Financial analysts

Gifting Phase

admin — Wed, 17 Nov 2010 15:35:41 +0000

The gifting phase is similar to, and may be concurrent with, the spending phase. In this stage, individuals believe they have sufficient income and assets to cover their expenses while maintaining a reserve for uncertainties. Excess assets can be used to provide financial assistance to relatives or friends, to establish charitable trusts, or to fund trusts as an estate planning tool to minimize estate taxes.

Spending Phase

admin — Tue, 16 Nov 2010 15:35:34 +0000

The spending phase typically begins when individuals retire. Living expenses are covered by social security income and income from prior investments, including employer pension plans. Because their earning years have concluded (although some retirees take part-time positions or do consulting work), they seek greater protection of their capital. At the same time, they must balance their desire to preserve the nominal value of their savings with the need to protect themselves against a decline in the real value of their savings due to inflation. The average 65-year-old person in the United States has a life expectancy of about 20 years. Thus, although their overall portfolio may be less risky than in the consolidation phase, they still need some risky growth investments, such as common stocks, for inflation (purchasing power) protection.

Consolidation Phase

admin — Mon, 15 Nov 2010 15:34:06 +0000

Individuals in the consolidation phase are typically past the mid- point of their careers, have paid off much or all of their outstanding debts, and perhaps have paid, or have the assets to pay, their children’s college bills. Earnings exceed expenses, so the excess can be invested to provide for future retirement or estate planning needs. The typical investment horizon for this phase is still long (20 to 30 years), so moderately high risk investments are attractive. At the same time, because individuals in this phase are concerned about capital preservation, they do not want to take very large risks that may put their current nest egg in jeopardy.

Accumulation Phase

admin — Sun, 14 Nov 2010 15:32:57 +0000

Individuals in the early-to-middle years of their working careers are in the accumulation phase. As the name implies, these individuals are attempting to accumulate assets to satisfy fairly immediate needs (for example, a down payment for a house) or longer-term goals (children’s college education, retirement). Typically, their net worth is small, and debt from car loans or their own past college loans may be heavy. As a result of their typically long investment time horizon and their future earning ability, individuals in the accumulation phase are willing to make relatively high-risk investments in the hopes of making above- average nominal returns over time.

Tracking Error

admin — Sun, 04 Jul 2010 08:35:50 +0000

Just as corporations have to deal with “forecasting error” in terms of the deviation of forecast exchange rates relative to the actual future rate, so investors have to deal with “tracking error” within their portfolios, which is the return of the portfolio relative to the investment benchmark index being used. Within this, there is “expected” and “realized” tracking error. Expected tracking error is as the name suggests determined before the fact — ex ante — whereas the realized tracking error is determined after the fact.
Determining the relevance of tracking error is also a function of comparing the portfolio’s hedging strategy with a random strategy, which creates hedge/don’t hedge signals with equal probability on a regular basis. Using polar benchmarks — i.e. 0% or 100% hedged — the equal probability of the outcome of the random strategy suggests that hedge deviations will be zero in half the cases and 100% in half the cases. However, with a partially hedged currency benchmark, the deviations will vary in direct proportion to the ratio of the benchmark. For instance, for a symmetrical or 50% hedged currency benchmark, the deviations will be 50% from each side of the benchmark.
From this, we can gather two things, firstly that the tracking error — or the deviation — is a function of the hedged ratio used for benchmarking and secondly that the tracking error for a partially hedged benchmark should be less than that for a polar benchmark. Indeed, generally, the tracking error for a symmetrical or 50% currency hedging benchmark should be around 70% of the tracking error using polar benchmarks. Expressed differently, the tracking error of a polar benchmark should be 1.41 (square root of 2) times higher than that of a 50% hedged benchmark. The advantage of a symmetrical or 50% currency hedged benchmark for a portfolio manager is that it reduces the tracking error of the portfolio and also enables them to participate in both bull and bear markets compared to the polar benchmark where the participation is limited to either/or.
Tracking error can be further reduced by a technique known as “matched hedging”, which increases or decreases the hedge ratio relative to the change in asset allocation. Historically, the act of asset allocation itself within fixed income portfolios has been a major and seemingly unavoidable factor in increasing a portfolio’s tracking error. Matched hedging can reduce though clearly not eliminate this.
Tracking error can also occur under passive currency management. This is because in order to implement a passive currency hedging programme a portfolio manager still has to adjust the amount of the currency hedge relative to the value of the underlying as it changes on a regular basis — i.e. once a month. In reality, many portfolio managers don’t bother to do this. As a result, the residual that is left over- or under-hedged contributes to the tracking error. In this, the portfolio manager has to balance the transaction costs of re-balancing the currency hedges against the negative effect on tracking error.

Preparing Yourself for the World of Investing

admin — Thu, 10 Jun 2010 14:54:38 +0000

Bulls, bears, stocks and bonds. Many people enjoy the notion of saying that they are investors, but few are actually prepared to invest in the right way. Investing is like a boxing match in that there must be adequate preparation and training before a boxer ever steps into a gym. Like a boxer, an investor has to seek the right investment advice because they have much to lose if they are ill trained before the main event.

Before You Invest

Prior to investing, you should prepare for it by getting your finances in shape. First, you should be aware of your debt levels. There is no such thing as good debt but some types of debt are acceptable such as a mortgage loan. You need to get rid of any extra debt you have before you ever invest.
The reason is simple: if you invest, you may not earn enough to offset the interest being charged on your debt, and even worse you could lose your investment as well. For example, if you’re paying 6% interest on a student loan, you would have to earn over 6 percent on your investment returns in order to justify not concentrating on your debt load first.
After ridding yourself of debt, you need to build an emergency fund. If you lose your job or run into unexpected expenses like medical bills or your old car breaks down, you will be covered. Before trying to make money by investing you should have adequate savings to keep you going when emergencies occur.

Doing Research

There are all kinds of great investments for you to try out, but when starting out you should pick one and dedicate yourself to learning as much as possible about it. For instance, if you choose to invest in the stock market you should be reading as much as possible about it daily. Next, you should try a virtual stock exchange where you’re given fake money to invest. Try out various investment theories and see which one suits your style and risk tolerance most. There is really no right answer, but the wrong answer is to go in without training.
Remember that you can always start out with more simple investments like CDs or bonds before trying your hand at the stock market. Countless investors lose money because they are not ready for the dedication necessary serious investing. Don’t let yourself be unprepared when risking your money.

The No-Debt Vow

admin — Sun, 23 May 2010 16:11:33 +0000

The No-Debt Vow

Everybody always asks me what the first step to getting out of debt is, and the answer is always the same — stop digging. If you have already put yourself in a very deep hole, the only way to start getting out of that hole is to stop digging. Debt reduction may seem like a tricky thing, but in many aspects it is not. If you are serious about getting out of debt and beginning to live a financially responsible life, you have to kill all bad habits before you can begin to heal the wounds.

So if you have made the no-debt vow, how do you force yourself to stick to this regimen? Well look at it as if it was a diet, as if you are trying to reduce the amount of debt in your financial meals every day. The extra debt you have added on by irresponsible spending and gorging you must now eliminate by frugal spending and wise expenditures. Fancy gadgets and expensive toys will pop out of nowhere to tempt you, but it is up to you to fight such temptations and limit the amount of money you spend.

Now what is the best way to avoid these temptations? Well in many aspects it is impossible because we don’t always know where these temptations will come from. However, sometimes we do. Therefore we must find a way to limit our exposure to the things that we know are weaknesses for us, meaning things we know we have a soft-spot for and may end up costing us. If you are able to limit your own exposure to such items you are limiting the possibilities of you relapsing and adding to your debt collection.

Long-term Positions

admin — Sun, 15 Nov 2009 08:55:02 +0000

Positions that are of longer term are more often hedged through swap markets than forward markets. The structure of a foreign currency swap is very similar to that of a floating rate interest rate swap. We will take the case of a floating rate ¥1000bn five-year loan with interest paid every three months. In order to hedge the annual interest payments we would enter into a yen–dollar swap agreement with terms as follows: Nominal values of the contracts are ¥1000bn and $1bn. The amount to be paid by the yen payer is set at the current spot yen 90-day interest rate for settlement 90 days after.
The amount to be paid by the US$ payer is set at the current US$ 90 day interest rate for payment 90–days after.
Interest rate parity ensures that the US-based bank has fully hedged the interest payments due from the loan. (This is a simplified example and in practice we would have to look more fully at the pricing basis and payment terms of the loan and take these into account.)
The following, slightly more complex, worked example is of a three-year euro–yen swap. The conditions of the two parties are as follows:
Nominal value. Nominal values of the contracts are ¥500bn and €600m.
Payment calculation. Interest to be calculated on a quarterly basis. Payments by the yen payer are to be based on the spot yen 90-day London interbank rate plus 150 bpts and at the spot euro LIBOR for the euro payer. On the day that the agreement starts the two payments due are calculated based on 90-day yen rates of 0.75% and euro rates of 2.25%, giving payments due of ¥281.250m nd €3.375m.
Settlement. Settlement is to be made 90 days after the date of calculation on a netted basis in US$. The calculated payments are converted into US$ based on the then yen:US$ spot rate of 99.50 and a euro:US$ spot rate of 1.205. The yen payment due is US$2 826 633 while that of the euro payer is $2 800 830. The yen payer pays the difference of US$25 803 to the yen receiver.

GAP ANALYSIS

admin — Fri, 02 Oct 2009 08:53:11 +0000

In many countries banks are required to disclose their period-end interest rate gap positions in the form of the following report. These reports show balance sheet assets and liabilities broken down by when they are next due for repricing. The effects of off-balance sheet items such as swaps are also included within the summary.
A positive interest rate gap means that more assets than liabilities are due to be repriced in a particular time interval. The following bank has a negative yield gap over the next 12 months and as such net interest margins should benefit from falling interest rates.
This would suggest that we can quantify the impact of rate changes within a specific time interval. The impact of an increase in short-term rates for a specific interval is given in general by:
Impact on net interest income = Balance sheet gap for time interval × àr For the three-month or less time interval for a 100 bpt increase in rates would imply:
Impact on net interest income = ?($7500m × 0.01) = ?$75m
Concentrating on managing short-term interest rate gaps can help banks report relatively stable spreads but this may have the effect of ignoring duration gaps for assets and liabilities with long duration. This will lead to increased risks of losses in economic value.
In practice analysts do not find gap reports of much use for a number of reasons:
They represent a snapshot in time and by the time they are released are usually well out of date. They indicate how a bank was positioning itself for changing interest rates rather than what they are now expecting. The use of the off-balance sheet instruments allows banks to adjust their gap positions in the medium and long term relatively quickly. They do not take any account of embedded options whether explicit as with mortgage pre- payments, or implicit options that exist in many deposits. If interest rates rise some demand deposit holders will exercise their option to withdraw their funds and redeposit them in an interest-bearing account. The time intervals are generally very broad and banks do not report an average repricing period. An analyst usually makes simplifying assumptions, for example that all deposits in the three to six-month time frame are repriced after four and a half months. Interest rates can remain stable for a protracted period but at times may change on a regular basis over a period of many months. It becomes increasingly difficult to estimate the potential impact of multiple interest rate changes on repricing. Rates across the yield curve do not usually change in parallel.
Banks are not passive observers. When interest rates are falling they will try to cut borrowing rates more than they cut lending rates. Lending rates are generally relatively sticky in a falling interest rate environment.

EMERGING MARKETS AND CURRENCY HEDGING

admin — Mon, 06 Jul 2009 08:37:42 +0000

It has been noted that emerging markets have different market properties to those of the developed markets. Here, it is important to sell these out and then in turn relate them to the considerations of passive and active currency risk management. First off, let us look at the major differences that appear present in emerging markets:
Liquidity risk — Emerging market currencies are less liquid than their developed counterparts. For instance, every day some USD300 billion goes through EUR–USD. This compares with around USD10 billion daily in the South African rand. Needless to say, this lower liquidity affects pricing and price action.
Convertibility risk — Even less than liquidity risk, convertibility risk is not a consideration for developed currency markets as all major currencies are freely floating and fully convertible. A number of emerging market currencies however are still not convertible on the capital account, and indeed a few are still not fully convertible on the current account.
Exchange controls — In line with this, several emerging market currencies still have varying degrees of exchange rate controls, which also distort exchange rate pricing and economic activity. Exchange controls create “black market” activity and paradoxically can lead to capital flight.
Emerging markets have structurally high levels of inflation — Stronger growth levels and economic inefficiencies are important reasons behind structurally high levels of inflation relative to developed markets. This in turn means that policy interest rates are in most cases substantially higher in emerging markets than in developed markets, resulting in high forward premiums.
Capital inflows however can depress market interest rates — The size of global capital flows relative to the size of local capital markets in most emerging markets can mean that the latter are swamped by a relatively small portfolio shift in assets either into the market or out of it. As a result, interest rate volatility is a lot higher.
Forward rate bias is lower in emerging markets — While forward exchange rates are poor predictors of future spot exchange rates in the developed markets, this is less so in many emerging markets. The exhaustive 2000 study by Bansal and Dahlquist tested the presence of forward rate bias and found emerging market currencies show significantly less correlation between current interest rate differentials and subsequent spot returns than those in the developed markets. That said, emerging market currencies tend to appreciate on a real basis and then collapse to adjust for the trade balance deterioration caused by that real exchange rate appreciation.
Implied emerging market volatility below developed market volatility is a buy signal —
Historically, lower levels of implied volatility in emerging market currencies than the corresponding developed market currencies has proven a good buy signal for the former. Intuitively, emerging market volatility should be higher, though there are periods when the sheer weight of capital inflows forces it artificially lower. Note that emerging market implied volatility is skewed in that it tends to fall only when the emerging market currency is strengthening, but always rises when the currency weakens.
Implied emerging market volatility is a very poor predictor of future exchange rates —
Looking at previous emerging market crises, the options market has usually got it “wrong” in the sense that such crises have never been priced in ahead of time by the options market. Thus, we can say that the options market is a poor predictor of future exchange rate levels in the emerging markets, though measured against historic volatility levels it may well be a much better indicator of relative value.
What we find in the emerging markets is that shifts in global capital flows have major domestic interest rate implications. For instance, high inflation and therefore interest rate differentials should, according to classical economic theory, suggest a depreciation of the local currency in proportion to that interest rate differential or forward premium. However, this may not occur due to heavy capital inflows, which swamp the domestic market’s ability to cope with these without economic distortion. As a result of this, the currency may experience significant nominal and real appreciation, in seeming violation of the international Fisher effect and covered interest rate parity. Real currency appreciation however leads to a real economic shock, and more specifically real trade and current account balance deterioration. Eventually, this has to be reversed and not too surprisingly through real currency depreciation. The longer and more powerful the real appreciation, the potentially more violent the subsequent depreciation. Emerging market currencies trade in these types of cycles, in line with the “speculative cycle” that we looked at earlier in the blog. As a result, we can tell from this that the forward rate bias is extreme for emerging market currencies on both sides of the forward. In line with this, some caution is needed in using the differential forward strategy in the emerging markets. Emerging market interest rate differentials would mean theoretically that an investor never hedged emerging market currency risk using the differential forward strategy, yet this is clearly not the appropriate strategy in some cases.
For similar reasons, the carry trade has provided significant alpha for active currency managers, both in the basic and in the optimized version. However, the distortion to interest and exchange rates that capital inflows provide in emerging markets means that a significantly higher degree of both care and discretion is needed in picking higher carry currencies to either invest in or hedge depending upon the reading of the risk appetite indicator.