Financial leverage

Hedge funds

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Hedge funds

Akshit Gupta

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

Introduction

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

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

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

Benefits of a hedge funds

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

Fee structure

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

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

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

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

Types of strategies used by hedge funds

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

Long/Short equities

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

Event driven strategy

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

Relative value strategy

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

Distressed securities

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

Major hedge funds in the world

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

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

Risks associated with hedge funds

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

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

Useful resources

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

Related posts

▶ Youssef LOURAOUI Introduction to Hedge Funds

▶ Shruti CHAND Financial leverage

▶ Akshit GUPTA Initial and maintenance margins in stocks

About the author

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

Financial leverage

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Financial leverage

Shruti Chand

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

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

Definition of financial leverage

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

Financial leverage Balance sheet

How does financial leverage work in real life?

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

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

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

How is financial leverage measured?

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

Financial leverage ratio

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

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

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

Example of financial leverage in action

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

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

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

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

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

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

Advantages of financial leverage

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

Disadvantages of financial leverage

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

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

Conclusion

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

Related posts on the SimTrade blog

   ▶ Shruti CHAND Balance Sheet

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

   ▶ Akshit GUPTA Initial and maintenance margins in stocks

   ▶ Youssef LOURAOUI Introduction to Hedge Funds

Relevance to the SimTrade certificate

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

About theory

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

Take SimTrade courses

About practice

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

Take SimTrade courses

Useful resources

SimTrade course Financial leverage

About the author

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

Film analysis: The Big Short

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Film analysis: The Big Short

Foreward

A pervasive moral stigma follows the financial sector, which has a dogged reputation for unethical and illegal behaviour. However, the ethical lapses often associated with finance are not always intentional. Instead, a contributing factor is that the teaching of finance and other business disciplines presents the challenge of linking theories and conceptual models to the “real world”. Entertainment media – such as films or books – are useful in this aspect as case studies; they provide students with an organisational frame of reference to better understand both situational contexts, and importantly, the human dimension behind financial numbers.

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the The Big Short film and explains the related financial concepts.

The film “The Big Short” recounts the subprime housing bubble which lead to the financial crisis in 2008. Through a compelling storyline, the complexities of the financial market – including CDOs, mortgage backed bonds, and the reckless trading of complex derivative instruments – lead to the subsequent financial collapse of the US housing market.

Film summary

“The Big Short” directed by Adam McKay and based on the best-selling book by Michael Lewis, explains how the subprime housing bubble, caused by increasingly risky subprime mortgage bonds, lead to the 2008 financial crisis. The danger was hidden such that only a few players predicted the collapse and used it to “short” the market. Once the bonds failed, the value of billion-dollar securities dropped to nothing, which bankrupted major investment banks and forced a government bailout to prevent economic collapse.

The film is presented as three concurrent stories about the investors who realised the risk of the subprime housing bubble and predicted the 2007 housing market crash. Wall Street investor Michael Burry realised that many subprime home loans packaged in the bonds were in danger of defaulting, and bets against the market with one billion dollars in credit default swaps. We also follow the stories of banker Jared Vennett, hedge-fund specialist Mark Baum, and two younger investors – Charlie Geller and Jamie Shipley – who work with retired banker Ben Rickert. After reading Burry’s findings, they also make a series of successful bets and profit off the downfall of the economy.

The subprime housing bubble caused worldwide chaos as banks entered a liquidity crisis, stock markets crashed, reputable companies collapsed, and millions suffered in the wake of the disaster. The crisis was felt worldwide, irrespective of your position and whether you benefited, survived or lost everything you’d worked towards. This movie helps those who aren’t in the financial sector, understand exactly what happened.

The Big Short film

Financial concepts from the The Big Short film

Financial derivatives

Leverage

Financial leverage can be used to increase (expected) profits but also increases risk by accentuating the gains and losses of a market position. When the largest banks and financial institutions in the world leveraged using derivatives, CDOs and other highly complex securities – the exacerbated losses can lead to collapse.

CDO

A Collateralised Debt Obligation (CDO) is essentially the repackaging “old” products as new, by the securitisation of loans into a product sold to investors on the secondary market. Another example are synthetic CDOs, which essentially bets on the direction the market is going to take and amplifies the monetary gain of a bullish market, but heavily exacerbates the losses from a bearish one.

Subprime Mortgage Backed Securities

Subprime mortgages are a loan to borrowers with a low credit rating, which increases the risk that they will default. Tranches in subprime mortgage-backed bonds are when subprime mortgages are mixed with top-rated mortgages, which effectively hides their risky nature from unsuspecting customers. These top-rated securities could not stand when the subprime mortgages failed, but the danger was looked over even by the banks who sold them.

‘Shorting’ the market

By predicting the danger of mortgage-backed securities and expecting defaults on subprime mortgages, some investors profited from the crisis through credit default swaps. However, this does not mean shorting the market is a good idea. As said by J.M. Keynes; the market can stay irrational much longer than you can stay solvent. Due to unpredictable factors such as politics, going short is a bet that can run out of time – even with a simple options strategy, your options will eventually expire. Sticking with a long term, value-based approach eliminates that problem. Keep short investments on the side to meet short term cash flow needs, but also know that a quality company will generate profits, dividends, and market returns over the long term, without ever expiring.

High Risk vs High Reward

Why did the banks making the loans expose themselves to subprime borrowers at such high levels? Because high-risk borrowers also offered high rewards. Before home prices imploded and the labour market tanked, banks were able to charge sufficiently high interest rates on loans to subprime borrowers which more than overcame the costs of their higher default rates. This combined with the banks’ ability to securitize loans and sell them meant that banks thought their risks were mitigated. Instead they focused on how higher subprime interest rates could boost their margins and profits. However, those default rates eventually grew too high for any interest rate to justify the risk, and the entire system collapsed.

Impartial assessors

Impartial regulators and assessors are critical to the safe functioning of the financial sector. A contributing factor to the crash was years of financial malfeasance and incompetence among the top salesmen and executives among Wall Street’s largest banks. Conflicts of interest and abuse of power by the banks meant credit rating agencies as well as professionals supposedly managing CDOs for the benefit of the customer, were in fact working in the bank’s interest. This fraudulent system meant the credit rating agencies were rating housing debt securities highly, right up until the crash.

Counter-party risk

This simply means the risk of the other party, if their investments are not able to pay out when the time comes. An example is how Baum and Geller bet against the banks, but when the crisis hit the banks eventually went bankrupt – these two investors had to be careful about receiving payment before the banks became insolvent.

Key insights for investors

Trust your instincts

It’s important to do your own homework and trust your instincts. Despite external pressure, the investors shorting the market held their ground, ensuring their investments paid off in the long-term. When the numbers go up and down, it’s important to be patient and study the reasons behind any change. While investment advice is useful, the incentives of others may conflict with yours. It’s your money, and just because an opinion is popular, doesn’t mean its correct.

See the reality

When buying securities, it’s vital to understand the reality of what the numbers represent – real people, real companies. In the film, we see workers paying off loans for three properties at varying rates, and how the incentive system cushioned bank managers’ salaries, helping the mortgage market expand. “No-one can see a bubble; that’s what makes it a bubble” – people lost their ability to see the forest for the trees. They were the weak link in the chain, which once broken, caused the crisis. Your finances are only as strong as their weakest link, so it’s important to diversify your risk.

Mentors

In the film, Geller and Shipley asked their mentor and retired trader Rickert for his support to meet the ISDA threshold. More than that, he taught them that greed is not good, and that their win was at the expense of millions of Americans who would lose their jobs. Have a mentor to guide you both morally and financially.

Opportunity in adversity

A final lesson from this movie, albeit a dark example, is that you can find the good in adversity. By shifting your mindset when facing failures or disasters, you can learn to find opportunity in anything.

Relevance to the SimTrade certificate

Through the SimTrade course, as well as a strong understanding about trading platforms and orders, you are taught about information in financial markets and how to use this to make successful trades. Several case studies teach you how to analyse market information to make valuations, and correctly assess how market activities will affect your own trades. The simulation and contest allow you to compete against others in the course and deepen your understanding of how a market reacts to different players.

Famous quote from the The Big Short film

An investor: “No one can see a bubble. That’s what makes it a bubble.”

Trailer of the The Big Short film

Related posts on the SimTrade blog

▶ All posts about Movies and documentaries

▶ Akshit GUPTA The bankruptcy of Lehman Brothers (2008)

▶ Akshit GUPTA Analysis of the Margin Call movie

▶ Marie POFF Film analysis: Too Big To Fail

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: Rogue Trader

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Film analysis: Rogue Trader

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the Rogue trader film and explains the related financial concepts.

Based on a true story, ‘Rogue Trader’ details how risky trades made by Nick Leeson, an employee of investment banking firm Barings Bank, lead to its insolvency. This film explores how financial oversight and a lack of risk management from Leeson’s supervisors, lead to irrecoverable losses and the eventual fall of the banking giant.

Film summary

‘Rogue Trader’ recounts the exploits of Nick Leeson and his role in the downfall of Barings Bank, one of the single largest financial disasters of the nineties. Directed by James Dearden, this film encapsulates the economic and social changes of a tumultuous period. Leeson is a young derivatives trader sent to work in Singapore for Barings Bank, a major investment bank at the time. After opening a Future and Options office in Singapore, Leeson is placed in a position of authority where he takes advantage of the thriving Asian market by arbitraging between the Singapore International Monetary Exchange (SIMEX) and the Nikkei in Japan. He begins making unauthorised trades, which initially do make large profits for Barings – however he soon begins using the bank’s money to make bets on the market to recoup his own trading losses. At first, he tries to hide his losses in accounts, but eventually loses over $1 billion of Barings capital as its head of operations on the Singapore Exchange. He eventually flees the country with his wife, but inevitably, he must face how his actions lead to the bankruptcy of Barings Bank.

The Rogue Trader film

Financial concepts from the Rogue Trader film

Financial derivatives

For any new investors, financial derivatives describe a broad class of trading instruments that have no tangible worth of their own, but “derive” their value from a claim to some other financial asset or security. A few examples include futures contracts, forward contracts, put and call options, warrants, and swaps. Derivative trading started from the practice of fixing contracts ahead of time, as a way for market players to insure against fluctuations in the price of agricultural goods. Eventually the practice was extended to cover currencies and other commodities. As exchange rates became increasingly unstable, the derivatives trade facilitated huge profits for those estimating the future relative value of various commodities and currencies, through the buying and selling complex products.

Barings Bank

Founded in 1762, Barings Bank was the second oldest merchant bank in the world before its collapse in 1995. Barings grew from being a conservative merchant bank to becoming heavily reliant on speculation in the global stock markets to accumulate its profits. The derivatives market was somewhere this could be done in a very short space of time. Following the stock market crash of 1987, derivatives became central to the banks’ operations as they sought to offset their declining profits. The volume of their derivative trading soared from less than $2 trillion in 1987, to $12 trillion in 1993. As finance capital became increasingly globalised, Barings branched out to exploit these new markets in Latin America and the Far East.

Tiger Economies

The term “tiger economies” is used to describe the booming Southeast Asian economies of South Korea, Taiwan, Hong Kong, and Singapore. Following export-led growth and especially the development of sophisticated financial and trading hubs, Western interest spiked for these untapped markets in the 1990s.

Arbitrage

Profitable arbitrage opportunities are the result of simultaneously buying and selling in different markets, or by using derivatives, to take advantage of differing prices for the same asset. In the film, Leeson makes a profit by exploiting the small price fluctuations between SIMEX in Singapore and the Nikkei 225 in Japan.

Cash neutral business

A cash neutral business means managing an investment portfolio without adding any capital. For Leeson, any money made or lost on the trades should have belonged to the clients, and only a small proportion of the trades were meant to be proprietary. However, Leeson used Baring Bank’s money to make bets on the market to recoup his trading losses.

Short straddle position

A short straddle is an options strategy which takes advantage of a lack of volatility in an asset’s price, by selling both a call and a put option with the same strike price and expiration date, to create a narrow trading range for the underlying stock. Lesson used this strategy but sold disproportionate amounts of short straddles for each long futures position he took, because he needed to pay the new trades, the initial margin deposits, and meet the mounting margin calls on his existing positions.

Errors account

An errors account is a temporary account used to store and compensate for transactions related to errors in trading activity, such as routing numbers to an incorrect or wrong account. This practice allows for the separation of a transaction so that a claim can be made and resolved quickly. Leeson used this accounting to conceal the losses to Barings Bank which eventually amounted to over £800 million, though the account was supposedly activated to cover-up the loss made by an inexperienced trader working under Leeson’s supervision.

Key insights for investors

Don’t Lose Sight of Reality

An important insight is noticing how Leeson forgot to consider the real-world impact of his trades. He reflects on seeing trading as just artificial numbers flashing across screens, “it was all paid by telegraphic transfer, and since we lived off expense accounts, the numbers in our bank balances just rolled up. The real, real money was the $100 I bet Danny each day about where the market would close, or the cash we spent buying chocolate Kinder eggs to muck around with the plastic toys we found inside them.” Leeson saw the Kobe earthquake as nothing more than an opportunity and conducted more trading in one day than he ever had before as the market was butchered. Investors can avoid Leeson’s mistake by keeping a firm grasp on reality, and remembering the real companies and people represented by the stock exchange.

Destructive Practices

Other employees at Barings Bank most likely relied on internal auditors to discern wrongdoings or mistakes made by others, but as can be seen from Leeson’s case, regulators can be slow to catch on to any wrongdoing – especially when there are large profits involved. The lesson here is that an investor must be aware and proactive in helping to prevent other investors from engaging in destructive trading practices. This is especially true when it comes to newer markets or products, where regulators are unsure what entails best practice.

Tacit Agreement

While Leeson is assumed to be the villain, consider how Barings was able to contravene laws forbidding the transfer of more than 25 percent of the bank’s share capital out of the country for nearly every quarter during 1993 and 1994? Ignorance is not an excuse – tacit agreement is as effective as active engagement. A lesson here is that investors should remain informed on all their business engagements regardless of how much profit it being made.

Relevance to the SimTrade certificate

Through the SimTrade course, as well as a strong understanding about trading platforms and orders, you are taught about information in financial markets and how to use this to make successful trades. Several case studies teach you how to analyse market information to make valuations, and correctly assess how market activities will affect your own trades. The simulation and contest allow you to compete against others in the course and deepen your understanding of how a market reacts to different players.

Famous quote from the Rogue trader film

Nick Lesson: “Despite rumours of secret bank accounts and hidden millions, I did not profit personally from my unlawful trading. To be absolutely honest, sometimes I wish I had.”

Trailer of the Rogue trader film

Related posts on the SimTrade blog

All posts about financial movies and documentaries

▶ Akshit GUPTA Analysis of The Rogue Trader movie (another analysis)

▶ Akshit GUPTA The bankruptcy of the Barings Bank (1996)

▶ Jayati WALIA Value at Risk

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Film analysis: Other People's Money

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Film analysis: Other People’s Money

Marie Poff

This article written by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020) analyzes the Other People’s Money film.

“Other People’s Money” is a film about a near obsolete publicly traded company, the New England Wire and Cable Company, interwoven with romance and community spirit. Issues arise because the original wire and cable division has become an obsolete parent firm of an otherwise profitable group of subsidiaries, but it employs much of the town’s population. While exploring the world of hostile corporate takeovers and the market for corporate control, this film shows the human impact of shareholder decisions. Good capitalism and greed clash in this fight to keep shareholders satisfied and save the factory from a dying industry.

Film summary

“Other People’s Money” directed by Norman Jewison, delves into the hostile takeover of New England Wire and Cable Company (NEWC) by Garfield Industries, where corporate raider Lawrence “Larry the Liquidator” Garfield is president. New England Wire is a publicly traded, debt-free company founded and managed by the Jorgenson family. Garfield arrives offering a peaceful takeover, explaining that the wire and cable division is in a dying industry, and is harming the profitable subsidiaries by depressing the share price. He believes that liquidating the harmful wire division is necessary to act in the best interest of the shareholders. However, Jorgenson denounces this offer as a death sentence for the employees and their town, arguing that companies should protect their community and have social responsibility. However, the market value of the company’s common stock decreases to equal less than the underlying value of its assets. Garfield then makes a takeover attempt, which culminates at the company’s annual shareholders’ meeting with Garfield succeeding in closing the wire and cable division of NEWC. The film ends with Kate Jorgensen calling with good news from a Japanese automobile company, who are interested in hiring the NEWC to product stainless steel wire cloth instead of wire.

Otehr peoples's money film

Financial concepts from the Other People’s Money film

Other People’s Money

Other people’s money (OPM) is a slang term referring to financial leverage, whereby using borrowed capital it’s possible to increase the potential returns, but also increase the risk, of an investment. In the film, the NEWC had an inefficient capital structure with no debt to leverage the company. Instead the company had a high amount of cash and liquid assets, as well as a fully funded pension plan for its employees, but had a debt-to-equity ratio of zero. There are trade-offs to having a higher debt-to-equity ratio, but in this case, leveraging OPM would have allowed the NEWC to remain in business by transitioning into a more profitable industry.

Corporate restructuring

Corporate restructuring is a process where the structure or operation of a company is significantly modified, usually in periods of significant distress and financial jeopardy. This could involve for example, mergers, takeovers, or divestiture. In this film, Garfield persuades the shareholders to divest of the failing division by selling the division and its remaining assets. Kate Jorgensen offers a better solution – a Japanese automobile company which will hire the NEWC to produce stainless steel wire cloth, allowing the company’s assets to be repurposed instead of liquidated.

Corporate takeovers

A corporate takeover refers to when one company makes a bid to acquire or take control of another, without necessarily obtaining the actual title. A takeover is usually done by purchasing a majority stake in the shares of the target company. In the film the NEWC is debt-free, making it attractive to corporate raiders or ‘takeover artists’, who aim to provide shareholders with a better return for their money.

Market for corporate control

The market for corporate control is the role of equity markets in facilitating corporate takeovers, and mainly refers to the market for acquisitions and mergers where there is competition for control rights. In this film, takeover artist Garfinkle is blocked from purchasing more shares in the NEWC by a judge’s injunction. He fights this as he believes that a free market for corporate control is needed to enable restructuring essential for the company to remain competitive. As a value-focused individual, Garfinkle believes in market dynamism as an effective tool for poor management, where market forces put pressure on managers to perform or risk sale of the company.

Creative destruction

Creative destruction is the union of evolutionary natural selection and economics. Resources are necessarily scarce, so the world advances only when outdated industries are encouraged to die quickly, allowing capital to be reallocated to more efficient and innovative industries. In this film, cable and wire is a dying industry due to the widespread adoption of fibre optics, so Garfield encourages shareholders to sell to him and reallocate their money towards a more productive venture. The underlying assumption is that though a transitioning industry will cause disruption, there is more to gain than lose when capital is put to best use and assets are used in an economically rational manner.

Key insights for investors

Wealth maximisation vs Social responsibility

As investors, the main goal is often to maximise wealth, and the game of making money can make it all too easy to value a business solely on its share price. However, this film shows that behind the numbers are the people who keep the business afloat, and who in turn rely on employment at the NEWC to support themselves. Jorgensen’s focus is on his social responsibility to the employees whose livelihoods depend on the wire plant, while Garfield believes in free enterprise and shareholder wealth maximisation. It’s clear that a balance between the two is required to create ‘good capitalism’, where all parties involved are treated fairly and humanely.

Many sides to every story

A meaningful insight from this film is that both players had valid reasons for their actions. While Garfield is painted as profit-focused at the expense of the employees, he’s also acting in the best interests of the shareholders – he refuses to take a “greenmail” bribe because he believes it would be immoral to sell out and victimise the shareholders whose funds are not being put to best use. Conversely, while Jorgensen is painted as the town’s hero, he is also neglecting his obligation to the shareholders by failing to recognize that his company was in a shrinking market, and would become obsolete if he did not accept innovations in the industry. This dual perspective is an introduction to business ethics, showing how utilitarian thinking can clash with other ideals pushing social responsibility and awareness. As investors, this is a reminder that there are always many perspectives to an issue, and real life is never black and white.

Relevance to the SimTrade certificate

SimTrade is a course designed to teach investors how the market works, including how to make orders and build a market position, while also teaching investors how to interpret and understand what these numbers represent in the real world. A combination of theory and practice helps you to understand the complexities of the stock market – including firm valuations, the impact of events on stock prices, and how to appreciate the degree of market efficiency.

The Other people’s money concept is introduced in Period 3 of the SimTrade certificate:

  • The Financial leverage course
  • The series of simulations about market making

Famous quote from the Other people’s money film

About leverage: “I love money. I love money more than the things it can buy. There’s only one thing I love more than money. You know what that is? Other people’s money.”

Watch Garfield making his point about wealth maximisation at the shareholders’ Annual Meeting of their company.

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

Trailer of the Other People’s Money film

Related posts on the SimTrade blog

▶ Shruti CHAND Financial leverage

▶ Akshit GUPTA Wall Street: Money Never Sleeps

▶ Kunal SAREEN Analysis of the Wall Street movie

About the author

Article written in November 2020 by Marie POFF (ESSEC Business School, Global Bachelor of Business Administration, 2020).

Analysis of the Margin Call movie

by

Analysis of Margin Call movie

Akshit Gupta

This article written by Akshit Gupta (ESSEC Business School, Master in Management, 2022) analyzes Margin Call movie and explains the related financial concepts.

Margin Call (2011) is an entangling American drama movie based on the events that took place within an investment bank during the financial crisis of 2008. The movie mirrors the impact of high exposure to Mortgaged Back Securities (MBS) that prevailed across big banks and depicts the events that lead to a near fall of an unnamed investment bank based out in New York City. It provides a very good analysis of the present financial system and throws light on the working of some large financial institutions.

Key characters in the Movie

  • Eric Dale- Head, Risk Management Department
  • Peter Sullivan – Junior Analyst, Risk Management Department
  • John Tuld – CEO of the Bank
  • Sarah Robertson- Chief Risk Management Officer
  • Jared Cohen- Divisional Head
  • Sam Rogers- Floor Head

Summary of the movie

Bolier room movie

The movie begins by introducing an unnamed investment bank where, owing to decreasing profits, 80% of the staff is getting laid off. Eric Dale, director of the risk management team, is one of the victims of this layoff. Before leaving the office Eric hands over a USB, which contains important analysis that he has been carrying out, to his junior named Peter Sullivan and asks him to complete the model with proper care. During the night, Peter finishes the model and discovers information that has the potential to bankrupt the entire firm. As per the model, the firm was over-leveraged and has even crossed historical volatility patterns many times in the past couple of weeks. If the market value of the firm’s risky assets drops by 25%, the losses would be greater than the entire market capitalization of the firm.

Alarmed by the findings of the model, Peter calls upon his supervisor Will Emerson to check the numbers. An emergency meeting is called up in the middle of the night where all the members of the senior executive committee are present including the CEO of the bank, John Tuld.

Running through the numbers and finding no other optimal way, John orders for an immediate sale of all the toxic financial assets firm holds, before the market could react.

The decision taken by Tuld is demurred by many top executives since they knew that it would destroy the firm’s relationship with all its customers and cause a major blow to the entire financial system. The value of the product they were selling to their customers in the name of MBS was plunging, just as the real estate market in the USA back in 2008.

Initially reluctant, Sam agrees to the sale of the toxic assets in exchange for huge compensation from Tuld. Sam orders all the traders on his floor to unwind their positions in the toxic asset purely in cash deals and offered them huge bonuses and commissions once they achieve a set target. Information about the company’s misdemeanor is spilled out and the traders are forced to sell at significant discounts.

Once the target sale is achieved and all assets are cleared, another round of laying off starts and most of the employees are let go with hefty compensations and bonuses. Sarah Robertson, the chief of risk management, is used as a scapegoat and also dismissed from her duties. Dismayed, Sam reaches out to Tuld to explain to him about his longing to leave the firm.  Tuld reminds him how the current crisis is no different from the previous crises and how the proportion of winners and losers always remains the same. Entwined between the dubious system and the need for financial resources, Sam decides to continue with the firm for another 2 years in anticipation of earning more money.

Relevance to the SimTrade course

The concepts shown in the movie correlates to the concepts of ‘Demand & Supply’ and ‘Financial Leverage’ taught in the SimTrade course. During the first decade of the 21st century, low-interest rates prevailed in the US economy giving rise to debt-financed consumption. The easy availability of sub-prime housing loans lured people from the lower strata of the society to avail the benefits of it. Subsequently, the increase in loan availability raised the demand for customized securities which came in the form of MBS, which became a trending asset in the market. The financial bubble kept on building up as the intrinsic value of MBS started dwindling. The falling asset value affected the investment bank as their business model was built on high exposure to these assets.

Also, this high exposure to subprime mortgages and toxic assets subsequently led to high level of leverages at the firm and statistical models of VaR (Value at Risk) and historical volatility failed to show a potential downside which could result in losses greater than the entire value of the firm. The risk models used by the firm considered the positions of other firms in the same assets and were not effective enough to take into account the risk magnitude of black swan events such as the default rates on subprime mortgages, the root cause behind the financial crisis of 2008. The financial damages and moral hazards associated with such an event are justified by the discount rates traders had to offer to unwind their position and also the client trust the firm lost as collateral damage. The movie shows the rationale of firms, referred to as too big to fail, in dealing with situations created as a by-product of their own actions.

Most famous quotes from the movie

“Sometimes in an acute situation such as this (referring to the sale of all toxic assets), often, what is right can take on multiple interpretations.” – Jared Cohen

“You know, the feeling that people experience when they stand on the edge like, this isn’t the fear of falling; it’s the fear that they might jump.” – Will Emerson

Trailer of the movie

Related Posts

   ▶ All posts about financial movies and documentaries

   ▶ Marie POFF Film analysis: The Big Short

   ▶ Marie POFF Film analysis: Too Big To Fail

   ▶ Shruti CHAND Financial leverage

Useful resources

SimTrade course Financial leverage

About the author

Article in October 2020 written by Akshit GUPTA (ESSEC Business School, Master in Management, 2019-2022).