Financial news

Production

admin — Mon, 27 Jul 2009 08:43:59 +0000

By working harder and giving up current leisure, we could increase our production of goods and services. Hypothetically, the production possibilities curve would shift outward if everyone worked more hours and took less leisure time. Strictly speaking, however, leisure is also a good, so we would simply be giving up leisure to have more of other things. If we were to construct a production possibilities curve for leisure versus other goods, this would be shown as simply a movement along the curve. However, if we restrict our model to only material goods and services, a change in the amount we work would be shown as a shift in the curve.
How much people work depends not only on their personal preferences but also on public policy. For example, high tax rates on personal income may cause people to work less. This is because high tax rates reduce the payoff from working. When this happens, people spend more time doing other, untaxed activities-like leisure activities. This will move the production possibilities curve for material goods inward because the economy can’t produce as much when people work less.

Improvement of rules

admin — Mon, 27 Jul 2009 08:42:32 +0000

An improvement in the rules under which the economy functions can also increase output. The legal system of a country influences the ability of people to cooperate with one another and produce goods. Changes in legal institutions that promote social cooperation and motivate people to produce will also push the production possibilities curve outward. On the other hand, poor institutions can reduce both the level of resources used (shifting the curve inward) and how efficiently they are used (causing the economy to operate inside its production possibilities curve).
Historically, legal innovations have been an important source of economic progress.
During the eighteenth century, a system of patents was established in Europe and North America, giving inventors private-property rights to their ideas. At about the same time, laws were passed allowing businesses to establish themselves legally as corporations, reducing the cost of forming large firms that were often required for the mass production of manufactured goods. Both of these legal changes improved economic organization and accelerated the growth of output by shifting the production possibilities curve outward more rapidly.
Sometimes governments, perhaps because of ignorance or prejudice, adopt legal institutions that reduce production possibilities. Laws that restrict or prohibit trade is one example. For almost a hunderd years following the American Civil War, the laws of several southern states prohibited hiring African-Americans for certain jobs and restricted other economic exchanges between blacks and whites. The legislation not only was harmful to African-Americans, it also retarded progress and reduced the production possibilities of these states.
The collapse of communism in the 1980s also illustrates the importance of economic institutions. After the collapse, Russia was unable to develop legal institutions protecting property rights and enforcing contracts. The absence of these institutions hampered investment and the gains from trade. Investors moved their money to countries with more secure property rights, and resources within the country were used inefficiently because trade was hindered. As a result, even though Russia has a well-educated labor force and abundant natural resources, its economic performance has been poor.

Making Ethical Decisions When Investing

admin — Fri, 17 Jul 2009 17:25:12 +0000

Just like there are different kinds of savings accounts, there are different types of investment accounts. You probably are aware of tech stocks and high-risk funds. You may be aware of foreign funds. However, did you know there is a socially responsible funds category too? If you want to follow your conscience while investing, you can take a look at the socially responsible investing funds described by Morningstar, for a start.

Socially Responsible Investing

According to Morningstar, an investment research firm, there are about 70 funds right now that would qualify for the socially responsible investing (SRI) category. They aren’t particularly focused on green technology or social endeavors either. Some may get the rating due to the fact that they don’t include any stocks in their funds which may be equated with vices like tobacco, gambling, alcoholic beverages, weapons, or nuclear energy. If a fund can prove it is not involved in these “sin stocks” then it can qualify for the socially responsible label.

That doesn’t mean you won’t get some companies that are trying to actively support social or environmental concerns. It’s just that, first, they must pass the filter for sin stocks and then, if they do anything extra it’s just a bonus. It’s not required to earn them the socially responsible label.

Do Your Homework With SRIs

Regardless of whether you want an active or passive SRI, you are going to have to do your homework on the type of business, earnings, and performance it has achieved. Just because a stock is socially responsible, does not mean it is going to make money for you. The same due diligence you perform on other stock choices should be done for these as well. Then, you can get the best of both worlds: ethical stocks and a fat return on your investment.

LAW AND RISK MANAGEMENT

admin — Wed, 24 Jun 2009 20:29:02 +0000

The risk manifests usually itself when the (creditor) party tries to reclaim what he feels is rightfully his due. This includes documentation risk and the formation of incomplete or unen- forceable contracts.
Lawyers are one of the ﬁrst row of experts to manage risk. Companies demand and expect a ‘water-tight’ contract to cover eventualities, usually of non-payment or underperformance. Legal management of risk was considered an isolated ﬁefdom of the solicitors, barristers and judges. Similarly, accountancy was a completely separate profession. Investment banking was the same. This is an unrealistic risk management system, which needs to be holistic if we are to have an effective protective system. Otherwise there are loopholes and gaps in contracts.
What the law covers
There are a few fundamental goals to consider when dealing with legal risk (sometimes called basis risk) management:
cost
time
probability of winning lawsuit
effectiveness
completeness of contract
enforceability
redress, e.g. ability of party to pay damages.
Completeness of contract
This is a potential problem because of the complexity of the legal system – even more so when we deal with separate state jurisdictions within the USA, or with national and EU levels of laws.
Redress: we can question the ability of the guilty party to pay damages once a favourable decision has been granted.
The question must be asked regarding “enforceability”. We live in a global economy, so can effective legal measures can be brought against parties that operate offshore? Our view of the jurisdiction, especially over offshore cases and the wide usage of the Internet, leads us to offer more questions initially, rather than answers.
What about those who conduct fraud in the USA and Europe on the Internet while based in China or Russia? Our experience in Russia, China and southeast Asia leads us to believe that the laws on paper look very good, but the real effectiveness of enforceability is lacking. Nothing can be done to punish these people who cannot be extradited.
We include the recovery rate within the Loss Database because it will be the basis for projecting the probability of getting compensation or insurance. This means that we have further transactional data when we are faced with making a similar investment again in the future. Recovery rates are sector-speciﬁc, lower for telecoms. Thus, the dot-coms had many “99 %” members, i.e. those whose equity value listed on the exchanges fell by 99 % from their peak. What is the recovery rate for your investment that you envisage?
The regulatory risks, risks of change in company law and the risk of lawsuits from clients, employees and every other stakeholder are further hazards. The list of ﬁnancially unclassiﬁable risks, means that any perceived “legal risk management” is generally assigned to the legal department. These are the “residual” risks that companies consider ﬁt to be handled by their legal department. This need not be the best way to organise legal risk management, but it is a return to the separate silos concept of viewing risk.
The “not my problem” syndrome does not work because the judge can rule that “whistle- blowing” is the duty of a responsible director or company manager.
It is no longer just the duty of the police to investigate. When lawyers, actuaries and accountants become aware of major trangression during their duties, it is sufﬁciently arguable that they are in breach of civic and company law if they do not inform the proper authorities. Thus, losses suffered, e.g. as result of incorrect accounts or money-laundering, must be reported.
Similarly, the silo risk view is potentially erroneous because it tries to pass the buck. Thus, professional indemnity insurance cannot always be relied upon to save your bacon. Grounds of negligence can override the quest for damages, so all you are left with is nothing.
However, plaintiffs can sue and still win considerable damages. Risk assessment over likely award and chances of loss now become a priority before a case is initiated. This will be more commonplace in the area of executive underperformance. Stakeholders can hit back, and win, through the legal system.
One of the interesting points of this open-fund trustee versus fund manager conﬂict is the choice of battleﬁeld. The fund trustees could have picked professional negligence based on a reckless investment stance, one that was not properly risk managed. In fact, they chose the comparison of underperformance against an agreed benchmark. Mercury had undershot the UK equities benchmark by a concrete 10 %, and that was not in dispute. A guideline for fund trustees and holders of the investment mandate is to set out ﬁxed benchmarks for agreement. A potential legal wrangle over whether a fund manager was, or was not, risk managed would probably not prove a fruitful ground to wage war.
The ﬁnal Combined Code is in the listing rules of the London Stock Exchange and is mandatory for all listed companies in the UK. It requires the boards to maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets. Directors should check the effectiveness of the company’s internal control and review all controls, including ﬁnancial, operational and compliance controls and risk management. Further developments with regard to Combined Code for corporate governance in the UK reinforced processes for identifying, evaluating and managing key business risks. They aim to protect the corporate wealth through sound leadership.
One alternative to speed up the legal process and cut counsel costs is to choose arbitration. This body can be stipulated in the initial contract. Sometimes it can work out to be swifter and cost-effective. Yet even arbitration can cost more to instigate than conventional litigation routes, given the lack of choice stated over arbitration bodies.
Given the dissatisfaction over level of service and professional costs, there is a growing trend for people to manage risk themselves. Once again, in an organic business world, we are in danger over losing the corporate command-control battle.

The Marginal Risk Contribution

admin — Tue, 23 Jun 2009 20:45:37 +0000

A very important question is “How much are you willing to pay to have, say, one more yellow egg in your basket?” If you believe blue eggs oﬀer the highest expected rates of return, would you even bring any yellow eggs? Yes! Even if you do not believe that yellow is likely to sell tomorrow, a yellow egg will likely sell precisely when most of your blue eggs won’t sell. Yellow provides you with the equivalent of “insurance”—it pays oﬀ when the rest of your portfolio is losing. Therefore, you may very well be willing to bring some yellow eggs, and even though you expect to make a loss on them—of course, within reasonable bounds. You may be prepared to lose 5 cents on each yellow egg you bring, but you would not be prepared to lose $100. In sum, yellow eggs are valuable to you because they are diﬀerent from the rest of your portfolio. What matters is the insurance that yellow pay oﬀ when your blue investments do not. Perhaps the most important aspect is that you realize that it is not the own risk of each egg color itself that is important, but the overall basket risk and each color’s contribution thereto. In fact, you already know that you may even expect to lose money on yellow eggs (just as you may expect to lose money on your homeowner’s insurance). This again emphasizes that having yellow eggs as insurance is useful only because most of your eggs are not yellow. The risk contribution of yellow thus inevitably must depend on all the other eggs in your portfolios. Of course, it would make no sense to bring only yellow eggs—in this case, you would not only expect to lose 5 cents per egg, you would also most likely always lose these 5 cents and on all your eggs. In the ﬁnancial market, the degree to which one stock investment is similar to others in your portfolio will be measured by the aforementioned beta—and if your portfolio is the market portfolio, then it is called the market beta. You will be willing to hold some stocks in the market portfolio that have a low expected rate of return because they are diﬀerent from the rest of your portfolio—but only some, and only if their expected rate of return is not too low.
In sum, when you look at your ﬁnal basket, you should consider each egg along two dimensions— how does it contribute to your overall expected rate of return (what is its own expected rate of return?), and how does it contribute to your overall portfolio risk (how does its return covary with that of your overall basket?). In a good portfolio, you will try to earn a high expected rate of return with low risk, which you accomplish by having a balanced mix of all kinds of eggs—a balance that evaluates each egg by its expected rate of return versus its uniqueness in your basket.

Market Downtrends

admin — Thu, 14 May 2009 11:15:55 +0000

Market downtrends, which characterize major bear markets, represent period of high risk for investors who are generally well advised to avoid assuming ner positions and/or to reduce currently invested stock positions for as long as suc downtrends are in effect. Just to review the tell-tale signs and patterns of behavic associated with bearish market climates.
Market downtrends are characterized by a series of lower peaks (resistance zones) and lower areas (support zones) from which rallies emanate.
For as long as a pattern of lower lows and lower highs remains in effect, a bea market is in effect.
Resistance zones during bear markets generally develop at or slightly below peaks of previous market recoveries. Previous areas of support often become areas of current resistance.
The capability of the stock market to penetrate a previous resistance zone could be an early indication of a significant trend reversal.
As you can see, there were transitions from area in which support factors dominated (1998 to early 2000) to areas in which resistance factors dominated (2000 to 2002), a transitional period (late 2002), and then a return to an area in which support factors were dominant (2003 to 2004).

Resistance Zones

admin — Mon, 11 May 2009 11:15:07 +0000

During declining and neutral market trends, resistance zones are likely to develop in areas in which there have been previous market trading, areas that have halted price advance in the past. How might a resistance zone develop? Well, suppose that a market advance has just come to an end, taking a particular issue down from a new high in price of $50 to a price of $44. There are likely to be many investors who regret not selling in the $49 to $50 zone, waiting and hoping for a second opportunity. If the issue recovers back to the $49 to $50 area, many of these investors, recalling that $50 was the last high, will offer shares for sale, perhaps driving the issue back down in price.
In this sequence, a “trading range” might develop between $44 (the most recent low for the stock, perhaps perceived as a buy zone) and $50 (the most recent high), perhaps perceived as an expensive area for that issue. The price of $44 to $45 will represent a support zone. The $49 to $50 area will represent a resistance zone.
If prices break down below $44 to $45say, to $37 to $38–the former support zone of $44 to $45 is likely to become a new resistance zone. There will have been many buyers at $44 to $45 hoping and looking for a return to their buying level for an opporhlnity to achieve a break even on their investment. These investors, among others, represent a source of ready supply in that resistance zone of $44 to $45. Conversely, if the stock penetrates the $50 level, moving perhaps to $55 to $56, that old resistance zone at $49 to $50 could become redefined as a favorable buying zone rather than a likely selling zone. The former resistance area will become a support zone.
These are significant concepts. When a support area is violated to the downside, the former area of support frequently becomes an area of resistance. When a resistance area is penetrated to the upside, this former area of resistance is likely to become an area of support.

Support Zones

admin — Sat, 09 May 2009 11:14:53 +0000

An awareness of patterns associated with support zones (areas usually associated with previous trading ranges, in which prices find support against further decline) and resistance areas (areas that resist further price advance) enables investors to more accurately define the diition of significant market trends. Such patterns also suggest areas in which price reversals are likely to take place.
Stock market advances do not take place in a straight line. They generally take place in a steplike series of advance, flat or retracement period, further advance, another flat or retracement period, and so forth.
During bull markets, retracements tend to take place at increasingly higher levels. The series of rising low areas between rising peak readings defines market trend.
Suppose, for example, that a stock is trading at a high of $50 per share, having recently risen in price from $45. A certain number of traders who purchased at $ will take profits at $50, creating, in the process, some temporary weakness in t stock. The stock might then back down to a price level of perhaps $47 to $48. If the general trend for that issue is bullish, which is the case in an uptrend, the will be buyers at hand waiting for a some reaction from the $50 level to take positions. If the buyers are aggressive, they likely will step into the market quickly, taking positions in the $47 to $48 area. This $47 to $48 area might be taken as an area “support,” a zone in which buyers will take positions in that issue.
Prices then rise, crossing the previous high at $50 (a temporary resistance ar because there was previous selling in that zone) and rising to perhaps $53 or when a new round of profit taking takes place. If prices back down, they are likely to find support in the area of the old previous high-in this case, in the ar around $50.
Each rise, retracement, and new rise during 1999 left behind a sort of indentatia in the chart pattern-a scoop of sorb, which represented a potential support zone for the next market declme. During uptrends, ideal buying zones often develop within those scoops or pockets between earlier market declines and the most rece market peaks.

TYPES OF DERIVATIVES, part 2

admin — Sun, 12 Apr 2009 02:39:43 +0000

In futures markets, the contracts have standardized terms and trade in a market that provides sufficient liquidity to permit the parties to enter the market and offset transactions previously created. The use of contracts with standardized terms results in relatively widespread acceptance of these terms as homogeneous agreed-upon standards for trading these contracts. For example, a U.S. Treasury bond futures contract covering $100,000 face value of Treasury bonds, with an expiration date in March, June, September, or December, is a standard contract. In contrast, if a party wanted a contract covering $120,000 of Treasury bonds, he would not find any such instrument in the futures markets and would have to create a nonstandard instrument in the forward market. The acceptance of standardized terms makes parties more willing to trade futures contracts. Consequently, futures markets offer the parties liquidity, which gives them a means of buying and selling the contracts. Because of this liquidity, a party can enter into a contract and later, before the contract expires, enter into the opposite transaction and offset the position, much the same way one might buy or sell a stock or bond and then reverse the transaction later. This reversal of a futures position completely eliminates any further financial consequences of the original transaction.
A swap is a variation of a forward contract that is essentially equivalent to a series of forward contracts. Specifically, a swap is an agreement between two parties to exchange a series of future cash flows. Typically at least one of the two series of cash flows is determined by a later outcome. In other words, one party agrees to pay the other a series of cash flows whose value will be determined by the unknown future course of some underlying factor, such as an interest rate, exchange rate, stock price, or commodity price. The other party promises to make a series of payments that could also be determined by a second unknown factor or, alternatively, could be preset. We commonly refer to swap payments as being “fixed” or “floating” (sometimes “variable”).
We noted that a forward contract is an agreement to buy or sell an underlying asset at a future date at a price agreed on today. A swap in which one party makes a single fixed payment and the other makes a single floating payment amounts to a forward contract. One party agrees to make known payments to the other and receive something unknown in return. This type of contract is like an agreement to buy at a future date, paying a fixed amount and receiving something of unknown future value. That the swap is a series of such payments distinguishes it from a forward contract, which is only a single payment. Swaps, like forward contracts, are private transactions and thus not subject to direct regulation. Swaps are arguably the most successful of all derivative transactions. Probably the most common use of a swap is a situation in which a corporation, currently borrowing at a floating rate, enters into a swap that commits it to making a series of interest payments to the swap counterparty at a fixed rate, while receiving payments from the swap counterparty at a rate related to the floating rate at which it is making its loan payments. The floating components cancel, resulting in the effective conversion of the original floating-rate loan to a fixed-rate loan.
Forward commitments (whether forwards, futures, or swaps) are firm and binding agreements to engage in a transaction at a future date. They obligate each party to complete the transaction, or alternatively, to offset the transaction by engaging in another transaction that settles each party’s financial obligation to the other. Contingent claims, on the other hand, allow one party the flexibility to not engage in the future transaction, depending on market conditions.

TYPES OF DERIVATIVES, part 1

admin — Sat, 11 Apr 2009 23:38:41 +0000

In this post, we take a brief look at the different types of derivative contracts. This brief treatment serves only as a short introduction to familiarize you with the general ideas behind the contracts.
Let us start by noting that derivative contracts are created on and traded in two distinct but related types of markets: exchange traded and over the counter. Exchange-traded contracts have standard terms and features and are traded on an organized derivatives trading facility, usually referred to as a futures exchange or an options exchange. Over-the-counter contracts are any transactions created by two parties anywhere else. We shall examine the other distinctive features of these two types of contracts as we proceed. Derivative contracts can be classified into two general categories: forward commitments and contingent claims. In the following post, we examine forward commitments, which are contracts in which the two parties enter into an agreement to engage in a transaction at a later date at a price established at the start. Within the category of forward commitments, two major classifications exist: exchanged-traded contracts, specifically futures, and over-the-counter contracts, which consist of forward contracts and swaps.
The forward contract is an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a price established at the start. The parties to the transaction specify the forward contract’s terms and conditions, such as when and where delivery will take place and the precise identity of the underlying. In this sense, the contract is said to be customized. Each party is subject to the possibility that the other party will default.
Many simple, everyday transactions are forms of forward commitments. For example, when you order a pizza for delivery to your home, you are entering into an agreement for a transaction to take place later (“30 minutes or less,” as some advertise) at a price agreed on at the outset. Although default is not likely, it could occur-for instance, if the party ordering the pizza decided to go out to eat, leaving the delivery person wondering where the customer went. Or perhaps the delivery person had a wreck on the way to delivery and the pizza was destroyed. But such events are extremely rare.
Forward contracts in the financial world take place in a large and private market consisting of banks, investment banking firms, governments, and corporations. These contracts call for the purchase and sale of an underlying asset at a later date. The underlying asset could be a security (i.e., a stock or bond), a foreign currency, a commodity, or combinations thereof, or sometimes an interest rate. In the case of an interest rate, the contract is not on a bond from which the interest rate is derived but rather on the interest rate itself. Such a contract calls for the exchange of a single interest payment for another at a later date, where at least one of the payments is determined at the later date.
As an example of someone who might use a forward contract in the financial world, consider a pension fund manager. The manager, anticipating a future inflow of cash, could engage in a forward contract to purchase a portfolio equivalent to the S&P 500 at a future date-timed to coincide with the future cash inflow date-at a price agreed on at the start.
In this manner, the pension fund manager commits to the position in the S&P 500 without having to worry about the risk that the market will rise during that period. Other common forward contracts include commitments to buy and sell a foreign currency or a commodity at a future date, locking in the exchange rate or commodity price at the start.
The forward market is a private and largely unregulated market. Any transaction involving a commitment between two parties for the future purchaselsale of an asset is a forward contract. Although pizza deliveries are generally not considered forward contracts, similar transactions occur commonly in the financial world. Yet we cannot simply pick up The Wall Street Journal or The Financial Times and read about them or determine how many contracts were created the previous day.4 They are private transactions for a reason: The parties want to keep them private and want little government interference. This need for privacy and the absence of regulation does not imply anything illegal or corrupt but simply reflects a desire to maintain a prudent level of business secrecy.
Recall that we described a forward contract as an agreement between two parties in which one party, the buyer, agrees to buy from the other party, the seller, an underlying asset at a future date at a price agreed upon at the start. A futures contract is a variation of a forward contract that has essentially the same basic definition but some additional features that clearly distinguish it from a forward contract. For one, a futures contract is not a private and customized transaction. Instead, it is a public, standardized transaction that takes place on a futures exchange. A futures exchange, like a stock exchange, is an organization that provides a facility for engaging in futures transactions and establishes a mechanism through which parties can buy and sell these contracts. The contracts are standardized, which means that the exchange determines the expiration dates, the underlying, how many units of the underlying are included in one contract, and various other terms and conditions.
Probably the most important distinction between a futures contract and a forward contract, however, lies in the default risk associated with the contracts. As noted above, in a forward contract, the risk of default is a concern. Specifically, the party with a loss on the contract could default. Although the legal consequences of default are severe, parties nonetheless sometimes fall into financial trouble and are forced to default. For that reason, only solid, creditworthy parties can generally engage in forward contracts. In a futures contract, however, the futures exchange guarantees to each party that if the other fails to pay, the exchange will pay. In fact, the exchange actually writes itself into the middle of the contract so that each party effectively has a contract with the exchange and not with the other party. The exchange collects payment from one party and disburses payment to the other.
The futures exchange implements this performance guarantee through an organization called the clearinghouse. For some futures exchanges, the clearinghouse is a separate corporate entity. For others, it is a division or subsidiary of the exchange. In either case, however, the clearinghouse protects itself by requiring that the parties settle their gains and losses to the exchange on a daily basis. This process, referred to as the daily settlement or marking to market, is a critical distinction between futures and forward contracts. With futures contracts, profits and losses are charged and credited to participants’ accounts each day. This practice prevents losses from accumulating without being collected. For forward contracts, losses accumulate until the end of the contract.’
One should not get the impression that forward contracts are rife with credit losses and futures contracts never involve default. Credit losses on forward contracts are extremely rare, owing to the excellent risk management practices of participants. In the case of futures contracts, parties do default on occasion. Nonetheless, the exchange guarantee has never failed for the party on the other side of the transaction. Although the possibility of the clearinghouse defaulting does exist, the probability of such a default happening is extremely small. Thus, we can generally assume that futures contracts are default-free. In contrast, the possibility of default, although relatively small, exists for forward contracts.
Another important distinction between forward contracts and futures contracts lies in the ability to engage in offsetting transactions. Forward contracts are generally designed to be held until expiration. It is possible, however, for a party to engage in the opposite transaction prior to expiration. For example, a party might commit to purchase one million euros at a future date at an exchange rate of $0.85/€. Suppose that later the euro has a forward price of $0.90/€. The party might then choose to engage in a new forward contract to sell the euro at the new price of $0.90/€. The party then has a commitment to buy the euro at $0.85 and sell it at $0.90. The risk associated with changes in exchange rates is eliminated, but both transactions remain in place and are subject to default.’