Fixed-income products

April 19, 2021 by Jayati WALIA

Fixed-income products

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

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?

April 17, 2021 by Raphaël ROERO DE CORTANZE

What is an Institutional Investor?

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?

April 17, 2021 by Raphaël ROERO DE CORTANZE

What is an Activist Investor?

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

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

April 12, 2021 by Rodolphe CHOLLAT-NAMY

Introduction to bonds

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

▶ 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

April 9, 2021 by Bijal GANDHI

Leading and lagging indicators

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.
U.S yield curve April 2021
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.

S&P 500 Evolution
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.

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?

April 3, 2021 by Youssef LOURAOUI

Is smart beta really smart?

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).

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, r_f the risk-free rate, β a measure of the risk of the asset and E(r_m) 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,r_m) represents the covariance of the asset with the overall market, and σ(r_m)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, r_f the risk-free rate, E(r_m) the expected return of the market, and β×(E(r_m)-r_f) 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).

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.

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).

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.

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

March 23, 2021 by Bijal GANDHI

Economic indicators

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,

Daily yield curve rates published by the U.S. Department of the Treasury
Durable Goods Manufactures’ report released monthly by U.S. Census Bureau
Manufacturing jobs survey by the U.S. Bureau of Labor Statistics
Building permits data published by United States Census Bureau

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:

Industrial production & capacity utilization report by Federal reserve statistical release
GDP published quarterly and yearly by Bureau of Economic Analysis
Real Personal income released yearly by Bureau of Economic Analysis

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

December 25, 2023March 16, 2021 by Shruti CHAND

Financial leverage

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.

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.

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.

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.

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.

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

March 13, 2021 by Qiuyi XU

SimTrade: an inspiration for a career in finance

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.

February 16, 2025March 2, 2021 by Bijal GANDHI

Organization of equity markets in the U.S.

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.

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

February 3, 2021 by Youssef LOURAOUI

ETFs in a changing asset management industry

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.

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)

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.

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

February 16, 2025February 3, 2021 by Juan Francisco RODRIGUEZ RODRIGUEZ

Markets

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.

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 limit order book

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

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.

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.

More about SimTrade

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

AMF

January 22, 2021 by Akshit GUPTA

Autorité des Marchés Financiers (AMF)

This article written by Akshit GUPTA (ESSEC Business School, Master in Management, 2022) presents the structure and functioning of Autorité des Marchés Financiers (AMF).

Introduction

The Autorité des Marchés Financiers (AMF) is an independent financial institution and administrative authority which possesses regulatory powers over the financial and banking industry in France. It was created under the Financial Security Act of 2003 with the primary purpose of ensuring protection of investors’ interests and smooth operations within the financial markets.

The authority has an independent legal identity and exercises authority, regulations, controls and sanctions over the players in the French financial system. In 2003, the AMF was formed as part of a merger between several financial regulators including Conseil de discipline de la gestion financière (CDGF), Conseil des marchés financiers (CMF) and Commission des Opérations de Bourse (COB).

The AMF is embodied with the primary objective of protecting the investors’ interests and savings in the financial markets along with monitoring and regulating the markets by issuing rules, guidelines, control measures and ensuring transparent flow of information. The authority is also responsible for issuing sanctions and penalties to market players in case any malpractices occur.

Organizational Structure

The Autorité des Marchés Financiers (AMF) primarily consists of 2 bodies namely, Le Collège and a Sanctions commission.

The Collège is headed by the President of the AMF, who is directly nominated by the President for the Republic of France for a non-renewable tenure of five years, along with a team of 16 people appointed directly by the public authorities. The operations and administrative work for the AMF is carried out by the Secretary General who is appointed by the President of the AMF and works under his supervision. The Collège has the powers to open sanctions and injunction proceedings against financial participants. The body is also responsible for defining the job framework, setting the budgets and staff remunerations for the AMF.

The Sanctions commission is an autonomous decision-making body that is responsible for exercising the sanctions on behalf of the AMF. The Commission consists of 12 people who are directly appointed by the public authorities.

The executive committee (Comité exécutif or Comex) is an additional body responsible for presenting proposals for the smooth execution of operational and strategic objectives for the AMF. The body is chaired by the President of the AMF and brings in an additional viewpoint to streamline the processes of the AMF.

Powers and responsibilities

The AMF is responsible for overseeing and regulating the activities in the French financial system and its players including listed companies, credit institutions, investment banks, investment firms and asset managers. It also looks after the financial products offered by the stated players in order to ensure the protection of investors’ interests and rights.

The AMF carries the above stated activities by means of enacting rules and regulations, authorizing products offered by financial players, issuing sanctions, implementing control measures and offering mediation system to ensure the smooth flow of market operations. It has the powers to investigate transactions carried out by any market participants to ensure the compliance of such transactions with the financial regulations of the French financial system.

Sanctions and penalties

The AMF is vested with the powers to issue sanctions and penalties to market professionals who act in contradiction to the rules and regulations of the financial system. The power to issue sanctions by AMF is split between the two primary bodies of the AMF that are the Collège and the Sanctions commission.

If any breach is found to have happened, the Collège is vested with the powers to decide upon the initiation of legal proceedings. If the Collège agrees upon initiating the legal proceedings, the Sanctions commission is responsible for deciding the quantum and degree of the sanctions to be inflicted upon the suspected individual/individuals.

The kind of malpractices that can take place in the financial system involves insider trading, stock price manipulations, circulation of false information, etc. which can affect the investors and possess a threat to their investments or financial safety.

The AMF can issue injunctions and individual sanctions to financial professionals (including individuals or firms) depending on the nature and magnitude of the breach that took place.

The Sanctions commission has the power to issue disciplinary sanctions which involve ban on practicing or reprimands and financial penalties amounting to 100 million euros or 10 times the amount of profits made by any individual or organization. The degree of such penalties depends upon the magnitude of the financial crimes involved and the advantages or benefits gained by the suspects.

Relevance to the SimTrade Certificate

The activities of the AMF relate to many topics covered in the SimTrade certificate:

The different players supervised by the AMF (listed companies which issued stocks then traded on an exchange, investment services providers such as brokers which provide access to the market, asset management companies which buy and sell securities on the market) are the participants to the market introduced in Period 1 of the SimTrade certificate.
Insider trading and market manipulations are linked to the concept of market efficiency introduced in Period 2 of the SimTrade certificate. These illegal activities have an impact on market prices.
Short selling is introduced in Period 3 of the SimTrade certificate. Short selling allows to speculate on the market by making a profit when the stock price decrease.

Useful resources

Autorité des Marchés Financiers (AMF)

Autorité des Marchés Financiers (AMF) Impose Sanctions

About the author

The article was written in January 2021 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2021-2023).

Corner

February 16, 2025January 15, 2021 by Akshit GUPTA

Corner

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents the technique of Cornering, which is a type of market manipulation in financial markets.

Introduction

Cornering a market refers to the acquisition of a significant amount of an asset which gives the manipulator a controlling interest in the market. This strategy is used to manipulate the market for the asset and the manipulator has the power to move the asset price in his/her favor. Cornering has been observed in the financial markets since a long time and strong regulations and rules have been put into place by regulators worldwide to prevent such activities to happen. In the United States, the Securities and Exchange Commission (SEC) and Federal Trade Commission (FTC) supervise the trading activities in the financial markets to catch the manipulators who indulge in such practices. While cornering can be considered as legal or illegal depending on the circumstances and the intention of the individual involved, most of the times it is done to deceit the honest investors and earn illegal profits.

In cornering, the manipulator acquires a controlling stake in the asset and pushes up the prices for the underlying asset. Once the prices have reached a significant level, the manipulator exits his/her position leading to market correction and a sharp fall in the asset prices.

Short squeeze

Short squeeze is a market situation where a mismatch of demand and supply (high demand and low supply) of an asset results in the asset price to rise significantly. In generally seen instances, when the share price of a company starts rising, short sellers rush to cover their positions to meet the margin requirements and avoid more losses. The sudden increase in demand is mismatched with the market supply, driving the asset price upwards in a frenzy manner.

Practices used to corner the market

Beyond the accumulation of assets in his/her position, the manipulator usually uses many practices to manipulate the price up or down in his/her favor. The most common practices used are the pump and dump scheme and the poop and scoop scheme detailed below.

Pump and dump scheme

In the pump and dump scheme, the manipulator circulates false positive information about a particular asset which leads to an increase interest amongst the investors for the particular asset and leads to more demand. As the demand for the asset rises, the prices also go up and the manipulator exits his/her position, thereby generating high profits and crashing the market for the asset. Such schemes are generally carried on lesser-known assets which have an information asymmetry, and the manipulator has the means to manipulate the market.

Poop and scoop scheme

In the poop and scoop scheme, the manipulator circulates false negative information about an asset in the market. Hearing the negative information, other investors undertake panic selling, thereby decreasing the prices for the asset. The manipulator buys the asset once the prices fall and manipulates the market.

Silver Thursday (1980)

Silver prices

The manipulators who practice cornering in a market, hoard large quantities of a security in the initial accumulation phase. As seen in the graph above, in the silver market cornering that started in the 1970s, the Hunt Brothers bought large quantities of silver over a period of 10 years in an attempt to corner the silver market. They were holding approximately one third of the world’s deliverable silver supply. The price of silver went up drastically over this period. But as their practices came to be noticed, the regulatory bodies in the United States amended the rules and regulations regarding commodity trading, bringing an end to their manipulation practice. Then the silver market crashed on March 27, 1980, a day known as ‘Silver Thursday’.

‘Silver Thursday’ is infamous for recording one of the highest falls in the market price of silver. In the months preceding the Silver Thursday, the U.S. Federal Reserve brought in new regulations restricting banks to issue loans for commodity speculations. At the same time, the Chicago Board of Trade (CBOT) increased the margin requirements on silver futures contracts, leading to high margin calls for the Hunt Brothers. Due to lack of access to new leverage, they were unable to meet the margin requirements for the silver contracts they held. The new regulations led to the failure of the attempt made by the Hunt Brothers to corner the silver market. As soon as the news hit the market, investors starting panicking leading to a sharp selling of the silver futures contracts. This ultimately led to a fall in the silver price from around $50 per ounce to $11 per ounce over a short span of time. Hunt Brothers were charged with civil charges for manipulating the silver market over the years and artificially increasing the silver price. Due to the new regulations and stricter laws, they also had to pay heavy fines amounting to millions of dollars which led to their bankruptcy.

Conclusion

Illegal cornering has been regarding as a common market manipulation practice throughout the world and the regulators keep a tight watch to control such practices from occurring. Although many attempts of cornering the financial markets have been made by several manipulators in the past, most of them have been unsuccessful. The manipulators also take huge risks while trying to corner the market as the irregular market patterns can be observed by professional investors. The inefficiencies seen in markets manipulated through cornering can prompt other investors to take opposing positions leading to heavy losses to the manipulators.

Relevance to the SimTrade Certificate

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

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.

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.

About the author

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

Regarder la vidéo "Qu'est-ce que SimTrade ?"

October 21, 2013 by Jennifer LEE

Qu’est-ce que SimTrade ? Deux minutes de vidéo pour en savoir plus :

Accéder à SimTrade

Nouvelle version de SimTrade avec facilitation du passage d'ordres

February 22, 2013 by Jennifer LEE

Une nouvelle version de la plateforme de trading SimTrade (version 1.7) a été mise en ligne le 21 février 2013.

Facilitation du passage d’ordres

Suite à des remarques de SimTraders avertis, le passage d’un ordre sur le marché se fait maintenant à l’aide de deux boutons “Acheter” et “Vendre” (le sens de l’ordre était auparavant défini comme un paramètre de l’ordre). Le passage d’un ordre est donc plus rapide et plus sûr (il n’y a plus à choisir le sens de l’ordre puis à valider l’ordre).

Amélioration de la simulation Pour l’amour du blé

La simulation du concours de SimTrading actuel Pour l’amour du blé présente de l’aléa sur l’aléa. En d’autres termes, à chaque lancement de la simulation, même sans l’intervention du SimTrader, le marché ne se reproduit pas à l’identique.

Participer au concours de SimTrading

Nouvelle version de SimTrade avec catalogue et annulation des ordres

December 9, 2012 by Jennifer LEE

Une nouvelle version de l’application SimTrade (version 1.3) a été mise en ligne le 6 décembre 2012.

Le catalogue : un nouveau moyen pour sélectionner une simulation

Le site SimTrade vient de s’enrichir d’une nouvelle partie : le catalogue des simulations. En accès libre, le catalogue permet de découvrir les simulations disponibles sur SimTrade.

Avec l’augmentation constante du nombre de simulations, il était nécessaire d’organiser les choses. Le catalogue permet de sélectionner une simulation facilement selon différents critères.

Annulation d’ordre

Réclamée par de nombreux SimTraders (adi90, GapTrade, lulu75, etc.), cette nouvelle version propose maintenant la fonctionnalité d’annuler des ordres pendant la simulation.

Qui n’a pas passé un ordre à cours limité à l’achat pour profiter d’une baisse du prix de l’action mais qui a vu le prix s’envoler et ne jamais toucher la limite de prix… Suite à une hausse du prix de l’action, il y a peu de chance que l’ordre d’achat avec une limite de prix devenue trop basse soit exécuté. En d’autres termes, cet ordre ne sert plus à rien… mais continue à immobiliser du cash pour un ordre d’achat et des titres pour un ordre de vente. La fonctionnalité d’annulation d’ordre permet d’annuler l’ordre (pour la quantité de titres non encore exécutés) et donc de libérer du cash suite à l’annulation d’un ordre d’achat et des titres suite à l’annulation d’un ordre de vente.

L’annulation d’ordres fait partie intégrante de toute stratégie de trading dynamique.

Vous pouvez nous contacter pour nous faire part de vos commentaires.

Nouvelle version de SimTrade avec traçabilté des ordres

September 18, 2012 by Jennifer LEE

Une nouvelle version de l’application SimTrade (version 0.9.7.0) a été mise en ligne le 18 septembre 2012.

Nouveautés pédagogiques

Rappelons que l’objectif de SimTrade est pédagogique : faire comprendre le fonctionnement des marchés financiers et apprendre à intervenir sur les marchés.

Au niveau pédagogique, la nouvelle version apporte la traçabilité des ordres de l’internaute-trader (le SimTrader). Dans la page “Trading” de la simulation, les ordres du SimTrader apparaissent maintenant en bleu et en gras dans le bloc “Carnet d’ordres” (il s’agit des ordres à cours limité du SimTrader, qui n’ont pas encore été exécutés). De même, les transactions du SimTrader, suite à l’exécution des ordres qu’il a passé sur le marché, apparaissent en bleu et en gras dans le bloc “Dernières transactions” ainsi que dans la fenêtre “Historique” qui reprend toutes les transactions de la journée de trading.

Ce nouveau développement permet de tracer les ordres et les transactions du SimTrader et donc de mieux comprendre l’impact du SimTrader sur le marché.

Vous pouvez nous contacter pour nous faire part de vos commentaires.

Fixed-income products

Introduction

Types of fixed-income products

Treasury bills

Treasury notes and bonds

Corporate bonds

Asset-backed securities

Benefits of fixed-income products

For issuers

For investors

Risks associated with fixed-income products

Useful resources

Related posts

About the author

What is an Institutional Investor?

What is an Institutional Investor?

Institutional investor VS Retail Investor

The impact of Institutional Investors

Key concepts

Bond

Credit Union

Mutual Funds

Options

Commodities

Forex

Futures contracts

About the author

What is an Activist Investor?

What is an Activist Investor?

Modus operandi

The Danone case

Activist investors: good or bad for shareholders?

Useful resources

Related posts

About the author

Introduction to bonds

What is a bond?

What are the main characteristics of a bond?

Example

What are the different types of bonds?

Types of issuers

Government bonds

Municipal bonds (“munis”)

Corporate bonds

Technical characteristics

Fixed-rate bonds

Floating-rate notes

Zero-coupon bonds

Convertible bonds

Useful resources

Rating agencies

Related posts

About the author

Leading and lagging indicators

Leading indicators

Composite index of leading indicators

Yield curve

Credit spreads

Stock market

Durable goods orders

Manufacturing jobs

Building permits

Unemployment claims

Manufacturing new orders

Consumer expectations

Leading Credit Index

Lagging indicators

Composite index of lagging indicators

Average duration of unemployment

Ratio, manufacturing, and trade inventories to sales

Change in labor cost per unit of output, manufacturing

Average prime rate charged by banks

Commercial and industrial loans outstanding

Ratio, consumer installment credit outstanding to personal income

Change in Consumer Price Index for services

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