Wednesday, May 23, 2012

Into the Belly of the Whale: Hedging and Credit Default Swaps

Upon first hearing the news of JP Morgan’s derivatives loss I was somewhat puzzled as it was termed a “hedge”.
In risk management, a hedge is a term used to describe transactions that offset some other set of transactions, with the net effect being that as a whole we are unaffected by the activity. If JP Morgan lost $2 Billion on a hedge, they should have made $2 Billion somewhere else.
Was the media sensationalizing one piece while ignoring the whole?
Let’s start from the beginning…

What is a Hedge?
According to Wikipedia, “a hedge is an investment position intended to offset potential losses that may be incurred by a companion investment”.
Suppose we are a cereal manufacturer – we buy corn and make corn flakes. We sell our corn flakes to supermarkets under contract. Our current contract lasts one year and we sell each box for $3.99.
Each box of cereal requires half a bushel of corn to produce. The current price of corn is about $6.50, so our cost is $3.25 (we are assuming that is our only cost in this example) per box.
At today’s price, we make $0.74 per box.
We purchase corn every day of the year. Our problem is that the price of corn will vary day by day, whereas our revenue will not. If the price of corn goes above $7.98, we lose money on every box of corn flakes we sell.
In order to protect ourselves from loss, we enter into an agreement with someone (called a “counterparty”). The terms of this agreement are that they will pay us the day’s market price for corn and we will pay them $6.80. This is known as a floating to fixed swap – one party’s payments “float” (which means they can change every day) and the other party’s payments (in this case ours) are “fixed” – they do not change.
By fixing our price of corn at $6.80, our cost per box is $3.40, so we have ensured that we will make $0.59 per box over the life of our contract.
For us, this transaction is a hedge, because we have executed a financial transaction in order to avoid losses from occurring.

If You Have a Hedge, the Gain or Loss Does Not Matter
Sticking with our corn example just a little bit longer, let’s see what happens under some different price scenarios.
If corn goes to $9.00, the margin on our cereal business loses $0.51 per box ($3.99 - $4.50). On our financial hedge, we have a gain of $1.10 per box ($9.00 received minus $6.80 paid, divided by 2). Adding together our loss of $0.51 on the physical transaction and the gain of $1.10 on our financial transaction, we arrive at $0.59 per box.
Now we will look at what happens if corn goes to $5.00.  The margin on our cereal business is an astounding $1.49 per box ($3.99 - $2.50). The results of our financial hedge, however, are abysmal, a loss of $0.90 per box ($5.00 received minus $6.80 paid, divided by 2).
At this point, the headlines scream out “Corn Flake Manufacturer loses $0.90 per box on derivative transactions”. There is a hue and cry, our share price tanks in the market, Congress subpoena’s our CEO, etc.
Yet, the derivatives loss is part of a well-functioning hedge. Combining our loss of $0.90 with our corn flake profit margin of $1.49 results in a net position of……$0.59 per box! The same amount when the market went the other way!

Figure A
Whether the hedge is a gain or loss is irrelevant – the fact that we wind up at $0.59 every time is the objective. We wanted to protect our profit margin against price fluctuation in our raw material supplies, and we have. A hedge cannot be looked at in isolation, it must be viewed in conjunction with the item we are attempting to protect.
To show this, in Figure A, the brown line is the hedge gain or loss while the orange line is our net position, which remains constant no matter the price.
So when first hearing of the JP Morgan saga I wondered if it was just being sensationalized by focusing on the loss, and the fact that it was a hedge was being downplayed.

Enter Stage Left – The Credit Default Swap
Figure B
The securities at issue in the JP Morgan hedge were Credit Default Swaps (CDS), so in order to understand something of what happened we need to understand these securities.
Similar to our corn example, a Credit Default Swap is an exchange between two parties. This is depicted in Figure B.
Party A seeks to protect themselves against a credit loss, and therefore enters into a contract with Party B who is willing to pay Party A in the event Party A suffers a credit loss. In order to induce Party B to take on this risk, Party A makes quarterly payments to Party B.
There are a number of factors involved in this transaction. The loss can be for a specific company or an index representing a “basket” of companies.
The loss itself is also defined in the agreement. It can be a failure to pay on a specific identified security (e.g. X Corp. Series A 4.9% Due 2017) or on a class of securities (e.g. Any X Corp. Senior Unsecured Debt Obligations). It can be the bankruptcy of X Corp., or the restructuring of X Corp.’s securities. Or it can be all of the above.

What Factors Drive a Credit Default Swap’s Value?
The price of a credit default swap is based on three factors:
·         interest rates,
·         the probability of default,
·         the loss incurred should a default occur.
Interest rates are a factor because the payments Party A makes occur quarterly through time, and therefore are not as valuable as their nominal amounts due to the time value of money.
The probability of default is significant on both sides of the swap.  Party A makes payments so long as there is no default, and Party B makes a payment if there is one.
Finally, the loss given default is significant to Party B's payment to Party A. The obligation of Party B is to make Party A whole on the transaction. If Party A's security pays out 90 cents on the dollar, Party B owes 10 cents. If Party A's security pays out 20 cents on the dollar, Party B owes 80 cents.
Given that there are multiple inputs, there will be variation in how the swap is priced and valued. If you think the loss given default should be 50%, and I think it should be 40%, then we will arrive at different prices for the swap.
By "locking down" some of the factors, we can calculate the others, and perform various sensitivity analysis.

Pricing Example
At the outset of the swap, the value of the agreement needs to be equal for both sides of the transaction. The value to Party A needs to be the same as for Party B. This is usually accomplished by through setting the premium payments from Party A to Party B. It is commonly referred to as the CDS Spread.
In mathematical terms, the swap needs to satisfy the following (where PV stand for Present Value):
For the Contingent portion of the swap, the present value equation is calculated by the following equation:

Figure C shows the calculation of a two year swap with a $1 million notional for a counterparty with a 2% per year default probability with a subsequent value of $19,699.

Figure C

The formula for the Fixed leg looks a little scarier:

A bit of further explanation of this equation:
·       the CDS spread is in basis points means we need to divide by 10,000 to get it into percentage terms to use with the Notional amount
·       the denominator of 4 is used to distinguish the fact that the CDS is an annual figure but payments are quarterly
·       the term after the + sign reflects the fact that a default during the term will mean some payment is due, but not the full amount. If the default probability is equally likely throughout the quarter, then on average the payment will be ½ of the normal quarterly amount, thus the divisor of 2 in that equation term.

So how do we determine the CDS rate that will make this value the same as the Contingent payment? Fortunately, we are able to use algebra to come up with the answer, solving for CDS as follows:
Figure D shows the calculation of the Fixed leg with the CDS rate set to 102.02771 basis points. Notice that the value of this leg matches the value of the fixed leg calculation in Figure C.
Figure D

Until Next Time
In the next Treasury Café post, we will look at sensitivity of the CDS prices to various factors held within the equation. Using this knowledge, we will begin to explore how this security might help establish a hedge, and also why it might not be ideal.

Key Takeaways
We have discussed how Credit Default Swaps are valued. By establishing the basic equations, we are able to analyze a CDS sensitivity to various factors. In addition, knowing the mechanics of this calculation and the variables involved will help us analyze JP Morgan’s situation, which involved hedging investments by using a CDS curve flattener trade.
·         What is your experience with Credit Default Swaps?
·         Do you think they are useful or not?
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Monday, May 14, 2012

You’re Not Diversified Enough for a Reason

The discussion of Apple’s dividend decision resulted in the exploration of factors that occur in real-life that deviate from the Perfect Capital Market Assumptions of financial theory, and how these impact our Financial Strategy.
The final item under this set of assumptions is Absence of Transaction Costs. This is a deceptively simple assumption, yet holds a large amount of implications.

Diversification is Key
One of the most basic principles of investing is to diversify your portfolio - having too many eggs in one basket increases your risk. Sure, if you invested 100% of your money in Google or Apple back in the day you may have hit a home run, but only in hindsight do we know that these were the correct picks.
The investment is made before you know the outcome. There were a lot of people who thought Webvan was the next Amazon, and you would have no money left if you had put 100% into that.
The “eggs in one basket” investment strategy will ultimately leave you hungry almost all of the time.

Theory Says….
Going to the other extreme, a lot of the highly regarded (Nobel Prize winning even) academic theories such as the Capital Asset Pricing Model assume that the investor is invested in the entire market.
So let’s pretend for a minute that the entire market is comprised of only 100 stocks spread out throughout the world. Furthermore, each of these stocks currently trades for $100. Finally assume that we have $10,000 to invest.
Figure A
If there were no transaction costs, investing in each and every stock is not an issue, and we would own 1 share of each firm in the market (100 x 100 = 10,000 : what we have available to invest).
Now let’s assume a stock trade costs $9.95 per trade. Figure A shows how much we actually have invested in the market after paying for the trade, and we can see that the fewer stocks we own the more we have invested, since we have made fewer trades that we had to pay for.
Therefore, because of transaction costs, we will tend towards holding smaller, more concentrated, less diversified (and therefore riskier) portfolios than we otherwise would.

In the Mind of the Investor
Because we have paid something to own the stock, we also experience the fact we begin our investment with a loss! We buy one share of stock for $100, it costs us $109.95. The price needs to go up by almost 10% just for us to break even on the purchase! But that’s not all, since we would still have a loss if we sold it at that point. If we count the buy event and the sell event together (a “round-trip” in trader talk), our stock needs to go up by 20% just to break even!
Of course, if we buy 100 shares instead of 1 share, these percentages are a lot smaller, so again there is an incentive to concentrate investments in fewer securities so we can spread that $9.95 over as many shares as possible.
But there is also a psychological element. The field of Behavioral Finance is a study in and of itself, but one of the things that has come from that field is that our losses hurt us much more than our gains help us. More pain is caused by a $10 loss than the pleasure of a $10 gain.
What happens then is that people hold on to their losers longer than they should in the hopes that the stock will rebound, thereby alleviating all that pain from loss.
With transaction costs, we begin the investment in this painful loss position (remember in the example above we have something worth $100 that cost us $109.95), and we will therefore have a tendency to hold on to this investment longer than we ought.
Conclusion – transaction costs result in investors holding on to investments longer than they should.

Tipping Points
Transaction costs also impact our trading strategy given our expectations of the investment.
Let’s say that we own a stock that will pay out $10 next year, and we have a discount rate of 12% and expect growth of 2% per year. We will value this at $100 using the Dividend Discount Formula, and everyone else in the market is of the same view.
Now the market hears some positive economic news that raises their growth expectations to 2.5%. Because of this, the stock price will rise to $105.26.
We, however, do not believe this economic news and consequently now own a stock we think is overvalued. Because we want to sell high and buy low, our desire now is to sell this stock. However, if we were to sell we would incur the $9.95 cost and we would recoup only $95.31. We are better off holding onto the stock even though it is overvalued.
The change in growth expectations needed to result in a net outflow of $100 given the $9.95 transaction cost is 2.9%. Thus, until the discrepancy between the market’s expectations and ours is great enough, we will not be able to make a transaction that keeps us whole with respect to our value expectations.
Conclusion – transaction costs make immediate reaction less likely, until the gap between the market’s expectations and the individual investor’s is great enough to attain a “tipping point”.

Steps We Can Take
Transaction costs are unavoidable. As an organization, if we are going to acquire or merge with another firm there will be fees we pay to investment bankers, lawyers, accountants, consultants, and others.
Given that transaction costs will occur, our organization’s decisions and behavior may differ from what is “theoretically correct” for valid reasons. However, we also do not want to be led into decision traps (e.g. holding onto losers too long, remaining too concentrated in a line of business) that we can avoid. To that end, we can take the following steps:
Know Your Cost of Capital – as discussed in earlier posts about the Capital Asset Pricing Model, the cost of capital is a “fuzzy” number. The cost of capital we choose to use has a range associated with it. Erring on the high side of that range will allow some absorbing of transaction cost impact without a whole lot of additional work.
Some prefer to model transaction costs explicitly and then apply the cost of capital to the post transaction cost cash flows. This approach is technically incorrect, as the derivation of the cost of capital did not include these items (e.g. it was calculated on pre-transaction cost returns).
Establish Diversification Targets – In order to protect against the tendency to hold fewer investments in the portfolio, a qualitative assessment (using strategic tools) combined with a non-transaction-cost-influenced quantitative assessment can be performed in order to establish targets. By doing this, it changes the perspective of the later analysis as it is not anchored initially on the transaction costs, and they can be layered in and assessed independently.
Establish Exit Targets During a Pre-Mortem – By assessing the conditions and economic signposts under which a divestiture or sale is warranted at the time of the investment initiation, we can establish a more objective target at the onset that will not be influenced later by transaction costs-du-jour. This will help us avoid holding onto investments too long or waiting for a “tipping point”.

Key Takeaways
The presence of transaction costs incents the firm to invest in fewer activities, diversify less, and remain invested longer than traditional theory suggests. By performing up-front analysis of our investments at the time we are embarking upon them, we can mitigate the impacts of some of the decision traps that may be caused later.

·         What examples of negative decisions caused by transaction costs have you experienced or witnessed?

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Tuesday, May 1, 2012

Five Things You Can Do To Counteract Irrational Bias

Are financial markets filled with rational investors? Before we even begin to look at the evidence, we know intuitively that this cannot be the case - the dot com boom and bust, the financial crisis of 2008, and Dutch tulips are but a few examples of the tendency to form bubbles that subsequently pop.
What are the implications for our dividend and financial strategy given that Perfect Capital Market Assumption #4 – Rational Investors and Markets – does not hold in the real world?

People are People
The reason that the Rational Investors and Markets assumption does not hold is simply the fact that all participants have one thing in common – they’re people!
And as people we are all subject to very human foibles (from a believer in economic rationalism, anyways) – acting on emotion, deciding based on our “gut”, honoring relationships, loyalty, tapping into our primordial instincts, etc. There is a long list of cognitive bias that we are subject to.

There is Safety in Numbers – and Risk!
One of our human traits is the herd instinct. We congregate into families, tribes and communities. We identify with various collectives of people – our city, our church, our profession, our company, our country. Hermits living in the woods are viewed as strange, abnormal folks.
A lot of the bubble-and-burst activity is tied to this tendency. Our friends buy tech stocks, talk about them at parties, and we call up our broker and order them the next day. Or our analyst buddies at XYZ are bullish on a stock, we become bullish too, which makes it easier to share a drink with them after work.
Yet, as Warren Buffet says - “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”. This quote points out the need to be the contrarian when it comes to financial markets. If you follow the herd you wind up running over the property value cliff, the dot com cliff, and the Dutch Tulip cliff.
The fact is, you need to run away from the herd in order to succeed.

Companies are People Too!
Companies are but an aggregation of people, and thus the same traits define them to some extent. Many companies exhibit the same irrationality that applies to individuals.
If your firm spends its time courting sell-side and buy-side analysts, it will end up thinking like these folks and seeking to deploy strategies that will satisfy this stakeholder group. Positive NPV? Not when the analysts are focused on Earnings Per Share (EPS)!
Another example is the timing of share repurchases. Research by McKinsey shows that companies on average are much more prone to buying near the top than the bottom. This is likely a combination of the overconfidence bias coupled with the social reinforcement firms receive from their analysts.

Five Things You Can Do to Counteract Irrational Bias
As an organization with the ability to harness the hearts and minds of our many constituents, we are in a position where we can counter-act the human tendency toward irrationality. How can we accomplish this?
Encourage alternative viewpoints through the culture – there are those within your firm that are able to articulate an alternative view of the facts quite different than the accepted norm. In order for these folks to come forward, a culture of awareness, tolerance, and acceptance are required. See here for additional information.
Encourage discovery through formalized process – the Catholic Church anoints a “Devil’s Advocate’ when it comes to determining sainthood. The role of this person is to present the strongest case possible that sainthood is not warranted. This role can be adapted to the strategic planning process and the capital investment allocation process. The key element is ‘immunity’ to those who play this role. See here for additional information.
Perform Introspective Activities – entrepreneurs are sometimes known for their “shoot from the hip”, “decide on the go” style. In order to avoid bias, however, there needs to be a capacity to reflect objectively on behavior without remaining anchored in the heat of the moment. See here for additional information.
Conduct a ‘Pre-Mortem’ – as part of a project planning or group implementation effort, participants can be asked to provide a ‘pre-mortem’ assessment of the effort. This is a twist on the “what do you want on your tombstone” exercise. However, rather than focus on the mission in life, members are asked to provide insight as to how things went wrong in the effort that ultimately made it unsuccessful. See here for additional information.
Learn How to Generate Feedback without the Herd – part of our tendency to follow the herd is that it provides immediate feedback - “They go left, I go left, therefore I am doing something correctly.” Develop benchmarks that are “Herd Independent”. Create your goals in the “vacuum of continuous improvement”. For example: “I know I did x with y this past year, so I am going to shoot for x with z (z being less than y) this coming year”. See here for additional information.

Key Takeaways
The tendency of human nature is irrational. It takes a lot of organizational initiative, structure, and willpower to overcome this, and for this reason organizations rarely attain this standard. This provides us with a golden opportunity.
·         What suggestions do you have for activities and processes that will enable an organization to overcome basic human irrationality?

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