctuating FX rates.

Thus it is essential for investors to take into account these factors and purchase fixed-income securities according to their individual requirements and risk appetite.

Useful resources

Amodeo K. (10/05/20201) Fixed Income Explanation, Types, and Impact on Economy The Balance.

Blackrock Education: What is fixed income investing?

Corporate Fiannce Institute: Fixed-income securities

Related posts

About the author

The article was written by Jayati WALIA (ESSEC Business School, Grande Ecole – Master in Management, 2019-2022).

What is an Institutional Investor?

What is an Institutional Investor?

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) explains what is an institutional investor.

What do an investment management firm like BlackRock, a Pension Fund like the Caisse de Dépôt et Placement du Québec and an insurance company like AXA Investment Managers have in common? They are all institutional investors, a wide group of investors that is behind the largest supply and demand movements in securities markets.

What is an Institutional Investor?

An institutional investor is an organization that pools money to purchase securities such as bonds or stocks, real-estate, and other assets on behalf of its clients. The characteristics of an Institutional Investor can be summarized in three points. An institutional investor:
Is a legal entity that manages a number of funds (not the fund itself)
Manages professionally numerous assets according to the interest and the goals of its clients
Manages a significant number of funds

Institutional investors include:

  • Banks (Goldman Sachs, BNP Paribas, etc.)
  • Credit unions (Navy Federal Credit Union etc.)
  • Insurance companies (Insurers like AXA or Reinsurers like SCOR)
  • Pension funds (Caisse de dépôt et placement du Québec etc.)
  • Hedge funds (Archegos, etc.)
  • Others: REITs (Real-Estate), investment advisors, endowments, and mutual funds.
  • Compared to other investors, Institutional Investors as professional investment managers face fewer regulations as they are believed to be more capable of protecting themselves from risk.

Institutional investor VS Retail Investor

A Retail Investor, or individual investor is a non-professional investor who purchases securities for its own personal accounts and often trade in dramatically smaller amounts as compared to Institutional Investors. Like Institutional Investors, Retail Investors are active in a variety of markets (bonds, options, commodities, forex, futures contracts, and stocks). Nonetheless, some markets are primarily for Institutional Investors, such as swaps and forward markets.

As an estimation, retail investors typically buy and sell stocks in round lots of 100 shares or more while institutional investors are known to buy and sell in block trades of 10,000 shares or more. Thus, institutional investors’ buying and selling decisions can have tremendous impact on shares prices. This is why Institutional Investors avoid buying or selling large blocks of small companies, as it could create sudden supply and demand imbalances which could be detrimental to the market equilibrium. Nonetheless, Institutional investors also typically avoid owning large stake in big companies because doing so can violate securities law: some Institutional Investors are limited as to the magnitude of their voting stake in a company.

As Institutional Investors’ investment strategy are expected to be formulated by market professionals, Retail Investors sometimes try to mimic buying and selling decisions of Institutional Investors. This behavior known as “smart money” also comes from the fact that Institutional Investors’ investment decisions are formulated according to extensive and well documented researches. As Institutional Investors have a lot more resources at their disposal (both cash and information) in order to invest, they bring in their wake numerous Retail Investors, eager to benefit from the Institutional Investors’ expertise.

The impact of Institutional Investors

As explained above, Institutional Investors can significantly impact financial markets through their buying and selling decisions. In 2015, the three biggest US asset managers (BlackRock, The Vanguard Group and Fidelity Investments) together owned an average of 18% in the S&P 500 Index and constituted the largest shareholder in 88% of the firms included in the S&P 500 index. Thus, it is no coincidence that Institutional Investors are often called “market makers” as they exert a large influence on the price dynamics of different financial instruments.

The majority of Institutional Investors focus on long-term profitability rather than short-term profit. Nonetheless, this statement strongly varies according to the investor which is considered. An Insurance Company for instance focuses on investment capable of creating long-term returns, as the money insurance companies invest comes directly from their client. As Insurance companies need to be capable of facing claim settlements, they cannot allow themselves to gamble with their clients’ money. That is why the Institutional Investors’ activism as shareholders is thought to improve corporate governance — exception being made for investors such as Hedge Funds which, through very aggressive investment management, can have long-term negative located impacts.
As a conclusion, the presence of Institutional Investors in a market creates a positive effect on overall economic conditions.

Key concepts

Bond

A bond is a fixed income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental)

Credit Union

A type of financial institution similar to a commercial bank, is a member-owned financial cooperative, controlled by its members and operated on a not-for-profit basis.

Mutual Funds

Mutual funds give small or individual investors access to professionally managed portfolios of equities, bonds, and other securities. Each shareholder, therefore, participates proportionally in the gains or losses of the fund.

Options

Options are financial instruments that are derivatives based on the value of underlying securities such as stocks. An options contract offers the buyer the opportunity to buy or sell—depending on the type of contract they hold—the underlying asset.

Commodities

A commodity is a basic good used in commerce that is interchangeable with other goods of the same type. Commodities are most often used as inputs in the production of other goods or services.

Forex

The foreign exchange market is where currencies are traded. Forex markets exist as spot (cash) markets as well as derivatives markets offering forwards, futures, options, and currency swaps.

Futures contracts

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. The buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Sources: OECD, Corporate Finance Institute, MarketWatch, Wallstreet Prep

About the author

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

What is an Activist Investor?

What is an Activist Investor?

img_SimTrade_Photo1_Raphael_Roero_de_Cortanze

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Master in Management, 2018-2022) explains what is an activist investor.

What is an Activist Investor?

Activist Investors regularly make the headlines. In March 2021, Emmanuel Faber stepped down as CEO of Danone as a result of an aggressive campaign led by Bluebell Capital Partners and Artisan Partners, two investment funds.
Who are these activist investors? What is their modus operandi? And, above all, what are the consequences of their actions on the companies they target?

Activist investors are mostly Private Equity firms, hedge funds and wealthy individuals that acquire a significant stake in a public company in order to influence how the company is managed, with a view to extracting short-term profits. As shareholders activists, they attempt to use their rights as a shareholder of a publicly-traded corporation to bring about change within the corporation.

Activist investors seek companies they think are mismanaged, have excessive costs or could be run in a more profitable way. Their goal is to boost the short-term profitability of a company, in order to make a quick capital gain by reselling the shares at a higher price than the activist investor acquired them before the company’s upheaval.

Owning a small proportion of the shares of a publicly-traded company is sufficient for an activist investor to wield enough shareholder power to implement short-term profit maximizing changes. Indeed, 5% or even 3% can already carry a lot of control power: above a certain percentage of ownership, it is possible to request the inclusion of a draft resolution on the agenda of a general assembly.

Modus operandi

The typical modus operandi of activist investors is the following:

  • acquire some shares of a company
  • heavily criticize the company’s current management
  • demand changes: cost reductions, board seats, departure of the current CEO, etc.
  • convince other shareholders of the validity of their criticism and demands in order to gather around them sufficient shareholder voting rights and ownership to propose and implement their decision during a general assembly
  • see these changes being implemented and bring short-term profitability
    resell the shares

The Danone case

Mid-January, the activist fund Bluebell Capital Partners (with an ownership believed to range between 2% to 3%) began attacking Emmanuel Faber’s governance. It was joined a few days later by Artisan Partners (0,6% of ownership). Together they deplored what they considered to be the poor performance of the company compared to its competitors Unilever or Nestlé.

Initially, a separation of functions between chairman and CEO was made in response to the investment funds’ attacks: Emmanuel Faber would have remained chairman while his former CEO position would have been filled by Gilles Schnepp, former CEO of the Legrand group. However, the two funds quickly objected to this move and Emmanuel Faber was eventually forced to leave the group while Gilles Schnepp succeeding him as chairman (with two co-CEOs running the Executive Committee). In less than two months, therefore, the CEO was removed, replaced by a profile a little less focused on corporate social responsibility and a little more on financial results.

Activist investors: good or bad for shareholders?

On the one hand, one might think that the intervention of an activist fund is a good thing for the shareholders. Shareholder activism might bring about change in the corporation, or even in the company’s objectives and vision, and will lead to a growth in profits, which will inevitably result in a rise in the share price rather quickly.

However, it is important to keep in mind that activist funds have a short-term investment horizon and want to increase the share price quickly in order to pocket a capital gain as soon as possible. It’s far from being synonymous with long-term value creation. Furthermore, the public image of a company can be severely damaged by industrial actions and cost-cutting plans.

It is therefore difficult to say whether activist funds are beneficial or not. The arrival of an activist fund in a very badly managed company can be very good news. But it all boils down to what is considered to be a “bad” management. Could Emmanuel Faber’s focus on corporate social responsibility be really considered as bad management?

The role of activist investor cab be seen in two famous financial movies: Other people’s money and Wall Street.

Watch Garfield (in the Other people’s money movie) making his point about wealth maximization at the shareholders’ Annual Meeting of their company.

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

Useful resources

Sources: Les Echos, Boursorama, Investopedia, LegalAction, Wikipedia

Related posts

Film analysis – Other People’s Money

Film analysis – Wall Street: Money Never Sleeps

About the author

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

Introduction to bonds

Introduction to bonds

Rodolphe Chollat-Namy

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

While the bond market is growing fast and is worth about $115,000 billion as of 2021, in the following series of articles we will try to understand what it is all about. It is therefore appropriate here, firstly, to try to define what a bond is.

What is a bond?

A bond is a debt security, i.e. a tradable financial asset, that represents a loan made by an investor to a borrower. It allows the issuer to finance its investment projects and the creditor to receive interest payments at regular intervals until maturity when it is repaid the nominal amount. Creditors of the issuer are also known as debt holders.
Bonds are fixed-income securities because you know from the debt contract the exact amount of cash you can expect in the future, provided you hold the security until maturity.

What are the main characteristics of a bond?

A bond has several characteristics:

  • The face value, also known as the par value or principal, equal to the original capital borrowed by the bond issuer divided by the number of securities issued.
  • The maturity, which expresses the number of years to wait for the principal to be repaid. This is the life of the bond. The average maturity of a bond is ten years.
  • The coupon, that refers to the payment of interest to the creditor at regular intervals. The interest rate paid may be fixed or variable. It is the creditor’s remuneration for the risk taken as a bondholder. The higher the risk, the higher the return, the coupon, will be.

Example

Let us take the example of a company needs to borrow ten million euros in the bond market.

It decides to issue fixed-rate bonds. It divides this issuance into 1,000 shares of €10,000. The face value of each bond is therefore €10,000. The nominal interest rate is set at 5%. Interest payments are made on an annual basis. The annual coupon is then equal to €500 (=0.05*10,000). The maturity of the bond is set at 10 years.

In terms of cash flows, you will receive €500 per year for ten years. At the end of the tenth year, the issuer will pay you a final installment of €10,000 in addition to the interest payment of €500.

What are the different types of bonds?

The bonds issued can be diverse. Their maturity, interest rate and repayment terms vary. In order to better understand them, we must first distinguish their issuer and then the terms of payment of interest.

Types of issuers

There are three main types of issuers: governments, local authorities, and companies.

Government bonds

A government bond represents a debt that is issued by a government and sold to investors to support government spending. They are considered low-risk investments since the government backs them. So, because of their relative low risk, they are typically pay low interest rates. Country that issues bonds use different terms for them. UK government bonds, for example, are referred to as gilts. In the US, they are referred to as treasuries: T-bills (expire in less than one year), T-notes (expire in one to ten years) and T-bonds (expire in more than ten years).

Municipal bonds (“munis”)

A municipal bond represents a debt that is issued by a local authority (a state, a municipality, or a county) to finance public projects like roads, schools and other infrastructure. Interest paid on municipal bonds is often tax-free, making them an attractive investment option. Because of this tax advantage and of the backing by their issuer, they are also pay low interest rates.

Corporate bonds

A corporate bond represents a debt that is issued by a company in order for it to raise financing for a variety of reasons such as ongoing operations (organic growth) or to expand business (mergers and acquisitions). They have a maturity of at least one year, otherwise they are referred to as commercial paper. They offer higher yields than government or local authority bonds because they carry a higher risk. The more fragile the company is, the higher the return offered to the investor is. They are divided into two main categories High Grade (also called Investment Grade) and High Yield (also called Non-Investment Grade, Speculative Grade, or Junk Bonds) according to their credit rating reflecting the firm financial situation.

Technical characteristics

In addition, the way in which interest is paid may vary from one bond to another. For this purpose, there are several types of bonds:

Fixed-rate bonds

A fixed-rate bond is a bond with a fixed interest rate that entitles the holder to receive interest payments at a predetermined frequency. The interest rate is set when the bond is issued and remains the same throughout the life of the bond. This is the most common type of bond.

Floating-rate notes

A floating-rate note is a bond with an interest rate that changes according to market conditions. The contract of issuance fixes a specific reference serving as a basis for the calculation of the remuneration. For example, the most common references for European bonds are Eonia and Euribor.

Zero-coupon bonds

A zero-coupon bond is a bond that does not pay regular interest. They are therefore sold at a lower price than the value redeemed at maturity by the issuer. This difference represents the investor’s return.

Convertible bonds

A convertible bond is a bond with a conversion right that allows the holder to exchange the bond for shares in the issuing company, the two parties having previously fixed a conversion ratio which defines the number of shares to which the bond gives right.

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

Related posts

   ▶ Rodolphe CHOLLAT-NAMY Bond valuation

   ▶ Rodolphe CHOLLAT-NAMY Bond risks

   ▶ Rodolphe CHOLLAT-NAMY Bond markets

   ▶ Bijal GANDHI Credit Rating

   ▶ Jayati WALIA Credit risk

About the author

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

Leading and Lagging Indicators

Leading and lagging indicators

Bijal GANDHI

In this article, Bijal GANDHI (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) elaborates on the concept of leading and lagging indicators. This reading will help you understand in detail the meaning of the leading and lagging indicators.

Leading indicators

Indicators that precede economic events and help predict the direction of an economy are termed as “leading indicators”. These indicators prove to be critical when the economy is heading from one stage to another in the business cycle. A single indicator may or may not be accurate to forecast the health of the economy. Therefore, these indicators are analyzed in conjunction through a composite index to predict the trend. In this post we deal with the U.S. case.

Composite index of leading indicators

The Composite Index of Leading Indicators is published monthly by The Conference Board to help market participants (traders, investors, financial analysts, central bankers, etc.) gauge the overall direction of the economy in the near-term future. It is a comprehensive index calculated with leading indicators based on their impact on the economy. This index is also known as the Leading Economic Index (LEI) in the U.S., and it comprises ten components detailed below.

The following is a snapshot of the LEI and the CEI for the United States. CEI refers to the coincident economic index which is based on the coincident indicators. Economic indicators that describe the current state of the economy within a particular segment (such as the job market or the market for goods and services), are termed “coincident indicators”. Coincident indicators move simultaneously along the changes in business cycles of the economy. Here we can see that the LEI increased for the month of February. The CEI also increased, following the LEI.

Bijal Gandhi
Source: The Conference Board.

Yield curve

Daily yields compare the return on short-term investment instruments like Treasury bills to long-term instruments like Treasury bonds. Generally, in the yield curve, the yields over the short term are lower than those over the long-term. When the yield curve inverts, it is a signal that the investors are expecting uncertainty over the long term. This may also be an indicator of a downturn in the economy or a recession.

Source: worldgovernmentbonds

Credit spreads

Credit Spread refers to the difference in yield between a risk-free instrument and a corporate bond over the same maturity. Credit spreads fluctuations are caused due to changes in other economic indicators like inflation, liquidity, etc. A widening credit spread would reflect investor concern and vice versa.

Stock market

The stock market is a leading indicator as stock prices are highly dependent on the future growth and expected earnings of companies. Investors may sell their stocks if they are not confident about the future of the company. The S&P 500 stock index for the U.S. is a close estimation of the total value of the business sector and therefore it is used to comprise the LEI.


Source: TradingView.

Durable goods orders

Durable Goods Manufactures’ report refers to the total capital goods purchased by companies. An increase in the volume of purchases is an indication that companies are confident about the future. It is classified under the leading indicator as business orders change much before an actual change in the business cycle.

Manufacturing jobs

The manufacturing jobs survey is also classified as a leading indicator as to the demand for labor shifts much before an actual change in the business cycle. If the demand for goods is anticipated to increase the supervisors may ask for a greater labor supply indicating a positive sign for the economy. A change in demand for labor will also impact other dependent sectors like transportation and retail.

Building permits

Building permit numbers are published monthly by the U.S. census which tells us in advance about the expected spending on construction-related projects. We all know the importance of the real estate sector on the economy from the subprime mortgage crisis in 2008.

Unemployment claims

The weekly claims for unemployment insurance help the government calculate the total layoffs and publish a report. This report is an indication of the changes in unemployment levels, business activities, and their impact on consumer income.

Manufacturing new orders

The Manufacturing New Orders Index published by the Institute of Supply Management (ISM) is calculated from the survey of purchasing manufacturers of hundreds of manufacturing firms. It indicates the change (increase or decrease) of orders of manufactured goods.

Consumer expectations

Consumer expectations is a survey conducted to gain insights from the end-users themselves. The surveyors ask the consumers about their opinions regarding jobs, income, and overall business conditions. They try to gauge the consumer sentiment for the next 6 to 12 months.

Leading Credit Index

This component is derived from six other financial indicators. All these financial indicators are forward looking such as 2 years swap spreads, security repurchases, investor’s sentiments, etc.

Lagging indicators

Lagging indicators are those economic indicators that lag the economic performance of a geographic region. Therefore, these indicators are not useful to predict the future health of the economy but to assess and confirm a pattern after a large movement in an underlying economic variable of interest like the unemployment rate. Since these indicators trail the shifts in the underlying variable, they are useful to analyze long-term trends in the economy. They are further categorized into economic, technical, and business indicators as per their use.

Composite index of lagging indicators

As discussed in the blog Economic Indicators, the Composite Index of Lagging Indicators is published monthly by the Conference Board. This Index includes the following seven components which help assess and confirm the economic situation of the U.S.

Average duration of unemployment

The Bureau of Labor Statistics computes the average number of weeks an individual has been unemployed. During a recession, long-term unemployment rises and vice versa.

Ratio, manufacturing, and trade inventories to sales

The Bureau of economic analysis computes the ratio of inventories to sales to understand the business conditions of both the individual firm and the industry. The inventory and sales data related to the manufacturing, wholesale, and retail is provided by the Bureau of the Census. When sales targets are not reached due to a weak economy, the inventories tend to shoot up and the ratio reaches its cyclical peak in the middle of a recession.

Change in labor cost per unit of output, manufacturing

The Conference Board computes the rate at which the labor costs per unit rise with respect to the cost of production per unit. During a weakening state of the economy, the production declines at a much higher rate than the labor costs even with layoffs of the laborers. This series is calculated over six months as monthly data can tend to be inconsistent.

Average prime rate charged by banks

The prime rate is the benchmark rate which banks use to estimate their interest rates for various types of loans. The change in this rate usually tends to lag the general economic performance. During periods of a strengthening economy, banks tend to resist reducing the interest rates, while during times of a weak economy, banks tend to resist increasing the interest rates.

Commercial and industrial loans outstanding

The total volume of outstanding business loans held by both banks and non-financial companies is computed by The Conference Board from the data compiled by the Board of Governors of the Federal Reserve System. When the revenues or profits decline in a business due to the weakening of the economy, banks start to take out more loans to cover their costs. Similarly, an improvement in the economy will result in liquidity and the demand for short-term credit may fall if the deflation sets in.

Ratio, consumer installment credit outstanding to personal income

This is the ratio of consumer debt to personal income. This ratio is a measurement of the indebtedness relative to income. This ratio tends to increase during times of expansion when the consumers are confident enough to pay off their debts in the future. Similarly, they tend to hold off borrowing even until after the months of recession due to skepticism and uncertainty.

Change in Consumer Price Index for services

The Bureau of Labor Statistics computes the rate of change in the services component of the Consumer Price Index (CPI). This is a lagging indicator as the services sector may raise prices well in advance in anticipation of a recession. The rise in prices may be due to market rigidities and recognition lag. Even with the recovery, firms in the services sector may keep cutting the prices. This is because they might not recognize when the recession is over.

Related posts on the SimTrade blog

   ▶ Bijal GANDHI Economic indicators

   ▶ Bijal GANDHI Gross Domestic Product (GDP)

Useful resources

US Department of Treasury

United States Census Bureau

Labor Statistics

About the author

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

Is smart beta really smart?

Is smart beta really smart?

Youssef LOURAOUI

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the concept of smart beta used in the asset management industry.

Mutual funds and Exchange traded funds (ETF) based on the smart beta approach have increased in size during the recent years. As Burton Malkiel (2014), we also wonder if the smart beta approach is really smart.

The smart beta industry

Smart beta funds have experienced a significant growth with total assets under management approaching market 620 billion dollar in the U.S. as shown in Figure 1 (Morningstar Reseach, 2017).

Figure 1. Smart Beta Exchange Traded Products growth in the US market (2000-2017).
Smart Beta Exchange Traded Products growth
Source: Morningstar Research (2017).

Traditional approach in portfolio management

The traditional approach to build asset portfolio is to define asset weights based on the market capitalization. The framework of this traditional approach is based on the Capital Asset Pricing Model (CAPM) introduced by the work of Henry Markowitz and William Sharpe in 1964. The CAPM is based on a set of hypotheses about the market structure and investors:

  • No intermediaries
  • No constraints (possibility of short selling)
  • Supply and demand equilibrium
  • Inexistence of transaction cost
  • Investors seeks to maximise its portfolio value by optimizing the mean associated with expected returns while minimizing variance associated with risk
  • Investors are considered as “rational” with a risk averse profile
  • Investors have access to the information simultaneously in order to execute their investment ideas

Under this framework, Markowitz developed a model relating the expected return of a given asset and its risk:

Relation between expected return and risk

where E(r) represents the expected return of the asset, rf the risk-free rate, β a measure of the risk of the asset and E(rm) the expected return of the market.

In this model, the beta (β) parameter is a key parameter and is defined as:

Beta

where Cov(r,rm) represents the covariance of the asset with the overall market, and σ(rm)2 is the variance of market return.

The beta represents the sensibility of the asset to the fluctuations of the market. This risk measure helps investors to predict the movements of their asset according to the movement of the market overall. It measures the asset volatility in comparison with the systematic risk inherent to the market. Statistically, the beta represents the slope of the line through a regression of data points between the stock returns in comparison to the market returns. It helps investors to explain how the asset moves compared to the market.

More specifically, we can consider the following cases for beta values:

  • β = 1 indicates a fluctuation between the asset and its benchmark, thus the asset tends to move in a similar rate than the market fluctuations. A passive ETF replicating an index will present a beta close to 1 with its associated index.
  • 0 < β < 1 indicates that the asset moves in a slower rate than market fluctuations. Defensive stocks, stocks that deliver consistent returns without regarding the market state like P&G or Coca Cola in the US, tend to have a beta with the market lower than 1.
  • β > 1 indicates a more aggressive effect of amplification between the asset price movements with the market movements. Call options tend to have higher betas than their underlying asset.
  • β = 0 indicates that the asset or portfolio is uncorrelated to the market. Govies, or sovereign debt bonds, tend to have a beta-neutral exposure to the market.
  • β < 0 indicates an inverse effect of market fluctuation impact in the asset volatility. In this sense, the asset would behave inversely in terms of volatility compared to the market movements. Put options and Gold typically tend to have negative betas.

In order to better monitor the performance of an actively managed fund, active fund managers seek to improve the performance of their fund compared to the market. This additional performance is measured by the “alpha” (Jensen, 1968) defined by:

Alpha Jensen

where E(r) is the average return of the fund over the period studied, rf the risk-free rate, E(rm) the expected return of the market, and β×(E(rm)-rf) represents the systematic risk of the fund.

Jensen’s alpha (α) represents the abnormal returns of the fund.

The Smart beta approach

The smart beta approach is based on the construction of a portfolio of assets using several different yield enhancement “factors”. BlackRock Investment Solutions (2021) lists the following factors mainly used in the smart beta approach:

  • Quality, which aims to study the financial environment of the underlying asset.
  • Volatility which aims to filter assets according to their risk.
  • Momentum, which aims to identify trends in the selection of assets to be retained by focusing on stocks that have performed strongly in the short term.
  • Growth is the approach that aims to select securities that have strong return expectations in the medium to long term.
  • Size which aims to classify according to the size of the assets.
  • Value that seeks to denote undervalued assets that are close to their fundamental values.

The smart beta approach is opposed to the traditional portfolio approach where a portfolio is constructed using the weights defined by the market capitalization of its assets. The smart beta approach aims to position the portfolio sensitivity or “beta” according to the market environment expectation of the asset manager. For a bull market, the fund manager will select a set of factors to achieve a pronounced exposure of his portfolio. Symmetrically, for a bear market, the fund manager will select another set of factors opting for a beta neutral approach to protect the sensitivity of his portfolio against bear market fluctuations.

Performance and impact factor

S&P Group (2016) studied the performance of different factors (volatility, momentum, quality, value, dividend yield, growth and size) on the S&P500 index for 1994-2014 broken down into sub-sectors (see Table 1). This study finds that each sector is impacted differently by choosing one factor over another. For example, in the energy sector, the strategies of value and growth has led to a positive performance with respectively 1.22% and 2.56%, while in the industrial sector, the strategies of size were the only factor with a positive performance of 1.66%. In practice, there are two approaches: focusing on a single factor or finding a combination of factors that offers the most interesting risk-adjusted return to the investor in view of his/her investment strategy.

Table 1. Sector exposures to smart beta factors (1994-2014).
Sector exposures to smart beta factors
Source: S&P Research (2014).

S&P Group (2016) also studies the performance of the factors according to the market cycles (bull, bear or recovery markets), business cycles (expansion or contraction) and investor sentiment (neutral, bullish and bearish). The study shows how each factor has been mostly effective for every market condition.

Table 2. Performance of factors according to different market cycles, business cycles and investor sentiment.
Performance of factors
Source: S&P Research (2014).

In summary, the following characteristics of the different approaches discussed in this article can be identified:

  • The CAPM approach aims to give a practical configuration of the relationship between the return of an asset with the market return as well as the return considered as risk-free.
  • Alpha is an essential metric in the calculation of the portfolio manager’s return in an actively managed fund. In this sense, alpha and CAPM are linked in the fund given the nature of the formulas used.
  • Smart beta or factor investing follows an approach that straddles the line between active and passive management where the manager of this type of fund will use factors to filter its source of return generation which differs from the common approach based on CAPM reasoning (Fidelity, 2021).
  • The conductive link of these three reasoning is closely related to the fact that historically the CAPM model has been a pillar in financial theory, the smart beta being a more recent approach that tries to disrupt the codes of the so-called market capitalization based investment by integrating factors to increase the sources of return. Alpha is related to smart beta in the sense that the manager of this type of fund will want to outperform a benchmark and therefore, alpha allows to know the nature of this out-performance of the manager compared to a benchmark.

Is smart beta really smart?

Nevertheless, the vision of this smart beta approach has raised criticisms regarding the relevance of the financial results that this strategy brings to a portfolio’s return. Malkiel (2014) questioned the smartness of smart beta and found that the performance of this new strategy is only the result of chance in the sense that the persistence of performance is dependent in large part on the market configuration.

In his analysis of the performance of the smart ETF fund called FTSE RAFI over the period 2009-2014, he attributed the out-performance to luck. The portfolio allocation was highly exposed to two financial stocks, Citigroup and Bank of America, which accounted for 15% of the portfolio allocation. Note that Citigroup and Bank of America were prosecuted by the American courts for post-crisis financial events and interest rate manipulation operations related to the LIBOR scandal. This smart beta fund outperformed the passive managed US large cap ETF (SPY). Malkiel associated the asset selection of the FTSE RAFI fund with a bet on Bank of America that with another market configuration it could have ended in a sadder way.

Figure 2. FTSE RAFI ETF (orange) compared with its benchmark (FTSE RAFI US 1000) and with SPY ETF (green).
FTSE RAFI ETF
Source: Thomson Reuters Datastream.

We can conclude that the smart beta strategy can allow, as outlined in Blackrock’s research (BlackRock Investment Solutions, 2021), an opportunity to improve portfolio performance while seeking to manage variables such as portfolio out-performance, minimizing its volatility compared to the market or seeking diversification to reduce the risk of the investor’s portfolio. It is an instrument that must be taken judiciously in order to be able to affirm in fine if it is smart in the end, as Malkiel would say.

Related posts on the SimTrade blog

   ▶ Jayati WALIA Capital Asset Pricing Model (CAPM)

   ▶ Youssef LOURAOUI Beta

   ▶ Youssef LOURAOUI MSCI Factor Indexes

   ▶ Youssef LOURAOUI Factor Investing

   ▶ Youssef LOURAOUI Origin of factor investing

Useful resources

Academic articles

Malkiel, B. (2014). Is Smart Beta smart? The Journal of Portfolio Management 40, 5: 127-134

El Lamti N. (2017) Are smart beta strategies really smart? HEC Paris.

Business resources

BlackRock Investment Solutions (2021) What is Factor Investing

Fidelity (2021) Smart beta

S&P Global Research (2016) What Is in Your Smart Beta Portfolio? A Fundamental and Macroeconomic Analysis

Morningstar Research (2017) A Global Guide to Strategic-Beta Exchange-Traded Products

Fidelity (2021) Smart beta

About the author

The article in April 2021 was written by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Economic Indicators

Economic indicators

Bijal Gandhi

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

This read will help you understand in detail the types of economic indicators, their impact on stock prices and their use by investors in the financial markets.

Economic indicators

Economic indicators are statistical data related to economic activity. They help to evaluate and forecast the health of the economy at the macro level. These indicators measure the systematic risk of the economy and are widely used by investors for their investment decisions. Economic indicators are generally published on a regular basis in a timely manner by governments, universities, and non-profit organizations. To build economic indicators, these institutions use census and surveys. For example, the U.S Bureau of Labor Statistics publishes a monthly report on the Employment Situation through a survey. This report details about the jobs lost or created every month, compensation costs, unemployment rate, etc.

Economic indicators can be of great use if interpreted accurately. Historically, it has had a strong correlation with the economic growth of a nation. The impact can be clearly seen in the long-term performance of the financial markets and therefore investors keep a close eye on them. They try to evaluate and understand the impact of each of the economic indicators to make informed decisions. The government, economists, corporations, and research organizations are the other beneficiaries of these indicators.

Types of economic indicators

Leading indicators

Economic indicators that help understand and forecast the future health of the economy, are termed “leading indicators”. These indicators tend to precede economic events and therefore prove to be critical during times of economic recession. A single leading indicator may not prove to be accurate, but several indicators analyzed in conjunction may help in providing insights into the future of the economy. Economists, investors, and policymakers may use and analyze these indicators according to their interests.

The evolution of the stock market is one of the major leading indicators. Weak earnings forecasts may indicate to investors the weak state of the economy beforehand. The stock market may therefore tend to decline preceding to the decline of the economy as a whole and vice versa. For the United States, other important leading indicators include the following,

Investors may or may not look at the same indicators as economists. For example, investors would be more interested in the data related to jobless claims by the U.S. Department of Labor to gauge the signs of a weakening economy.

Coincident indicators

Economic indicators that describe the current state of the economy within a particular segment (such as the job market or the market for goods and services), are termed “coincident indicators”. Coincident indicators move simultaneously along the changes in business cycles of the economy. For example, the payroll data published by the U.S. Bureau of Labor Statistics can help analyze the demand for employees. This evaluation would help understand if the economy’s present condition is strong or weak. Therefore, coincident indicators reflect the real-time situation. They are more useful when used with the leading and lagging indicators. For the United States, other important coincident indicators are:

Lagging indicators

Economic indicators that describe the past state of the economy which confirms a pattern only after a large movement in the underlying variable, are termed “lagging indicators”. These factors tend to trail the shift in the underlying asset and are therefore useful to validate the long-term trends in the economy. Lagging indicators can further be classified under economic, technical, and business indicators as per their use.

The Lagging Index is published by The Conference Board . This economic indicator lags the composite economic performance of the U.S. This indicator is calculated with following seven economic components:

  • Average prime rates
  • Average duration of unemployment
  • Change in the Consumer Price Index for services
  • Ratio of manufacturing and trade inventories to sales
  • Real dollar volume of outstanding commercial and industrial loans
  • Change in labor cost per unit of output in manufacturing
  • Ratio of consumer installment credit outstanding to personal income

Important economic indicators

Gross domestic product

GDP refers to the sum of all goods and services produced in a country during a specific period. The motive is to calculate either the total income or spending in a country and compare it with the preceding period. This difference over time (from a quarter to another or from a year to another) allows economists to understand whether the economy has contracted or expanded.

GDP being the key indicator of the economy, has a significant impact on the investors’ sentiment. A positive change in the GDP would mean that the economy is thriving as compared to the previous period. This would further mean lower levels of unemployment, higher spending, and positive earnings outlook for the companies. This would translate into higher stock prices for investors. Therefore, GDP can be termed as an important economic indicator for both economists and investors.

Inflation (CPI & PPI)

Inflation is referred to the rate at which the value of goods and services rise and consequently the value of currency declines. It is one of the most important economic indicators for investors because it measures the real value of an investment being eroded in a certain period. For example, if the inflation rate is 4% and yield from an investment is 3%, then investors would in real terms lose 1% every year. Therefore, it is a vital factor in investment decision-making, as a higher inflation rate would mean that investor should get an even higher return on their investment. The effect of inflation on the costs incurred by the companies is another factor investor should look at. Decline in inflation would mean lower costs for companies resulting in better overall performance.
The most relevant inflation indexes are Consumer Price Index (CPI) and Producer Price Index (PPI)

  • The Consumer Price Index (CPI) is defined by the Bureau of Labor Statistics in the U.S. as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services”. It is widely used as a close proxy and estimate to inflation. It helps economists, investors and others get an idea about the change in prices in the economy and make informed decisions accordingly.
  • The Producer Price Index (PPI) is defined by the Bureau of Labor Statistics in the U.S. as “a measure of the average change over time in the selling prices received by domestic producers for their output”. It differs from the CPI as it calculates the cost from the perspective of the producer instead of the consumer. It is an important tool as inflation can be tracked in the PPI much before any other economic indicators (including the CPI).

Interest rates

Interest rates are vital economic indicators both for economists and investors. In the U.S., the Federal fund rate is the interest rate at which the banks borrow from each other on an overnight basis. It is targeted by the Federal Open Market Committee (FOMC), which is the monetary policy making body in the U.S. The FOMC sets this target rate eight times a year. The announcement of the changes in the Fed rate is religiously followed by investors. This is because rate adjustments are decided by the FOMC after careful consideration of several economic variables ranging from inflation to employment.
Financial markets (both equity and bond markets) generally react heavily as even a minor rise or decline in this rate can significantly impact the borrowing costs of corporations.

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

Financial leverage

Financial leverage

Shruti Chand

In this article, Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022) elaborates on the concept of financial leverage.

This read will help you get started with understanding financial leverage and understand its impact of the business, advantages and disadvantages.

Definition of financial leverage

Financial leverage in simple words is the use of debt to acquire additional assets. Imagine this, if you are borrowing money and using it to expand your business’ assets, you are using financial leverage. Financial leverage is also known as gearing as it deals with profit magnification. Debt is important for a company because it’s an integral way to grow business. The most important question to ask here is why would someone borrow money to acquire assets? The answer is that financial leverage is based on the expectation that the income or capital gain from assets will exceed the cost of borrowing.

Financial leverage Balance sheet

How does financial leverage work in real life?

Let’s say a company wants to acquire an asset, the financing options available to the company are: equity and debt.

  • Equity: shares issued to the public by giving out ownership.
  • Debt: funds borrowed through bonds, commercial papers and debentures to be paid back to lenders along with interest.

Here, in case of equity, no fixed costs are incurred, hence the profit/capital gain from the asset remains totally as profits, while in case of debt and leases, there are fixed costs associated in terms of interest that the company expects to be lower than the profit/capital gain expected.

How is financial leverage measured?

Since financial leverage is considered to be a measure of the company’s exposure to risk, company’s stakeholders look at the Debt / Equity ratio, which is a measure of the extent of financial leverage.

Financial leverage ratio

Total Debt = Current liabilities + Long-term liabilities
Total Equity = Shareholders’ equity + Retained Earnings

Analysis: The higher the debt-equity ratio, the weaker the financial position of the enterprise. Hence, lesser the ratio, lesser the chances of bankruptcy and insolvency.

Other ratios that can be used to measure financial leverage: Debt to Capital Ratio, Interest Coverage Ratio, and Debt to Ebitda Ratio.

Example of financial leverage in action

A company with $1 million shareholder equity, borrows $4 million and has $5 million to invest in assets and operations. This will allow this company to set up new factories, take up growth opportunities and expand.

Let’s assume the cost of debt is $0.5 million for a year and at the end of the first year, the company makes $1 million in profits (20% for the return on assets), the realised profit for the business becomes $1 million (profits) – $0.5 million (debt cost) = $0.5 million (50% for the return on equity for shareholders).

Now on the other hand, if the company makes $1 million in losses (-20% for the return on assets), then the realised loss for the business is $1 million + $0.5 million= $1.5 million. (-150% for the return on equity for shareholders).

You can see how in adverse situation that the effect of leverage can be really detrimental.

Now let’s consider a scenario with no leverage, the business utilizes only the $ 1 million that it already has. Considering the profit and loss percentage in the previous scenario, the business will end up making or losing $200,000 in profitable and loss making scenario respectively (20% for the return on equity for shareholders for the positive scenario and -20% for the negative scenario).

Any business needs to support its activity with borrowed money to acquire assets and hence it can be seen that manufacturing companies such as automakers have a higher debt equity ratio than service industry companies.

Advantages of financial leverage

Among the main benefits of financial leverage is the opportunities to invest in larger projects. There are also tax advantages (linked to the deductibility of interests in the income statement).

Disadvantages of financial leverage

As attractive as financial leverage might sound for a business to grow, leverage can sometimes in fact be really complex. As much as it magnifies gains, it can also magnify losses. With interest expenses and credit risk exposure, a company can often destroy shareholder value to a greater extent if it would have grown its business without Leverage.

All in all, leverage can increase burden on the company, high risk of losses, may lead to bankruptcy and other reputational losses.

Conclusion

It is really important for a company to be wise with its financial leverage position. While giving out too much ownership is not good for the shareholders, in the same way taking too much debt can also be hazardous for the company. Hence, even though the debt equity ratio differs for different industries, it is of a consensus that ideally it shouldn’t be more than 2.

Related posts on the SimTrade blog

   ▶ Shruti CHAND Balance Sheet

   ▶ Louis DETALLE What are LBOs and how do they work?

   ▶ Akshit GUPTA Initial and maintenance margins in stocks

   ▶ Youssef LOURAOUI Introduction to Hedge Funds

Relevance to the SimTrade certificate

This post deals with financial leverage for firms. Similarly, financial leverage can be used investors in financial markets. This can be learnt in the SimTrade Certificate:

About theory

  • By taking the Financial leverage course (Period 3 of the certificate), you will know more about how investors can use financial leverage to buy and sell assets in financial markets.

Take SimTrade courses

About practice

  • By launching the series of Market maker simulations, you will practice how investors can use financial leverage to buy and sell assets in financial markets.

Take SimTrade courses

Useful resources

SimTrade course Financial leverage

About the author

Article written in March 2021 by Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022).

SimTrade: an inspiration for a career in finance

SimTrade: an inspiration for a career in finance

Qiuyi Xu

In this article, Qiuyi Xu (ESSEC Business School, Global Bachelor of Business Administration, 2019-2021) shares her experience as an intern in a securities company in China.

Interested in finance, I took the SimTrade course during my study at ESSEC Business School. This course helped me gain knowledge about financial markets as well as served to motivate me to continue my exploration in the sector of finance. Now I have started an internship at the investment banking department of a top 10 securities company in China.

The concept of “investment banking services” is slightly different in China. While in the US and Europe, it refers to all kinds of services (investment banking division, asset management, sales & trading and research departments), in China, it mainly includes securities (stocks and bonds) issuance and underwriting, merger & acquisition and restructuring.

My mission

My mission is to support the team responsible for an initial public offering (IPO) project. An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance. Public share issuance allows a company to raise capital from public investors.

A main part of our work is to conduct pre-IPO due diligence. Due diligence is regularly carried out to assess the market maturity of the IPO candidate. We deal executers, together with the accompanying issuing houses and the advisers, typically commissions due diligence covering the financial, tax, legal, commercial, IT, operational, environmental and human resource areas. The objective of the pre-IPO due diligence is to analyze the sustainability of the business model, the plausibility of planning and the disbursement capacity of the company.

I am responsible for financial due diligence and shareholders’ due diligence. A pre-IPO due diligence delivers insights into the sustainability of the company’s business model, assesses the competitive landscape, delves into the opportunities available in the candidate’s industry and fully assesses the potential risks that could impact the company.

For financial due diligence, I check the bank card records of transactions of senior executives to identify whether their receipts and payments are normal transactions or there are possibilities of property transfer or commercial bribery. In addition, I check a large number of loan contracts, including the debt amount, starting and ending date, guarantors and guarantee amount to confirm whether the company’s liabilities are within a reasonable range and whether it has potential debt crisis. I am also responsible for writing the relevant part of financial analysis in the prospectus. For shareholders’ due diligence, I have collected the information of the company’s shareholders which should be disclosed in the prospectus through questionnaires under my mentor’s guide. In the case of an IPO, the shareholders of a company are usually directors, supervisors, and senior managers. Since they are the persons who are actually responsible for the operation of the company, we need to disclose in the prospectus their educational and professional backgrounds in detail so that investors can judge whether the company’s top management team can manage the company well to ensure its long-term growth. It is also important to know their investments in other companies or their holdings of shares of other companies, and to recognize the benefit relationship between shareholders and related companies.

Although I did not have the opportunity to participate in the whole process of an IPO project as it usually takes about two years to carry out a project from the beginning of due diligence to the final listing on an exchange, I still feel it is a rewarding experience because so far, I have helped my mentor completed a lot of basic information processing and through this process I have learned how the data and information in the prospectus are obtained, and I have gained an extensive series of knowledge of auditing, commercial laws, and corporate management.

Through the communication with the associates in my group, I learned about what the working environment and lifestyles are like for bankers. The work in an investment bank may begin with dealing with trivial things for several years, but the fact that many elites gather there and their pursuit of perfection in work allow people to develop working capacities and qualities that ordinary people need ten years to cultivate in three years. For example, the customers you are facing are senior executives of large companies, so you can touch the ideas of leaders in the industry; your skills to make and present slides will be greatly improved by doing numerous presentations to customers; and by analyzing the company’s business, you will have a deep understanding of the industry that it is in after each deal.

Relevance to the SimTrade certificate

Primary market and secondary market are interdependent upon each other. Primary market brings new tradeable stocks and bonds to secondary market. A company is considered private prior to an IPO. It grows with a relatively small number of shareholders including early investors like the founders, family and relatives along with professional investors such as angel investors. To expand at a higher speed, the company needs to raise more capital. That’s what an IPO can provide. Via an IPO, securities are created in the primary market. Those securities are then traded by public investors in the secondary market. The secondary market provides liquidity to company founders and early investors, and they can take advantage of a higher valuation to generate dividends for themselves.

From the course SimTrade, I learned many factors that may affect a company’s stock price. For example, when the company appoints a new director who has many years’ experience in the company’s business sector, this favorable news will attract more investors to invest because they believe that under the guidance of this new director, the company’s performance will improve. As a result, the valuation will increase, and the stock price will rise. If the news comes like the company’s new product development has failed, it will lower the expectations of investors, causing some of them to sell stocks and invest in other stocks, accompanied by a decline in stock price. This knowledge about the secondary market also helps me find out more factors that should be considered in pre-IPO due diligence. We should identify the company’s potential competitive advantages, which will become an attraction to public investors and ensure its vitality in the securities market; we also need to recognize its risk factors because if the company does not operate well, it will face the risk of delisting, and more importantly, we are responsible for ensuring the sustainable trade order in the secondary market.

In short, the SimTrade course has equipped me with necessary knowledge needed in internship as well as future work and paved the way for me to secure an ideal position. This will be an asset that I will cherish for the rest of life.

About the author

Article written in May 2021 by Qiuyi Xu (ESSEC Business School, Global Bachelor of Business Administration, 2019-2021).

Organization of equity markets in the U.S.

Organization of equity markets in the U.S.

Bijal Gandhi

In this article, Bijal Gandhi (ESSEC Business School, Master in Management, 2019-2022) talks about the organization of the equity markets in the U.S.

Give this article a read, if you wish to know more about the market participants, intermediaries, and the products in this segment.

Financial markets in the U.S. account for 46% of the global stock market value as of October 2020. The combined market capitalization of the US stock market stands at around 41.17 trillion thereby dominating the global financial landscape. It holds a long-standing reputation and prominence owing to factors like legitimacy, transparency, tight regulations, and availability of capital to fund some of the world’s largest companies.

Primary markets vs Secondary markets

Primary markets are the markets where new securities are issued by corporations to raise capital to finance their new investments. These new securities are offered to the investors for the first time. The corporation may raise capital through an Initial Public Offering (IPO), rights issue, or private placements. Corporations that are already listed may opt for a Seasoned Equity Offering if they wish to raise more capital through the sale of additional shares or bonds. The companies who wish to go public in US, must adhere to the compliance and filing of the U.S. Securities and Exchange Commission before the listing.

Once the securities are issued in the primary market, secondary market provides the investors with a platform to trade in these securities. This smooth exchange of securities between investors creates liquidity and price discovery. These transactions take place over stock exchanges like NASDAQ and NYSE Euronext.

Exchanges vs OTC markets

Exchange is a centralized marketplace to trade securities through a network of people. The exchange establishes a formal setting to ensure fair trading, transparency, and liquidity. The are several rules and regulations in place to eliminate frauds and unscrupulous activities.

The transactions which do not take place over a centralized exchange are known as over the counter markets. OTC markets are less transparent, and they are subject to fewer regulations. They are digitalized markets where participants quote different prices and act as market-makers. American depository receipts are often traded as OTC.

Market intermediaries

The organization of such a huge marketplace has resulted in the creation of several intermediaries and participants. Let us delve deeper into what role each of these stakeholders play in the U.S. financial market organization.

Stock exchanges

A stock exchange is the principal intermediary in the financial market organization of a nation. An exchange can be either a physical or an electronic platform which intermediates between corporations, government, and market participants. In the U.S., a stock exchange must register and comply with the norms of the SEC. It is only after that it can facilitate the process of buying and selling of financial instruments on its platform.

A stock is first listed on an exchange through initial public offering (IPO). The shareholders can participate in this initial offering which is also known as the primary market. These shares are then publicly bought and sold on the exchange or the secondary market.

According to Reuters, as of 2020, there are a total of 13 stock exchanges in the U.S. out of which NASDAQ and NYSE Euronext are the largest exchanges in the world.

Broker-dealers

An investor or trader cannot directly purchase shares from the stock exchange. They must do so through an intermediary called a broker. A broker acts as a link between the investor and the stock exchange. In US, a broker can either be an individual or a firm who is registered with the SEC and SRO (self-regulatory organization). The SEC defines a broker as “any person engaged in the business of effecting transactions in securities for the account of others”. Similarly, a dealer is “any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise”.

Brokers also perform several other secondary functions such as:

  • Marketing, sale, and distribution of investment products
  • Ensuring liquidity and smooth flow of financial products in the open market
  • Operation and maintenance of trading platforms

They may also act as underwriters and placement agents for securities offerings.

Clearing agencies

Clearing agencies in US are broadly classified under two categories, Central counterparty (CCP) and Central securities depository (CSD).

A clearing agency is a CCP when it intercedes between the two counterparties by performing the role of a buyer to every seller and a seller to every buyer in a transaction. The following are the clearing agencies in the US:

  • National Securities Clearing Corporation (NSCC)
  • Fixed Income Clearing Corporation (FICC)
  • The Options Clearing Corporation (OCC)

A clearing agency is a CSD when it operates a centralized system for the safekeeping of securities and maintaining records of ownership, sale, and transfer. The Depository Trust Company in New York, U.S. performs the role of a CSD. It is also the largest depository in the world.

Regulatory agencies

The Securities and Exchange Commission (SEC) is the US government regulatory body entrusted with the responsibility to protect the investors. Their primary goal is to supervise every intermediary and participant in the securities market to avoid any fraud or misconduct under its supervision. It ensures this through strict regulations, compliance, full disclosure, and fair dealing in the securities market.

Similarly, the Commodities Futures Trading Commission (CTFC) is an independent Federal agency established in the U.S. to regulate the derivatives markets (commodities, futures, options, swaps). The main responsibility of this agency is to ensure fair, transparent, efficient, and competitive capital markets.

Market participants

Corporations

Corporations are the most vital and primary participants in the capital market ecosystem. To raise capital for their operations, they issue new securities and instruments with the help of the intermediaries. They may do so by listing their shares on a stock exchange or by issuing debt instruments such as bonds. This opens avenues of investments for individuals and institutions and gives them a medium to invest, trade or park their funds.

Retail investors

Retail investors are nonprofessional individuals who either trade or invest in financial securities in their personal accounts. The amount of their investments is generally smaller with respect to institutional investors. They facilitate these transactions through a broker for a fee.

Institutional investors

Banks, mutual funds, pension funds, hedge funds, insurance companies and any other similar institution which invest large sums in the capital markets are termed as institutional investors. These investors are professionals and experts at handling funds and therefore there are several regulations by SEC that may specifically apply to them.

Investment banks

Investment Banks act as an intermediary between the corporations and investors. They play a major role in facilitating the transfer of funds from the lenders to the borrowers. Apart from that, they also assist the corporations in the sale and distribution of securities, bonds, and similar financial products. They aim to make a sale by connecting the corporations with investors who have similar risk and return appetite. Investment Banks perform several other ad-hoc functions including underwriting and providing equity research.

Robo-advisors

The most recent addition to the participants list is the robo-advisors. Retail investors often find it difficult to invest in the stock markets due to lack of knowledge and expertise. Robo-advisors are of great help here. They are digital platforms that study the financial situation of an individual and provides investment solutions through automation and algorithmic financial planning. These advisors require no human supervision and are therefore low cost. There are around 200 robo-advisors in the US. The robo-advisors like human advisors are subject to the registration and regulations under SEC.

Type of products

Stocks

The most traded instrument is the stock. There are two broad categories of stocks: common stocks and preferred stocks.

  • Common stocks: The investor in common stocks is entitled to both, the dividends, and the right to vote at shareholders meetings. It is a security which represents ownership of the company by the same proportion as its holding. In case of liquidation of the company, the shareholders’ right on the company’s assets are after that of the debt holders and preferred shareholders.
  • Preferred stocks: Preferred stock is more like a hybrid combination of equity and debt. Preferred shareholders have no voting rights, but they receive regular dividends unless decided otherwise. They have a priority over common stockholders in case of bankruptcy.

The choice of stock depends upon the investors risk appetite and goals. Investors may choose to invest in one or a combination of growth, value, income, or blue-chip stocks.

Market Index

Market index is a portfolio of stocks which represents a particular fragment of the financial market. The value of this index is derived from the underlying stocks and the weights attached to each of those stocks. The methodology to assign weights and calculate the index value may differ but the underlying idea to measure the fragment’s performance remains the same. In the US, they use the Dow Jones Industrial Average (DJIA), S&P 500 Index and Nasdaq Composite Index to gauge the performance of the US economy and the financial market.

Investors cannot directly invest in an index, therefore they can either invest in a mutual fund that follows that index or into index derivatives.

Derivative Instruments

Derivatives are financial instruments whose value is derived from an underlying asset. The underlying instruments include stocks, market indexes, interest rates, bonds, currencies, and commodities. Futures, options, forwards, and swaps are the types of derivatives that are most traded in the US markets.

Investors use derivatives to hedge their risk while speculators use it to gain profits from the same.

Mutual Funds

The financial markets are complex and therefore retail investors often find themselves unable to make their financial decisions. This is where the mutual funds step in. These are funds that pool money from several investors to invest in different types of securities. These funds are professionally managed by fund managers for a small fee. The main goal of the fund manager is to produce profits for the investors. Mutual funds vary in terms of the underlying securities, investment objectives, structure, etc.

Mutual funds are popular due to the benefits derived by retail investors in terms of diversification, liquidity, and affordability. In US, mutual funds are managed by “investment advisors” registered under the SEC and they are obliged to file a prospectus and regular shareholder reports.

Exchange Traded Funds

Exchange traded funds (ETFs) are like mutual funds, but unlike mutual funds, ETFs can be traded on the stock exchange and their value may or may not be the same as the net asset value (NAV) of the shares. An Index based ETF simply tracks a particular index and gives the investors an opportunity to invest in its components through the ETF. Actively managed ETFs are not based on an index but rather a stated objective which is achieved by investing in a portfolio of one or many assets.

Related posts

Useful resources

Relevance to the SimTrade certificate

The concepts about equity markets (secondary markets, trading, incorporation of information in market prices, etc.) can be learnt in the SimTrade Certificate:

About theory

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

Take SimTrade courses

About practice

  • By launching the Send an Order simulation, you will practice how financial markets really work and how to act in the market by sending orders.
  • By launching the Efficient market simulation, you will practice how information is incorporated into market prices through the trading of market participants and grasp the concept of market efficiency.

Take SimTrade courses

About the author

Article written by Bijal Gandhi (ESSEC Business School, Master in Management, 2020-2022).

ETFs in a changing asset management industry

ETFs in a changing asset management industry

Youssef LOURAOUI

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2016-2020) talks about his research conducted in the field of investing.

As a way of introduction, ETFs have been captivating investors’ attention in the last 20 years since their creation. This financial innovation has shaped how investors place their capital.

Definition

An ETF can be defined as a financial product that is based on a basket of different assets, to replicate the actual performance of each selected investment. An ETF has more or less the same proportion of the underlying components of the basket, depending on the style of management of the asset manager. ETFs represent nearly 90% of the asset under management of the global Exchange Traded Products (ETP).

History

The first ETF was the Standard and Poor’s Depository Receipts (SPDR) introduced in 1993. It appears to be an optimized product that enables investors to trade it like a stock, with a price that fluctuates during the day (not like mutual funds whose value is known at the end of the day only). The main advantage of ETFs for investors is to diversify their investment with lower fees than buying each underlying asset separately. The most important ETFs in the market are the ones with the lowest expense ratio as it is a crucial point to attract money from investors in the fund.

Types of ETF

ETFs can be segmented in different types according to the asset class, geography, sector, investment style among other criteria. According to Blackrock’s classification (2021), the overall ETF market can be divided into the following classes:

  • Stock ETFs track a certain stock market index, such as the S&P 500 or NASDAQ.
  • Bond ETFs offer exposure to a wide selection of fixed income instruments.
  • Sector and industry ETFs invest in a particular industry such as technology, healthcare, or financials.
  • Commodity ETFs track the price of a commodity such as oil, gold, or wheat.
  • Style ETFs are devoted to an investment style or market capitalization focus such as large-cap value or small-cap growth.
  • Alternative ETFs offer exposure to the alternative asset classes and invest in strategies such as real estate, hedge funds and private equity.
  • Foreign market ETFs follow non-U.S. markets such as the United Kingdom’s FTSE 100 index or Japan’s Nikkei index.
  • Actively managed ETFs aim to provide a certain outcome to maximize income or outperform an index, while most ETFs are designed to track an index.

Figure 1. Volume of the ETF market worldwide 2003-2019.
Volume of the ETF market worldwide 2003-2019
Source: Statista (2021).

Figure 1 represents the volume of the ETF market worldwide over the period 2003-2019. With over 6,970 ETFs globally as of 2019 (Statista, 2021), the ETF industry is growing at an increasing pace, recording a thirty-fold increase in terms of market capitalization in the 17-year timeframe of the analysis. It reflects the growing appetite of investors towards this kind of financial instruments as they offer the opportunity for investors to invest virtually in every asset class, geographical region, sector, theme, and investment style (BlackRock, 2021).

iShares (BlackRock), Xtrackers (DWS) and Lyxor (Société Générale) can also be highlighted as key players of the ETF industry in Europe. As shown in Figure 2, Lyxor (a French player) is ranked 3rd most important player with nearly 9% of the overall European ETF market (Refinitiv insights, 2019). iShares represents nearly eight times the weight of Lyxor, which is slightly above the average of the overall European ETF volume in dollars.

Figure 2. Market share at the promoter level by Assets Under Management (March 31, 2019)
Market share at the promoter level by Assets Under Management (March 31, 2019)
Source: Refinitiv insights (2019).

It goes without saying that the key player worldwide remains BlackRock with nearly 1/3 of the global ETF market capitalization. According to Arte documentary, BlackRock is without a doubt a serious actor of the ETF industry as shown in Figure 2 with an unrivaled market share in the European and global ETF market. With more than 7 trillion of asset under management, BlackRock is the leading powerhouse of the asset management industry.

Benefits of ETF

The main benefits of investing in ETFs is the ability to invest in a diversified and straightforward manner in financial markets by owning a chunk of an index with a single investment. It allows investors to position their wealth in a reference portfolio based on equities, bonds or commodities. It also helps them to create a portfolio that suits their needs or preferences in terms of expected return and risk and also liquidity as ETFs can be bought and sold at any moment of the day. Finally, ETFs also allow investors to implement long/short strategies among others.

Risks

Market risk is an essential component to fully understand the risk of owning an ETF. According to the foundations of the modern portfolio theory (Markowitz, 1952), an asset can be deconstructed into two risk factors: an idiosyncratic risk inherent to the asset and a systematic risk inherent to the market. As an ETF are composed of a basket of different assets, the idiosyncratic risk can be neutralized by the effect of diversification, but the systematic risk, also called the market risk is not neutralized and is still present in the ETF.

In terms of risk, we can mention the volatility risk arising from the underlying assets or index that the ETF tries to replicate. In this sense, when an ETF tries to emulate the performance of the underlying asset, it will also replicate its inherent risk (the systematic and non-systematic risk of the underlying asset). This will have a direct impact on the overall risk-return characteristic of investors’ portfolio.

The second risk, common to all funds and that can have a significant impact on the overall performance, concerns the currency risk when the ETF owned doesn’t use the same currency as the underlying asset. In this sense, when owning an ETF that tracks another asset that is quoted in another currency is inherently, investors bears some currency risk as the fluctuations of the pair of currencies can have a significant impact on the overall performance of the position of the investor.

Liquidity risk arises from the difficulty to buy and sell a security in the market. The more illiquid the market, the wider the spreads to compensate the market maker for the task of connecting buyers and sellers. Liquidity is an important concern when picking an ETF as it can impact the performance of the portfolio overall.

Another risk particular to this instrument, is what is called the tracking error between the ETF value and its benchmark (the index that the ETF tries to replicate). This has a significant impact as, depending on the overall dispersion, the mismatch in terms of valuation between the ETF and the benchmark can impact the returns of investors’ portfolio overall.

Passive management and the concept of efficient market

Most ETFs corresponds to “passive” management as the objective is just to replicate the performance of the underlying assets or the index. Passive management is related to the Efficient Market Hypothesis (EMH), assuming that the market is efficient. Passive fund managers aim to replicate a given benchmark believing that in efficient markets active fund management cannot beat the benchmark on the long term.

Passive fund managers invest their funds by:

  • Pure replication of the benchmark by investing in each component of the basket (vanilla ETF)
  • Synthetic reproduction of the benchmark by replicating the basket with derivatives products (like futures contracts).

An important concept is market efficiency (also known as the informational efficiency), which is defined as the ability of the market to incorporate all the available information. Efficient market is a state of the market where information is rationally processed and quickly incorporated in the market price.

It is in the heart of the preoccupations of fund managers and analysts to unfold any efficiency in the market because the degree of efficiency impacts their returns directly (CFA Institute, 2011). Fama (1970) proposed a framework analyzing the degree of efficiency in a market. He distinguishes three forms of market efficiency (weak, semi-strong and strong) which correspond to the degree in which information is incorporated in the prices. Earning consistently abnormal returns based on trading with information is the opposite view of what an efficient market is.

  • The weak form of market efficiency refers to information composed of past market data (past transaction prices and volumes). In a weakly efficient market, past market information is already included in the current market price, and investors will not be able to distinguish any pattern or prediction of future prices based on past data.
  • The semi-strong of market efficiency refers to publicly available information. This includes market data (as in the week form) and financial disclosed data (financial accounts published by firms, press articles, reports by financial analysts, etc.). If a market is considered in the semi-strong sense, then it must be in a weak sense as well. In this context, there is no additional gain in determining under or overvalued security as all the public data is already incorporated in the asset price.
  • The strong of market efficiency refers to all information (both public and private). Markets are strongly efficient when they reflect all the available information at any time in the asset prices.

Related posts on the SimTrade blog

   ▶ Micha FISCHER Exchange-traded funds and Tracking Error

   ▶ Youssef LOURAOUI Passive Investing

Useful resources

Academic resources

Fama, E. (1970) “Efficient Capital Markets: A Review of Theory and Empirical Work” Journal of Finance 25(2), 383–417.

Business

Arte documentary (2014) “Ces financiers qui dirigent le monde: BlackRock”.

BlackRock (January 2021) ETF overview.

Refinitiv insights (2019) Concentration of the major players in the European ETF market.

About the author

The article was written in February 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2016-2020).

Markets

Markets

Juan Francisco Rodriguez Rodriguez

This article written by Juan Francisco Rodriguez Rodriguez (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021) presents the basics of markets and details two types of market microstructure: the fixing procedure and the limit order book.

What is a market?

The market is a process that operates when there are people who act as buyers and sellers of goods and services, generating an exchange. There is a market if there are people with the intentions to buy and sell, and when participants agree to exchange goods and services at an agreed price. For the market to work, you need buyers and sellers, and these two parts are what make up the market.

Buyers

On the one hand, the buyer is the person who acts in a market with the intention of acquiring a good or service by paying an amount of money (or in exchange for another good or service). Therefore, when someone buys, this person considers that the good or service he is receiving is worth more than the money he is paying for.

Sellers

On the other hand, the seller is the person who is willing to deliver a good or service by accepting a quantity of money (or in exchange for another good or service). The seller considers that the money that she is receiving has more value than the good or service that she offers.

Supply and demand

In a market, the price of the product is determined by the law of supply and demand. If the price is high, few people will be willing to pay for it but many will want to produce it; if the price is low, many will be willing to buy it but few willing to produce it. The price will be eventually at an acceptable level for both parties.

Market with a fixing procedure

Financial markets

Market used to be a physical place where the processes of exchange of goods and services took place, but due to technology markets no longer need a physical space.

Add two images: one for a physical market, one for a digital market (guys in front of computers) for Wall Street

Market with a fixing procedure

The fixing procedure is a form of trading securities in financial markets by fixing single prices or “fixing”. This procedure is commonly based on auctions. At the close of each auction the orders are crossed to maximize the quantity exchanged between buyers and sellers, and the new price is set.

Auctions are periods in which orders are entered, modified, and canceled. No negotiations are executed until the end of the auction. During this period, an equilibrium price is set based upon supply and demand, and negotiations take place at the end of the auction at the last equilibrium price calculated to maximize the quantity exchanged between buyers and sellers.
The fixing procedure is used for securities presenting a low level of liquidity. It is also used to set the opening and closing prices for continuous markets.

Market with a fixing procedure

Market with a limit order book

A limit order book is a record of pending limit orders waiting to be executed against market orders.

Market with a limit order book
A limit order is a type of order to buy or sell a security at a specific price. A buy limit order is a buy order at a fixed price or lower. When your buy limit order arrives to the market, it is confronted to the other side of the order book: the “Sell” side of the order book. If the sell orders in the order book are at the same or lower price than the price limit of your buy order, a transaction takes place. Similarly, a sell limit order is a sell order at a fixed price or higher. When your sell limit order arrives to the market, it is confronted to the other side of the order book: the “Buy” side of the order book. If the sell orders in the order book are at the same or higher price than the price limit of your sell order, a transaction takes place.

When the price limit of a buy limit order arriving to the market is lower than the best proposition on the “Sell” side of the order book, it is simply recorded in the order book, and is carried out as long as it has reached the market price. When the price limit of a sell limit order arriving to the market is higher than the best proposition on the “Buy” side of the order book, it is simply recorded in the order book, and is carried out as long as it has reached the market price.

Relevance to the SimTrade Certificate

These terms are very relevant to the SimTrade Certificate because they lay the foundations for us to know how financial markets work and the different ways in which a transaction can be carried out, whether to buy or sell an asset. I definitely think this will add value to my career in finance and help me make better investment decisions in the future.

The SimTrade platform uses a market with a limit order book, which corresponds to the current standard for real financial markets organized around the world.

The concept of markets relates to the SimTrade Certificate in the following ways:

About theory

  • By taking the Discover SimTrade course, you will discover the SimTrade platform that simulates a market with a limit order book.
  • By taking the Trade orders course, you will know more about the different type of orders that you can use to buy and sell assets in financial markets.

Take SimTrade courses

About practice

    • By launching the Sending an Order simulation, you will practice how financial markets really work and how to act in the market by sending orders.
  • By launching the Market order simulation and the Limit order simulation, you will practice market orders and limit orders that are the two main orders used by investors to build and liquidate positions in financial markets.

Take SimTrade courses

More about SimTrade

Article written by Juan Francisco Rodriguez Rodriguez (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2021).