WallStreetBets

May 28, 2021 by Shruti CHAND

WallStreetBets

In this article, Shruti CHAND (ESSEC Business School, Grande Ecole Program – Master in Management, 2020-2022) explains what WallStreetBets is about.

This read will help you get started with understanding WallStreetBets and understand its impact in the stock market.

Meaning of WallStreet Bets

On the social media website Reddit, there are specific online communities that are dedicated to discussion on a particular topic, these are known as subreddits. And, WallStreetBets (r/wallstreetbets), or WSB, is one such subreddit. On WSB, the members discuss stock markets and options trading.

WSB has gained notice due to its aggressive trading strategies, indecent nature, and its role in the GameStop short squeeze. Members of the WSB are often young retail traders who are said to have a highly speculative style of trading that ignores the traditional investment practices and risk-management techniques. Their activity is even considered to be on the lines of gambling.

The growth of such individual investors has been powered by the rise of no-commission brokers and mobile online trading platforms (like Robinhood) which have made trading easy and accessible to everyone. Members of these communities like WSB often use high-risk day trading as an opportunity to make quick financial gains and obtain additional income.

The GameStop Short Squeeze

It would be unfair to talk about WSB and not discuss the GameStop Short Squeeze, an incident that threw the market into chaos and disrupted trading.

GameStop, a struggling company in the video games business, had become one of the most bet-against stocks on the market. Many big investors (hedge funds like Melvin Capital et Citron Capital) had taken large short positions on the stock, hoping to cash in on the company’s inevitable failure. Short selling is an incredibly risky strategy as the loss can be infinite when the stock price is going up. Members of WSB are said to have an aversion towards short sellers because of how it affects the financial system.

In January 2021, harnessing the power of the internet, Redditors on WallStreetBets started encouraging each other to buy the GameStop stock to drive the price up, which would adversely affect the short-sellers. This coordinated effort led the GameStop stock price to begin to rise. Eventually, GameStop had become a movement, which was not just about making money but about taking down ‘the man’ and punishing short sellers. It even led to the coining of the term ‘meme stock’. It attracted a huge amount of media attention and the number of members of WSB rose from 2 million to 6 million in a matter of days. As a result, in a mere few weeks, GameStop stock prices increased by a whopping 1700%.

Previously, it was believed that individual investors (also called ‘retail’ investors) have no real impact on the market and that such a thing was only within the capability of the big players of the game. This notion was successfully challenged by this incident. It was seen as the ‘little guys’ taking down the giants of Wall Street. It is believed that this trend of democratization of investing is here to stay.

Epilogue

After the GameStop short squeeze, it was anticipated that such manipulation in stock prices could happen again when groups like WSB target more companies. It turned out to be true as many stocks like AMC, Blackberry, etc. saw a surge in prices in an apparent Reddit-fuelled short squeeze.

In the financial world, WallStreetBets has received varied reactions. Trading platforms like Robinhood have tried to curb the power of Redditors by limiting transactions on the grounds of protecting customers. Many analysts and investors have derided and leveled insults at the WallStreetBets investors.

Whatever the future may hold, it is apparent that together, these amateur investors are changing some long-held beliefs about investing and they are gaining influence in the market in the process. Their online interactions have led to the reshaping of the power dynamic between retail and institutional investors.

Useful resources

WallStreetBets

Relevance to the SimTrade certificate

This post deals with WallStreetBets in the Stock Market. More so, we learnt that retail investors can also have a real impact in the market.

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By launching the series of Trading Exercises, you will practice how investors can become an investor in the stock market.

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About the author

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

Consumer Confidence Index

May 27, 2021 by Bijal GANDHI

Consumer Confidence Index

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

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

Introduction

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

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

Measuring Consumer Confidence Index

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

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

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

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

Present Situation Index

Current business conditions
Current employment conditions

Expectations Index

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

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

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

Bijal Gandhi

Source: The Conference Board

Interpreting Consumer Confidence Index

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

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

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

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

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

Useful resources

The Conference Board

About the author

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

Purchasing Managers’ Index

May 27, 2021 by Bijal GANDHI

Purchasing Managers’ Index

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

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

Introduction

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

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

PMI is formulated by three main institutions:

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

Calculation of PMI

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

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

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

The PMI is calculated as:

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

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

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

Importance of PMI

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

For Manufacturers

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

For Suppliers

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

For Investors

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

For Government

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

Why should one be concerned about PMI?

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

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

Bijal Gandhi

Source: www.tradingview.com

Useful resources

Institute for supply management

Trading View

About the author

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

Credit Rating

May 27, 2021 by Bijal GANDHI

Credit Rating

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

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

Introduction

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

Rating agencies

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

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

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

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

Types of Credit Rating

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

Investment grade

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

Speculative grade

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

Users of Credit Rating

Credit Ratings are used by multiple entities like the following:

Institutional investors

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

Intermediaries

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

Debt Issuers

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

Businesses & Corporations

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

Understanding Credit Rating

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

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

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

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

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

Importance of Credit Ratings

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

For Lending Entities

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

For Borrowing Entities

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

For Investors

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

Useful resources

S&P Global Ratings

Moody’s

Fitch Ratings

About the author

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

Bond Markets

May 24, 2021 by Rodolphe CHOLLAT-NAMY

Bond markets

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

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

The primary market

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

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

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

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

Syndication

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

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

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

Auction

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

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

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

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

The secondary market

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

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

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

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

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

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

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

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

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

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

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

The quoted price will be: 88%.

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

Useful resources

Rating agencies

S&P

Moody’s

Fitch Rating

▶ Rodolphe CHOLLAT-NAMY Bond valuation

▶ Rodolphe CHOLLAT-NAMY Bond risks

▶ Bijal GANDHI Credit Rating

▶ Jayati WALIA Credit risk

About the author

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

The 2007-2008 subprime crisis

May 24, 2021 by Marc RAHME

The 2007-2008 subprime crisis

In this article, Mark RAHME (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) explores the 2007-2008 subprime crisis.

Finance in 2021 was unlike anything imagined: cryptocurrencies going up and down, vaccines, trading restrictions, … all and all, it is safe to say that the year is a very particular one. Despite the losses and the misericord that the pandemic has brought upon us, perhaps it would be interesting to take a look back at how humanity managed to plummet its financial status without the intervention of an infectious virus. As such, we cannot but invoke the 2007-2008 world financial crisis. So, what are the reasons behind this dark event in financial history?

Front pages from then and now: 14 years apart, yet the same end: financial crash.

The Washington Post: Markets in disarray

Source: The Washington Post.

The Guardian: The economy could shrink

Source: The Guardian.

How ABS was the New Sexy for Bankers:

Starting 2000, the US was experiencing strong economic growth, and so bankers were easing up regulation on giving out loans and advances (corporate, retail, …) seeing things were going well, having as collateral to the real estate or asset bought with the loan. These collaterals were known as Collateralized Debt Obligations (CDO) or Assets Backed Securities (ABS).

Sub-Primers and Primers: Why Give to One, when you can Give to Both?

At the same period, there was a debt increase for real estate appropriation. Effectively, banks started having more structured and different loan offers for housing acquisition. This enabled banks supply more people with loans with the same periodic settlements as the amount of rent they were paying. In other words, instead of paying rent for the house you were in, you could pay the same amount and buy it for no additional cost. This process was spread even more because of the increase in people’s income, resulting from the economic growth. However sometimes loans were granted to individuals who could not afford it. These individuals, who evidently had a high risk of defaulting, were dubbed as “sub-primers”, but were ironically the prime target for bankers. As such, the demand for the real estate increased, thus the price of the houses as well.

It should be noted that, because of the way long term debt contract deals written by banks, loaners were paying the interest payment on their loan first, and their actual loan was to be paid later (while not all loaners were necessarily always aware of this). Despite this, there was no real problem at this point.

Transforming Assets into Financial Vehicles: The Role of SPVs:

Perhaps the real cause of what led to this international crisis was the securitization of Special Product Vehicles (SPV), or the process of externalizing assets into a fund (the SPVs in question) by financial institutions and selling it as shares. The basic idea is that an asset is transformed, or liquidized, into a financial product, that is sold on the market. Effectively, the underlying asset behind the real estate (that is now transformed into a fund) were the credit loans that were used to buy real estate. Naturally, seeing the economic growth, financial institutions that created these funds, like Lehman-Brothers, were promising high returns seeing the high demand for real estate. And so started the sale of financial securities to international investors outside of the US. Banks started adopting an “Originate-to-distribute” model, which involves lenders creating loans with the objective of selling them to other institutions and entities, instead of holding on to them until maturity (originate-and-hold).

Simultaneously, there was:
• A decrease in interest rates in the US from 2000 to 2004:
o 2000: 6.50%
o 2001: 1.75%
o 2002: 1.25%
o 2003: 1.00%

which prompted people to go get even more loans and advances, when they couldn’t particularly afford paying it back.

• An increase in inflation from 2004 to 2006:
o 2004: 2.25%
o 2005: 4.00%
o 2006: 5.00%
o 2007: 5.25%

and it is around this time that interest rates started increasing.

The Final Countdown:

It was finally in 2006 that the US real estate market collapsed because of an economic slowdown due to unemployment increase (so absence or decrease of income, by consequence inability to pay back loans), and the other factors mentioned above (increase of interest rates, inflation rates). This economic slowdown resulted in the inability of loaners to pay back their obligations, and so banks started acquiring and selling the real estate collaterals (CDOs or ABS). But it is because of this sudden “crash” that there was a sharp decrease in the price of real estate. Keeping in mind that financial institutions had created funds (SPVs) deriving from these assets, and that investors from all around the world that had invested and bought shares in these funds, the collapse of the US real estate market was exported to all those investors, which led to the world financial crisis.

This led to a default in the 1st semester of 2007, as well as social crisis in the US (Approx. 1 million of American householders lost their homes and are still indebted). Even a federal bailout of Approx. 700 Billion USD was not enough to avoid the collapse of (like City Bank).

As such, we can summarize the economic reasons of the crisis were inflation, unemployment, interest rates increase, … But the financial reasons were that investors did not care/read about what was behind the funds created by financial institutions like Lehman-Brothers. The investors in question, which included big foreign intuitions did not care on the nature of the funds that were complex and opaque, but rather on the potential returns it presented them. Further, some blame the responsibility of this whole crisis on such financial institutions, without whose intervention, the collapse would have limited exclusively to the housing sector in the US.

Conclusion

One would think that after such an event, it would be sometime until humanity would face another similar economic or financial crisis. Usually, this would be true, as the major crises in the 20th century can be counted on your fingers (The Great Depression of 1929, Petrol Choc of 1973, …), and have some lapse of time between one another. But 21 years into the 21st century, and we have already faced 2 world crises. One could think that Kondratiev would not have come up with his famous wave were he living nowadays.
All and all, hard times will come and go, just as prosperous times will come and go. But the fact remains it is up to us to decide what to do: Opportunities are everywhere, even in dark times. One only has to have the wit and courage to go search for opportunity, and seize it.

Key Concepts to Understand the Subprime Crisis

Subprime and prime borrowers

Subprime indicates having or being an interest rate that is higher than a prime rate and is extended chiefly to a borrower who has a poor credit rating or is judged to be a potentially high risk for default (as due to low income). Lenders classify potential borrowers into two general categories: prime and subprime. Having a credit score between 580 and 669 is considered subprime according to the FICO scale and these borrowers are considered a higher risk to lenders. Prime borrows typically have a score greater than 669 and are consider to have the least risk of defaulting on a credit card or loan. Being a prime borrower makes you an attractive customer for banks and justifies your demand for the lowest possible interest rates. Prime borrowers are generally approved for higher loan amounts, higher credit limits, and lower down payments. In general, a good credit score gives prime borrowers more negotiating power when shopping for a credit card or loan.

Collateralized Debt Obligations (CDO)

A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period. A collateralized debt obligation is a type of derivative security because its price (at least notionally) depends on the price of some other asset.

Assets Backed Securities (ABS)

Asset-backed securities, also called ABS, are pools of loans that are packaged and sold to investors as securities—a process known as “securitization.” The type of loans that are typically securitized includes home mortgages, credit card receivables, auto loans (including loans for recreational vehicles), home equity loans, student loans, and loans for boats.

Useful Resources

Amadeo, Kimberly (20/10/2020) Subprime Mortgage Crisis and Its Aftermath The Balance.

Dam, Kenneth (2010) The Subprime Crisis and Financial Regulation: International and Comparative Perspectives, University of Chicago Law School.

Kenny, Thomas (01/04/2020) Asset-Backed Securities (ABS) The Balance.

The Corporate Finance Institute: CDO

S&P Global

The Federal Reserve

BSI Economics

About the author

Article written in May 2021 by Mark RAHME (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Quantitative Trader – Job Description

February 16, 2025May 23, 2021 by Akshit GUPTA

Quantitative Analyst – Job description

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) presents the job description of a Quantitative Analyst.

Introduction

Quantitative analysts or “quants” are professionals that work on designing, implementing, and analyzing algorithms based on mathematical or statistical models to help firms in taking financial decisions. With the advent of technology-based trading, the demand for quantitative analysts has seen a rise in the recent years. The analysts are generally employed at investment banks, hedge funds, asset management firms, brokerage firms, private equity firms, and data and information providers. They develop algorithms using programming knowledge of several languages like C++, Java, Matlab, Python, and R. Quantitative analysts possess strong knowledge of subjects like finance, mathematics, and statistics.

Quants create and apply financial models for derivative pricing, market prediction, portfolio analysis, and risk management. For example, quants develop pricing models for derivatives using numerical techniques for asset valuation (including Monte Carlo Methods and partial differential equation solvers) like the Black-Scholes-Merton model and more sophisticated models. Such models are used by traders and structurers in the trading rooms of investment banks. They design and develop decision-supporting analysis, tools and models that support profitable trading decisions. In risk management departments, quantitative models are used to assess the risks associated with the bank’s portfolios. Some popularly used techniques include Value-at-risk, stress testing and direct analysis of risky trades. Along with all this, quants are also responsible for regular back testing of the tools and models they develop, in order to maintain quality assurance and add improvements if any.

Types of Quantitative Analyst

The professionals working as quantitative analyst can be divided into two categories namely, front-office quantitative analysts and back/middle office quantitative analysts.

Front-office analysts

The front-office quants are employed at firms that are involved in sales and trading of financial securities which includes investment banks, asset management firms and hedge funds. The role of the analyst is to devise profitable strategies to trade in different financial securities by leveraging the use of algorithms to implement these investment strategies. They are also responsible for managing the risk of the firm’s investments by using quantitative models. With the advent of algorithm-based trading, the job of a quantitative analyst and a trader has mostly consolidated. The analysts in the front-office generally work on trading floors and deal with clients on a regular basis. The job of the front-office analysts is quite stressful as compared to the other quantitative analysts but on the upside, it provides them with better compensations.

Quantitative analysts in credit rating agencies and asset management firms develop quantitative models to predict the macroeconomic trends across different geographies.

Back-office and middle-office analysts

The analysts working in the back/middle office are generally employed by investment banks and asset management firms.

The analysts working in the back/middle office are primarily responsible to develop algorithms to validate the quantitative models developed by quants working in the front-office and to estimate the model risk.

After the financial crisis of 2008, the demand for risk managers has increased across all financial institutions. The quant analysts in the back/middle office also work as risk managers to manage the firm’s risk exposure.

Whom does a Quantitative Analyst work with?

A quantitative analyst depending on the type of office he/she is employed in, works in tandem with many internal and external stakeholders including:

Institutional clients of the firm – A quantitative analyst working in the front office deals with the institutional clients (or even wealthy retail customers) of the firm to implement profit generating strategies on the client’s investments.
Sales and Trading – A front office quantitative analyst also works with the sales and trading team of the firm to execute trades based on the quantitative models.
Portfolio managers – A front office quantitative analyst also works with the portfolio managers of the firm to manage portfolios based on the quantitative models.
Economists and Sector specialists – A back/middle office analyst developing models to predict the macroeconomic trends work with economists and sector specialists to gather information about specific sectors and economies
Legal Compliance – A quantitative analyst also works with the legal compliance team of the firm to maintain a proper check over different rules and regulations and prevent legal challenges
Equity researchers – The quantitative analyst developing models to predict the stock market developments also works with the equity researchers to obtain insights about financial and non-financial data about different companies

How much does a Quantitative Analyst earn?

The remuneration of a quantitative analyst depends on the type of role and organization he/she is working in. As of the writing of this article (2021), an entry level quantitative analyst working in a financial institution earns a median salary of €60,000 per year (source: Payscale). The analyst also avails bonuses and other monetary/non-monetary benefits depending on the firm he/she works at.

What training do you need to become a Quantitative Analyst?

An individual working as a quantitative analyst is expected to have a strong base in computer science, mathematics, and market finance. He/she should be able to understand and develop mathematical and statistical models using programming languages and possess knowledge of market finance. He or she must understand financial and economic trends and have strong research skills and interpersonal skills.

In France, a Grand Ecole diploma with a specialization in financial engineering, mathematics or market finance is highly recommended to get an entry level job as a quantitative analyst in a reputed bank or firm.

The Financial risk management (FRM) or Chartered Financial Analyst (CFA) certification provides a candidate with an edge over the other applicants while hunting for a job as a quantitative analyst.

In terms of technical skills, a quantitative analyst should be efficient in the use of programming languages like C++, Java, Matlab, Python, and R.

Relevance to the SimTrade course

The concepts about quantitative analysis 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.

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 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.

Useful Resources

Payscale

About the author

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

Financial products marketing

May 23, 2021 by Ashima MALIK

Financial products marketing

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

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

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

Marketing channels

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

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

Challenges

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

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

Useful resources

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

About the author

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

How can we apply supply chain management to finance?

May 22, 2021 by Paul Antoine BOHOUN

How can we apply supply chain management to finance?

In this article, Paul Antoine BOHOUN (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021) explains how can we apply supply chain management to finance.

At the end of my master’s degree in logistics and transports, I did an internship at Logistics & Supply Chain Consulting (LSCC) as a junior consultant. LSCC is an Abidjan based consulting firm composed of 10 employees and is engaged in various missions of counsel, audit, and training for public or private entities on several supply chain related subjects. During my time there, I have been able to work on procurement, inventory management, and operational excellence problems for both private and public clients. The missions consisted in business planning and logistics auditing. It has been a great experience for me as a supply chain trainee. The culture of the firm offered me the opportunity to step up on important missions and be in direct contact with the clients.

This internship was the set for my professional thesis for which I worked on the diagnosis of a rubber company which had operational dysfunctions and was preparing the expansion of its activities. Particularly, I participated in the auditing of the procurement and purchasing processes. Our analysis, indeed, revealed that the procurement of primary goods lacked automation and that a further training for some employees were needed. My role was to prepare interviews, collect and analyze procurement data to assess the department performance and elaborate recommendations based on the data analysis results.

How is supply chain applied to finance?

Let us enumerate some aspects of supply chain which are important to link with finance for better performance of any company.

First of all, the sales and operations planning (S&OP) plays a big role in the profitability of a company. S&OP aims to provide an accurate forecasting of sales and the corresponding resources that will be needed to achieve them. The crucial component in this effort is the reliability of the used data. Decisions makers within the company also want to be able to orchestrate a relevant supply and demand plan with the associated expected revenues and/or margin.

Furthermore, there is supply chain finance (SCF) which is a system for buyers and sellers to facilitate their operations by having the financial resources available as soon as possible for the seller end as late as possible for the buyers. It is then a credit system that allows a smooth running of the businesses. A key point about SCF is also the fact that it is increasingly difficult to apply because of regulations and reporting requirements. The following figure compares the benefits from the use of a SCF system in a company between the buyer and the supplier.

Figure 1 : Benefits comparison – Buyer versus Supplier.

Key concepts

Supply Chain Management

SCM is applied to business as the optimization of the flows of goods, information, and the financial flows within and between companies by functional and cross-company integration. Overall, SCM mainly deals with the design and optimisation of the flows of goods and information. The financial aspect of it is broadly neglected.

Supply Chain Finance

Supply chain finance (SCF) is a term describing a set of technology-based solutions that aim to lower financing costs and improve business efficiency for buyers and sellers linked in a sales transaction. It provides short-term credit, which can optimise cash flow by allowing buyers to lengthen their payment terms whilst providing suppliers with the option to receive payments earlier.

Data

Data refers to all useful information coming out of a company’s day to day activity and its environment (suppliers, clients, competitors, etc.). Its collection, organization, and security represent a major challenge for companies’ performance and decision making. It is divided into qualitative and quantitative information and its analysis has infinite applications.

Resources

PWC : Enhancing working capital performance

Investopedia : Supply chain finance

Hans-Christian Pfohl & Moritz Gomm (2009) “Supply chain finance: optimizing financial flows in supply chains” Logistics Research 1(3-4):149-161.

About the author

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

Bourse Régionale des Valeurs Mobilières

May 22, 2021 by Paul Antoine BOHOUN

Bourse Régionale des Valeurs Mobilières

Dans cet article, Paul Antoine BOHOUN (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021) présente la Bourse Régionale des Valeurs Mobilières(BRVM).

La Bourse Régionale des Valeurs Mobilières (BRVM) est la place boursière principale dans les pays francophones d’Afrique Subsaharienne, elle n’est cependant que la 12e place boursière en Afrique. Son développement connait une accélération depuis le début des années 2010, décennie durant laquelle sa capitalisation a quasiment doublé grâce notamment à l’introduction de plusieurs sociétés avant de retomber à son niveau de 2010. Des experts tel que Bloomfield Corp s’accordent à attribuer ce recul à une correction suite aux valorisations records que le marché a connu ainsi que les mauvaises performances de certaines entreprises.

Logo BRVM

Histoire

La création de la BRVM intervient dans le cadre de la coopération entre les pays d’Afrique de l’Ouest au sein de l’UEMOA. Elle est une institution financière spécialisée créée le 18 décembre 1996 afin de faciliter et organiser le marché unique et la coopération entre les pays membres. Elle prend la forme d’une société anonyme dotée d’une mission de service public communautaire et disposant d’un capital de 2 904 300 000 francs CFA. Cette bourse est commune à huit pays de l’Afrique de l’Ouest : Bénin, Burkina Faso, Guinée-Bissau, Côte d’Ivoire, Mali, Niger, Sénégal et Togo. En 2021, 46 entreprises y sont cotées. Elle dispose également d’antennes nationales de bourse (ANB) dans chacun des pays membres. Chaque ANB est reliée au siège par un relais satellitaire qui assure l’acheminement des ordres et des informations à tous les investisseurs de la Bourse de façon équitable.

Entreprises cotées et secteurs

La BRVM est constituée de 46 entreprises (2021) qui sont regroupées au sein des secteurs suivants : Industrie, Services Publics, Finance, Transports, Agriculture, Distribution, Autres. Parmi les secteurs représentés, on note l’importance des sociétés financières 41% de la capitalisation totale de la BRVM.

Fait notable, les entreprises cotées à la BRVM sont majoritairement de droit ivoirien (35 sociétés sur 46 et représentent 40% de la capitalisation boursière au 30 avril 2021.

Indices

La BRVM a deux indices notables : le BRVM Composite (Figure 1) regroupant l’ensemble des 46 valeurs cotées et le BRVM 10 (Figure 2) qui regroupe les dix valeurs les plus actives sur le marché.

Figure 1 : BRVM Composite entre juin 2020 et avril 2021.
Indice BRVM Composite

Figure 2 : BRVM 10 entre juin 2020 et avril 2021.
Indice BRVM 10

Business model

La BRVM cumule trois principaux types de revenus :

Les frais d’introduction en bourse ou d’émissions d’obligations, payés par les émetteurs (sociétés ou Etats)
Les frais d’accès à l’information boursière, payés par les investisseurs et intermédiaires institutionnels et privés afin d’avoir des données sûres et en temps réel concernant le marché
Les commissions de courtage, payées par les investisseurs sous la forme de commission sur chaque ordre passé à la BRVM.

La BRVM s’est notamment diversifié avec une ouverture à la finance islamique en 2016, année durant laquelle elle a admis à la côte cinq SUKUK émis par des Etats membres de l’UEMOA.

Concepts clés

Indice boursier

Un indice boursier est un groupe théorique d’actions choisies de façon raisonnée parmi des valeurs cotées sur une même place financière. Ce sont souvent les actions les plus importantes qui sont regroupées sous son sein, par exemple le S&P 500 aux Etats-Unis, le CAC 40 en France ou le BRVM 10 en Afrique occidentale. L’indice a pour avantage de permettre l’évaluation de la performance d’un secteur, d’une bourse ou même d’une économie à travers le prisme d’un seul indicateur.

Capitalisation boursière

La capitalisation est l’estimation de la valeur d’une société par actions. Celle-ci est dynamique, elle évolue conjointement avec le cours de l’action de ladite société. Son calcul est le suivant :

Capitalisation boursière = Nombre d’actions en circulation × Cours de l’action.

Par exemple, au 27 avril 2021, la société Nestlé CI avait 22 070 400 titres en circulation et l’action s’échangeait à 1 020 XOF. Sa capitalisation boursière était donc égale à :

22 070 400 × 1 020 = 22 511 808 000 XOF.

Information financière

Dans le cadre des marchés financiers et des entreprises cotées en bourse, l’information est un ensemble de données concernant une entreprise permettant aux investisseurs de prendre leur décision d’investissement. Ces données sont composées des états financiers de l’entreprise (bilan, compte de résultat, tableaux de flux et annexes). Cette information est, en outre, établie sur la base de normes d’enregistrement et de présentation qui présentent un certain formalisme, mais qui, en contrepartie, assurent un caractère cohérent, homogène et stable à l’information fournie.

Nous faisons une distinction entre les sociétés cotées et les sociétés non cotées, ces dernières n’ont en effet pas l’obligation de rendre public leurs informations financières. Cependant elles sont utilisées en interne par les dirigeants dans leur prise décision et aussi par les parties prenantes telles que les banques, les pouvoirs publics, les clients, etc.

Ressources utiles

Wikipedia : Bourse régionale des valeurs mobilières

BRVM : Rapports annuels

Financial Afrik : BRVM : l’analyse de Bloomfield Investment sur une année 2017 en baisse

Sika Finance : Cotation boursière de Nestlé CI

Les Echos Investir : L’information financière des sociétés

A propos de l’auteur

Article écrit en Mai 2021 par Paul Antoine BOHOUN (ESSEC Business School, Master in Strategy & Management of International Business (SMIB), 2020-2021).

Why was 2020 a record year in terms of financial market returns?

May 22, 2021 by Raphaël ROERO DE CORTANZE

Why was 2020 a record year in terms of financial market returns?

2020: a year of all records

The year 2020 has been the scene of the greatest economic downturn since the Great Depression and the fastest market collapse on record. From mid-February onwards, stock markets have plummeted. In one month, the Paris stock market fell by nearly 40% and the New York stock market by more than 30%. On March 16, the Dow Jones lost 13%, topping the October 1929 Black Monday slide of 12,82% (the biggest Dow Jones fall still being the “Black Monday” October 1987, where it lost 22,6% in a day). It took only 16 trading days for the Dow Jones to push into bear market territory, while the S&P 500 lost 34% in only 33 trading days. The speed of the crash was unprecedented.

The rebounds were also spectacular. As of June 30, Wall Street recorded its best quarter since 1998. In November, the European stock markets experienced the strongest monthly increase in their history, with an 18% jump in the Euro Stoxx 50 and a 20% jump in the CAC 40.

Over the whole year 2020, 88% of the major asset classes have returned positively. The American markets have been the big winners. The Dow Jones gained more than 6%, while the Nasdaq Index jumped more than 43%. Amazon’s share price has risen by more than 70%, followed by Apple with more than a 50% increase and Facebook and Google with a 30% increase. Some increases are spectacular, such as those of the biotech company Aytu BioScience, jumping more than 500%, or Tesla, which recorded a rise of more than 600%.

The Paris Stock Exchange has ended 2020 in the red, but with a moderate decline of around 6% in the CAC 40 index, after the record year of 2019 (when the index of the 40 main French stocks had risen by 26%, its best performance in twenty years). European markets have not experienced such a powerful rebound 2020, as evidenced by the Euro Stoxx 50 index, which lost over 4%.

Why did the markets have bounce back much faster than the real economy?

Stock markets crashed in 2020 because of the uncertainty and the fear shared by investors about the impact of the Covid-19 crisis. When the World Health Organization (WHO) declared the disease a pandemic, countries began locking down, fear and uncertainty spread through the market, leading towards unprecedented asset sales.

If the rebound of markets has been so fast, it is because of the immediate response of Central Banks and governments. The massive asset buyback programs led by Central banks as well as state aids, loans and repayment facility programs have help to reassure investors. Indeed, investors view the markets as forward-looking, anticipating how economies and corporate earnings would perform in the upcoming months and years. In this context, the decorrelation between markets and real economy is not strange, as markets have immediately bet on a return to normalcy in a relatively short time frame.

What could come next?

2020 was the year of all records. The total amount of equity raised during IPOs in the US ($156 billion) topped the 1999 internet bubble record. Thanks to the wide response of Central banks and governments, confidence has returned and investors started taking risks again. 420 IPOs were performed in the US in 2020, which represents an 88% increase compared to 2019.

The stock market performance of certain technology companies and the craze for IPOs appears quite reminiscent of the atmosphere of beginning of the millennium, just before the burst of the internet bubble. Experts are puzzled. Hervé Goulletquer, Deputy Director of Research at La Banque Postale Asset Management has declared that “If we look at current valuations, this means that the health shock has had no medium-term impact on corporate earnings. That’s a bit of a stretch.” Indeed, The GAFAMs have seen their stock market valuation double between January 2019 and July 2020. They now weigh about a quarter of all stocks in the U.S. S&P 500 stock index. Together, the GAFAMs are worth more than the GDP of Japan, Germany or France!

If tech companies have outperformed this year, it is not the case for sectors such as industry and manufacturing, which are still struggling to emerge from the covid crisis as they took a bigger hit due to social-distancing measures and lockdowns.

On the one hand, if the old economy has not collapsed, it has resorted to debt like never before. Tech giants, on the other hand, are more and more dominant. Microsoft, Amazon and Google are now the only three members of the very exclusive club of companies with a market capitalization above 1,000 billion dollars.

During the year 2020, the appetite for tech has turned into a fever. Will this frenzy burst into a second internet bubble? Time will tell…

Key concepts

Bear market

A bear market is a period of persistent price declines. Declines in stock prices are 20% or more from recent highs and are fueled by pessimism or negative market sentiment. Bear markets are most often associated with declines in an overall market or in a particular index such as CAC 40, Dow Jones etc.

S&P 500

The S&P 500 index is a stock market index based on the 500 largest companies listed on stock exchanges in the United States. The index is owned and managed by Standard & Poor’s, one of the three major credit rating companies. It covers approximately 80% of the U.S. stock market by capitalization.

NASDAQ

NASDAQ (short for National Association of Securities Dealers Automated Quotations) is currently the second largest U.S. equity market, by volume traded, behind the New York Stock Exchange. The NASDAQ index, also known as “the NASDAQ”, is the stock market index that measures the performance of the companies listed on it.

Dow Jones

The Dow Jones Industrial Average (DJIA) or Dow Jones, is a stock market index that measures the stock performance of 30 large companies listed on stock exchanges in the United States.

Euro Stoxx 50

The Euro Stoxx 50 a stock market index for the euro zone. Like the CAC 40 for France, the Euro Stoxx 50 groups 50 companies according to their market capitalization within the euro zone.

Useful resources

https://www.thebalance.com/dow-jones-closing-history-top-highs-and-lows-since-1929-3306174

https://www.thebalance.com/fundamentals-of-the-2020-market-crash-4799950

https://edition.cnn.com/2020/12/31/investing/dow-stock-market-2020/index.html

https://www.bloomberg.com/news/articles/2020-12-21/stock-market-in-2020-bear-market-for-humans-while-dow-and-nasdaq-hit-records

https://www.theguardian.com/business/2020/dec/30/ive-never-seen-anything-like-it-2020-smashes-records-in-global-markets

https://www.bfmtv.com/economie/entreprises/2020-annee-record-sur-les-marches-americains_VN-202012090039.html

https://www.lemonde.fr/economie/article/2020/12/30/une-folle-annee-2020-sur-les-marches-financiers_6064796_3234.html

https://eu.usatoday.com/story/money/2020/08/19/stock-market-record-economy-recession-coronavirus-pandemic-recovery/3345090001/

About the author

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

Inflation & deflation

May 22, 2021 by Raphaël ROERO DE CORTANZE

Inflation & deflation

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

Inflation

Definition

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

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

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

The origin of inflation

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

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

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

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

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

The post WW1 German hyperinflation

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

Deflation

Definition

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

The origins of deflation

Deflation mainly comes from imbalances between demand and supply:

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

The Japanese deflation

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

Key concepts

Reflation policy

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

Useful resources

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

Kaldor (1985) The scourge of monetarism.

Baumol (1966) Performing Art: The Economic Dilemma.

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

About the author

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

Women in Finance

May 17, 2021 by Alexandre VERLET

Women in Finance

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

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

The difficulty to consider the financial industry as a whole

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

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

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

What can be done to promote women in finance?

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

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

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

Useful resources

Academic research

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

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

Websites

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

About the author

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

Understanding financial derivatives: futures

May 17, 2021 by Alexandre VERLET

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

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

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

What is being traded?

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

Futures and organized markets

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

Going deeper into the clearing house system

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

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

About the author

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

Who will become London’s heir as Europe’s main financial center in the wake of Brexit?

May 17, 2021 by Alexandre VERLET

Who will become London’s heir as Europe’s main financial center in the wake of Brexit?

In this article, Alexandre VERLET (ESSEC Business School, Grande Ecole Program – Master in Management, 2017-2021) explores the Brexit’s consequences on the City’s monopoly over European finance, and which capital could possibly claim the throne.

A historic perspective on the City’s dominance

To determine whether Brexit will cause London’s fall as Europe’s main financial center, we shall examine if the causes of London’s rise might be undermined by its isolation from the single market. In 1973, Charles Kindleberger, an economic historian considered that London would not make it as Europe’s finance capital, saying that “Sterling is too weak, and British savings too little.” Obviously, he was wrong, since London concentrates a third of all European Union capital markets activity and 90% of euro-denominated derivatives clearing. This shows how London’s unquestioned position as the hypercentre of European finance is actually pretty recent, and that it is definitely not immutable, especially since assets move fast. The key element of London’s transformation is the Big Bang, the sudden and massive deregulation of financial markets that resulted from an agreement between Thatcher and the London Stock Exchange. But before that, the City and its iconic banks such as HSBC played a major role in the emergence of the Eurodollars market, making London a key partner for US banks’ European activities. When financial markets started their meteoric expansion in the 1980’s, London was ready to take advantage of it. Adding to that, the city had managed to build long term advantages such as a very favorable regulation through unquestioned political support from both Tories and Labor, a top-notch financial and legal system, and the highest concentration of highly qualified workforce you could find in Europe. It goes without saying that London’s success is first and foremost to have managed to become the financial capital of the economic heavyweight that Europe is. London is more of an investment heaven that any other European capital thanks to the British government’s unquestioned support but belonging to the EU was a required to be the EU’s financial hub.

The financial consequences of Brexit so far

Nevertheless, the Brexit is a slow and rather improvised process, and European financial hubs are interdependent, so it was in all parties’ interest that London did not collapse following the Brexit announcement. In the wake of Covid-19, the European Commission allowed European firms to keep using London’s clearinghouses as they currently do until 2022. The shift is happening slowly, and it is difficult to predict the long-term consequences of Brexit. Nevertheless, EU rules state that some trades such as euro-denominated derivatives, must be executed on an EU trading venue, so it is unlikely that London will keep its European competitors at distance for long. Soon after the Brexit was officialized, firms had already shifted about 7,500 staff and more than $1.6 trillion of assets to the EU, around 15% of US banks’ assets. However, while European financial centers have apparently benefited from Brexit, the US has by far been the main beneficiary of the new trading landscape. The direct regulatory consequence of Brexit is the loss of passporting rights, so the rights to trade are dependent upon equivalence decision made by the EU Commission. The City of London currently only has an equivalence arrangement in two areas of financial services, but the US have 22 arrangements. So, New York and Chicago have been executing many of the trades that London could not do anymore, as European financial centers who have passporting rights cannot rival with American cities’ capital markets. That is why Martin Heneghan and Sarah Hall (LSE) consider that so far, Brexit created a negative-sum game for European finance. What would make the EU’s hubs much more attractive is the capital markets union, which has been discussed for years with no progress so far. If that were to happen, European financial centers would finally take over most of London’s financial activity resulting from European economies, and the strength of a unified European capital market would prevent New York and Chicago from being the main beneficiaries of Brexit.

And the winner is…

What is happening so far is a decentralization of financial activities, each capital trying to emphasize their advantages to benefit as much as they can from Brexit. Dublin and Luxembourg’s fund-management hubs made it the priority destination for major, insurers, Amsterdam has attracted trading firms with its fast fiber network, and Paris and Frankfurt are battling to become the main hub of Euro clearing’s $75 trillion dollars market. But unlike what is often heard in the French media, nothing suggests that Paris or Frankfurt will be the financial sector’s obvious choice, quite the opposite actually: the competition is tight, and each city has its own advantages to offer. The focus on those two cities is due to the fact that both aggressively campaigned to become London’s heir, and their economic weight and political strength are long-term advantages that few other cities can rival with. Nevertheless, nothing indicates so far that Dublin, Amsterdam or Luxembourg are being left behind. Amsterdam is actually the winner when it comes to trading activities, as shown on the graph below (source: Financial Times). The low corporate tax and fintech activity of Dublin and the massive investment funds located in Luxembourg are other advantages that could sustain a decentralized finance system in Europe, therefore denying Paris or Frankfurt from taking it all.

Overview of the jobs’ redistribution: an opportunity for ESSEC finance students?

Although it will not be clear which city will have benefited most from the Brexit before 2030, you might be interested in checking the current trends of the major banks and investment firms where ESSEC students seek employment. Here’s what the think tank New Financial reported as of late 2020. In total, 440 financial services firms moved their staff due to Brexit, 135 firms choosing Dublin, 102 firms choosing Paris, 93 for Luxembourg, 62 for Frankfurt, and 48 for Amsterdam.
Bank of America is moving a significant part of its markets business to Paris, more than 400 people, and part of its banking business to Dublin. Barclays’ chose Dublin also and moved 250 people there. Blackrock is making Amsterdam its EU hub, but it also has an office for alternative investments (hedge funds and private equity) in Paris. The major French banks, BNP Paribas and SocGen, are obviously relocating to Paris, where their HQ are, and similarly Deutsche Bank is relocating to Frankfurt. Citigroup had planned to make Frankfurt its post-Brexit markets hub, but staff reportedly rebelled and lobbied to be moved to the French capital instead, because of culture, schools and proximity to London. Nevertheless, only 5% of the 6,000 people working in London for Citigroup were so far moved. JP Morgan initially expected to move most of its banking and markets businesses to Frankfurt after Brexit, but subsequently decided to move to Paris too. JP Morgan is however moving its asset management and wealth management businesses to Dublin and Luxembourg respectively. Credit Suisse planned to move its EU-focused investment bankers to Frankfurt post-Brexit, and its salespeople and traders to Madrid. Deutsche Bank’s European headquarters will clearly be in Frankfurt, where the bank’s global head office is located. Goldman Sachs is moving its investment banking and markets businesses to Frankfurt and Paris after Brexit. It is moving its asset management business to Dublin, but also opened new offices in Milan and Stockholm. In total, 500 GS jobs are leaving London. HSBC, which already used Paris as its European hub, is moving 1,000 people there. Morgan Stanley moved its investment banking and markets business to Frankfurt, and its asset management business to Dublin. Nomura and Standard Chartered chose Frankfurt, each moving around 100 people. The same goes for UBS, who decided to move 200 people to Frankfurt.

Although London remains the main financial center and employer in Europe, and while it is unsure if any city will replace it, London’s monopoly will inevitably end, and many jobs will be created or redistributed in the 5 competing European cities. All in all, if you wish to work in finance at some point, keeping up on the post-Brexit evolution of financial centers in Europe is a must.

About the author

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

Classic brain teasers from real-life interviews

January 30, 2024May 17, 2021 by Alexandre VERLET

Classic brain teasers from real-life interviews

In this article, Alexandre VERLET (ESSEC Business School, Master in Management, 2017-2021) provides 10 brain teasers from real-life investment bank interviews, and explains simple ways to solve it.

In most finance interviews, applicants must face the feared trial of brain teasers, defined as unusual questions which have basically nothing to do with finance. Investment banks and funds use them to assess the problem-solving skills, the creativity, the logical reasoning, and the ability to ask the right questions of their candidates. In this article, we will take a look at the most common types of brain teasers based on real examples from the major investment banks and see the simplest way to solve them. Keep in mind that your own method is probably the best since it’s yours, but if you get stuck on a brainteaser in the course of an interview, it can always be useful to remember the general methods on how to solve them. Here we go.

Examples of brain teasers

The bee: a classic distance/time question meant to confuse you

Let there be a point A 100 km from a point B. A car travelling at 50km/h starts from point A, at the same time a bee flying at 130km/h starts from point B. Each time the bee meets the car it returns to B and then once at point B it returns to the car, coming back and forth until the car meets point B. How many kilometres did the bee travel?

Answer: The car travels for 2 hours (since it travels 100km at 50km/h), and the bee flies for exactly the same time as the car travels, so the bee travels 260km (since it flies at 130km/h).
That’s it!

The cube: picturing volumes in your head

A cube of 10 m3 volume is divided into 1,000 small cubes of one cubic metre volume. This cube is dipped in paint. How many cubes are coloured?

Answer: The uncoloured cubes are the ones inside. If you think of the cube as divided into “3D” columns and rows that go through the cube, you will see that the first and last of each row will be coloured, and the 8 remaining will be inside. There are 8*8*8 uncoloured cubes inside i.e. 512, so the number of coloured cubes is 1000-512=488

The gold bar

The gold bar, a question for practical minds (or people who read this article).

I have a gold bar that weighs 7 kg, and I would like to give 1 kg of gold to a person every day for a week. I am only allowed to cut the bar twice. How can I do this?

Answer: Once you have figured that you can actually take back parts of the gold (you will quickly figure there’s no way to do it otherwise), the is to process step by step.
I cut the bar into 3 pieces: a 1kg piece, a 2kg piece and a 4kg piece.
Day 1: I give the 1kg piece.
Day 2: I give the 2kg piece and take back the 1kg piece.
Day 3: I give the 1kg piece.
Day 4: I give the 4kg piece and take back the other 2 pieces.
Day 5: I give the 1kg piece.
Day 6: I give the 2kg piece and take back the 1kg piece.
Day 7: I give the 1kg piece.

The arena

The arena: geometry and common sense.

I am in the centre of a circle of radius a, a lion is running twice as fast as I am, but it cannot enter the circle. The lion is running towards the point closest to me at all times.
How can I get out of the circle without being eaten?

Answer: Double the radius is shorter than the semicircle (2a vs a*pi). So the lion will not have time to catch up with me if I go to a point on the circle and then run directly in the opposite direction.

The clock

The clock: geometry (though owning a watch can help)

It is 3:15 pm, what is the degree between the minute hand and the hour hand?

Answer: Perhaps the most common of all brain teasers (I got it in an interview), so they expect you to be quick and right. Do not say 0, clocks are not so common these days but you should know that the hour hand moves forward while the hour hand turns. The hand has therefore advanced by a quarter of an hour, i.e. : 1/4*(1/12*380)= approximately 7.9

The glasses

The glasses: common but not so easy

We have a 5 L glass A, a 7 L glass B, and a water tap, how do we make 6 L?

Answer: We fill B, empty it into A to its maximum, B then contains 2L. We then empty A. Then, put the contents of B into A. We fill B and then empty it into A to its maximum. This leaves 4L remains in B. Empty A, then put the contents of B into A, then fill B and empty A to its maximum: there is then 6L left in B.

The racetrack

The racetrack: an even trickier distance/time question

A racetrack is 100 km long, a car does a first lap at 50 km/h, at what speed must the car go
in order to travel an average of 100 km/h?

Answer: Be careful, the answer is not 150 km/h. Indeed, if the car made the first lap at 50 km/h then it has driven 2 hours at the end of the first lap. However, if the car is driving at an average of 100 km/h, it must have done the 2 laps in 2 hours. This is impossible because it has already driven for 2 hours. This problem has no solution.

Slot machines

Slot machines: one of the real tough ones

There are 10 slot machines in front of me. In 9 of them the coins weigh 10g, in one of them the coins weigh 20g. You can take as many coins as you like out of each machine. How do you find the machine with the heaviest coins in one weighing?

Answer: Put 1 coin from machine 1, 2 coins from machine 2, 3 coins from machine 3 on the scale… If F is the final weight, then the difference between F is (1+2+3+…+10) allows you to find the machine with the heaviest parts. Indeed (F-(1+2+…+10))/20 gives us the number of this machine, so the number of the machine is (F-55)/20. That solution is super smart so congrats if you found it by yourself.

The crash

The crash: finally, the real distance/time question!

Let point A be X km away from point B. A drives at Y km/h, B drives at Z km/h. When will
A and B meet?

Answer: Simply solve for Yt=X-Zt with t as the unknown, then find t the time when they meet (in hour).

The bridge

The bridge: a typical back and forth question.

Four bankers have to cross a narrow bridge at night. They have only a torch and maximum 17 minutes to cross the bridge. The bridge cannot be crossed without a torch and can only support the weight of a maximum of two bankers. The analyst can cross the bridge in 1 minute, the associate in 2 minutes, the VP in 5 minutes and the MD in 10 minutes. How can they cross the bridge in time?

Answer: The analyst first crosses the pond with the associate, this takes 2 minutes. Then the analyst crosses the bridge in the opposite direction with the torch, this takes 1 minute. Then the analyst gives the torch to the VP who crosses with the MD, this takes 10 minutes. The VP then gives the torch to the associate who crosses the pond in the opposite direction in 2 minutes. Finally, the associate and the analyst cross the bridge in 2 minutes.
They have all crossed the bridge in 17 minutes.

Advice

Keep practicing, there are tons of it on the internet! Knowing the 50 most common brain teasers should allow you to nail any question in seconds, but keep in mind that you will probably face a question you have never done before, so the method is more important that knowing brain teasers by heart! Remember that sometimes you may think you recognise a brain teaser you know when you actually don’t. Take the distance/time questions for instance: I have presented you with 3 questions that looked similar but with totally different answers and methodologies, so watch out for that!

About the author

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

Understanding financial derivatives: swaps

May 17, 2021 by Alexandre VERLET

Understanding financial derivatives: swaps

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

The origins of swaps

The origins of swaps lie in ‘parallel loans’. In the 1970s, while floating exchange rates were common, the transfer of capital between countries remained tightly controlled. Multinational companies were particularly affected when they transferred capital between their subsidiaries and their headquarter. In order to solve this problem, parallel loans were set up. To understand the principle of these loans, let us take an example. Michelin and General Motors (GM) are two multinational companies. Michelin, a French company, has a subsidiary in the United States, and General Motors, a US company, has a subsidiary in France. Suppose that both companies want to transfer funds to their respective subsidiary. In order to circumvent international transfers, the two parent companies can simply agree to lend an equivalent amount of money to their counterparty’s subsidiary. For example, Michelin’s parent company would transfer X amount in euros to General Motors’ French subsidiary, while General Motors’ parent company would transfer the equivalent amount in dollars to Michelin’s US subsidiary. With swaps, companies are also able to have access to cheaper capital and better interest rates.
As this type of financing arrangement became more popular, it became increasingly difficult for companies to find counterparties with exactly the opposite needs. In order to centralise supply and demand, financial institutions began to act as intermediaries. In doing so, they improved the original product (parallel loans) to swaps.

How big is the swap market?

The word swap comes from the English verb “to swap”. In finance, swap means an exchange of flows (and sometimes capital). Financial institutions were the first to realise the huge potential of the swaps market. In order to satisfy the growing demand, an interbank market was created. In the wake of this, several financial institutions became market makers (or dealers) to organize the market and bring liquidity to market participants. The role of a market maker is to offer bid and ask prices in a continuous manner. The financial institutions involved in the swap market have also come together in an association called the International Swap Dealers Association (ISDA). As a result, swaps became the first OTC market to have a standardised contract, further accelerating their development. With this success, the ISDA contract quickly became the standard for other OTC derivatives markets, allowing ISDA to expand its area of influence. The latter will be renamed the International Swaps and Derivatives Association. The ISDA ‘s work turned out to be an unprecedented success in the financial world. According to figures from the Bank for International Settlements (BIS), more than 75% of the outstanding amounts in the OTC markets involve swaps.

The GDP worldwide is about ten times less than the total known outstanding amounts in the OTC derivatives markets! The reason for this discrepancy is probably the almost systematic use of leverage in transactions involving derivatives.

Interest rate swaps

Interest rate swaps are a must in the OTC derivatives markets, with the notional amount outstanding in OTC interest rate swaps of over $400 trillion. In their most basic form (plain vanilla swaps), they provide a very simple understanding of how swaps work.
A plain vanilla swap is a financial mechanism in which entity A pays a fixed interest rate to entity B, and entity B pays a floating interest rate to entity A, all in the same currency. With this mechanism, it is possible to transform a fixed interest rate into a floating rate, and vice versa. It should be noted, however, that the plain vanilla is not the only type of interest rate swap. The definition of all interest rate swaps is as follows: an interest rate swap is a transaction in which two counterparties exchange financial flows in the same currency, for the same nominal amount and on different interest rate references. This definition obviously includes plain vanilla (a fixed rate against a floating rate in the same currency), but also other types of interest rate swaps (e.g. a floating rate against another floating rate in the same currency).

Currency Swaps

Currency swaps are the oldest family of swaps. A currency swap is a transaction in which two counterparties exchange cash flows in different currencies for the same nominal amount. Unlike interest rate swaps, in the case of currency swaps there is an exchange of the nominal amount at the beginning and end of the swap. Currency swaps can be classified into four categories, depending on the nature of the rates used:

Counterparty A (fixed rate) versus counterparty B (fixed rate)

Counterparty A (fixed rate) versus counterparty B (floating rate)

Counterparty A (floating rate) versus Counterparty B (fixed rate)

Counterparty A (floating rate) versus Counterparty B (floating rate)

This type of swap can reverse the currencies of two debts denominated in different currencies and also the type of interests (fixed or floating). In other words, companies use it to transform an interest payment in euros into an interest payment in dollars for instance, and a fixed interest into a floating interest for example.

Equity and commodity swaps

Interest rate and currency swaps are by far the most common families of swaps used by market participants. However, there are other types of swaps, notably equity swaps and commodity swaps. Since indices are made up of a set of stocks, equity swaps work in a similar way to index swaps. It is a matter of exchanging an interest rate (fixed or variable) against the performance of a stock or an index. Swaps have also been put in place for the commodity market. A commodity swap allows a counterparty to buy (or sell) a given quantity of a commodity at a future date, at a price fixed in advance, and to sell (or buy) a given quantity of a commodity at a future date, at a price varying according to supply and demand in the market.

Let us consider company A, that owns a certain amount of gold. The value of this asset is not stable, as it varies according to the price of gold on the markets. In order to protect itself against this over a specific time period, company A can simply ask its bank to arrange a swap in which the company exchanges (“swaps”) the variable price of its gold stock against a price fixed in advance. The mechanism for this type of swap is quite similar to the mechanism for equity swaps, which we discussed previously.

We could think of infinitely more types of swaps, as it has become a very common way to hedge against risk. Perhaps the most famous one would be the Credit Default Swap (CDS), which is a credit derivative that allows its buyer to protect himself against the risk of default of a company. In return, the buyer of the CDS pays a periodic premium to the seller of the CDS. The CDS has played an important role in the 2008 financial crisis, but this story deserves an article of its own.

Useful resources

ISDA

About the author

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

How to compute the present value of an asset?

May 15, 2021 by William LONGIN

How to compute the present value of an asset?

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

What is present value?

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

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

How is present value computed?

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

Present value of a cash flow

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

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

Present value of a series of cash flows

Application 1: Computation of the present value of a stock

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

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

Present value of the series of cash flows for a stock

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

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

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

Application 2: Computation of the present value of a bond

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

Present value of the series of cash flows for a bond

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

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

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

How to properly compute cash flows?

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

Who is using present value?

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

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

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

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

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

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

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

▶ Jérémy PAULEN How to compute the IRR in Excel

▶ Sébastien PIAT Simple interest rate and compound interest rate

About the author

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

Gamestop: how a group of nostalgic nerds overturned a short-selling strategy

August 19, 2024May 13, 2021 by Raphaël ROERO DE CORTANZE

Gamestop: how a group of nostalgic nerds overturned a short-selling strategy

In this article, Raphaël ROERO DE CORTANZE (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) talks about the Gamestop case which has shaken up Wall Street last january.

Gamestop: an unprofitable company with slender turnaround prospects

Gamestop is a US company specializing in the distribution of video games and electronic equipment (similar to Micromania in France). After golden years in the 1990’ and 00’, Gamestop has sunk since 2010 into a spiral of debt and successive sales of its stores around the world. The company’s response has been to cut costs and shut down underperforming stores, rather than trying to adapt to new trends of consumer behavior. Indeed, physical stores have lost momentum over the years, this decrease being powered by the rise of e-commerce and recently COVID-19 and lockdown restrictions. Hence, at the end if 2020, Gamestop’s future appear to be bleaker than ever.

Last January, Gamestop became the target of a short-selling strategy (see below) by several hedge funds. In a short-selling strategy, hedge funds bet on the decrease of a stock to pocket profits. But, retail investors came into action to “save” Gamestop from the claws of these hedge funds.

Indeed, in the United States, the stock market has opened up in recent months to small investors. Since the beginning of the Covid-19 crisis, many stocks have fallen, allowing an entry into the world of the stock market with little investment. Thus, students, employees or even retirees have been tempted. After having learned that some hedge funds were betting on a decrease of Gamestop’s stock, a retail investor began buying Gamestop stock on the Robinhood application, then calling on Reddit for other retail investors nostalgic of Gamestop to come to the rescue and buy more Gamestop’s stock to increase the stock price. Their strategy paid off: the stock price surged up to 1400% and the hedge funds had to incur losses.

What is short-selling strategy?

A short-selling strategy revolves around selling something you do not own. If you do not own something you want to sell, you can borrow it, sell it and then give it back at the end of the borrowing time. A short-selling strategy can be simplified into 3 steps:

Investor A (that can be a hedge fund) borrows a number N of shares of the targeted companies from Investor B (usually an ETF or a mutual fund through a broker)
Investor A sells the borrowed shares to Investor C at a price p
When it’s time to give the shares back to Investor B (the lender), Investor A buys back N shares of the targeted company at the price p’ and gives them back to Investor B with fees f. Investor A pockets the following profit: (N * p) – (N * p’) – f = N * (p – p’) – f

In other words, a short-selling strategy bids on the fact the stock price of the targeted company will drop between the moment Investor A sells the shares it has borrowed, and the moment it buys them back to give them back to Investor B with fees.

Hedge funds pocket money only and only if the selling operation yields more than the absolute value of buying the shares back and paying the fee. This is why hedge funds target companies of which the stock price is expected to fall, due to poor financial management or bleak turnaround prospects. In this case, Gamestop was the perfect candidate for a short-selling strategy.

The lessons of the Gamestop case

Due to the mayhem around Gamestop’s stock price, Robinhood had to block its retail customers from purchasing GameStop shares because of a “too volatile” price (while hedge funds were still able to trade elsewhere). GameStop achieved its first quarterly sales increase in two years during Q1 2021, thanks to the notoriety brought by the case. Nonetheless, the hype around GameStop has quickly come to an end, as it is still an unprofitable company with slender turnaround prospects. The fall is GameStop stock price following the end-of-January records and the recent events demonstrate it. At the beginning of April, GameStop announced it may sell up to $1bn of additional shares as it looks to take advantage of the Reddit-driven trading frenzy. This announcement was quickly sanctioned by the market, and the stock price fell.

This demonstrates that a hype created by nostalgic retail investors is not sufficient to entail a turnaround of the financial situation of GameStop. It still has some major management problems, such as wages below average. A Stanford University Management Professor, Jerry Davis, argue on this case that “Rescuing an extremely low-wage employer from short-sellers by pumping up its stock is not exactly storming the Bastille.”

A few retail investors pocketed a lot of money by selling their GameStop shares at the right moment. But the majority were caught up by the harsh reality of the market and the decline in the stock price. Will GameStop be able to take advantage of the frenzy around its stock price to bring measures and decision which could make its future better without being sanctioned by the market? Time will tell.

Useful resources

The Financial Times (February 25, 2021) GameStop shares extend surge in early trading

The Financial Times (April 5, 2021) GameStop shares fall after it announces plan to sell up to $1bn in stock

The Financial Times (February 7, 2021) The biggest lesson of GameStop

Vincent Matalon (February 7, 2021) Raid sur le cours boursier de GameStop : des investisseurs amateurs racontent pourquoi ils se sont pris au jeu France Info

About the author

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

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

May 13, 2021 by Raphaël ROERO DE CORTANZE

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

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

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

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

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

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

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

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

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

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

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

A cohabitation of rationality and “animal spirit”

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

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

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

Key concepts

Walsarian auction

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

Useful resources

Academic articles and books

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

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

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

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

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

Press

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

Videos

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

About the author

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

WallStreetBets

Meaning of WallStreet Bets

The GameStop Short Squeeze

Epilogue

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Useful resources

Relevance to the SimTrade certificate

About practice

About the author

Consumer Confidence Index

Introduction

Measuring Consumer Confidence Index

Interpreting Consumer Confidence Index

Useful resources

About the author

Purchasing Managers’ Index

Introduction

Calculation of PMI

Importance of PMI

For Manufacturers

For Suppliers

For Investors

For Government

Why should one be concerned about PMI?

Related posts on the SimTrade blog

Useful resources

About the author

Credit Rating

Introduction

Rating agencies

Types of Credit Rating

Investment grade

Speculative grade

Users of Credit Rating

Institutional investors

Intermediaries

Debt Issuers

Businesses & Corporations

Understanding Credit Rating

Importance of Credit Ratings

For Lending Entities

For Borrowing Entities

For Investors

Related posts on the SimTrade blog

Useful resources

About the author

Bond markets

The primary market

Syndication

Auction

The secondary market

Useful resources

Rating agencies

Related posts

About the author

The 2007-2008 subprime crisis

How ABS was the New Sexy for Bankers:

Sub-Primers and Primers: Why Give to One, when you can Give to Both?

Transforming Assets into Financial Vehicles: The Role of SPVs:

The Final Countdown:

Conclusion

Key Concepts to Understand the Subprime Crisis

Subprime and prime borrowers

Collateralized Debt Obligations (CDO)

Assets Backed Securities (ABS)

Useful Resources

Related posts on the SimTrade blog

About the author

Quantitative Analyst – Job description

Introduction

Types of Quantitative Analyst

Front-office analysts

Back-office and middle-office analysts

Whom does a Quantitative Analyst work with?

How much does a Quantitative Analyst earn?

What training do you need to become a Quantitative Analyst?

Relevance to the SimTrade course

About theory

About practice

Useful Resources