Archives for August 2010

Term Structure of Interest Rates

Introduction

Interest rates are important in pricing market securities. Interest rates are also important at corporate level since most investment decisions are based on some expectations regarding alternative opportunities and the cost of capital—both of which depend on the interest rates. Interest rates are also closely watched by bond portfolio managers, who base their strategies around the direction of interest rates.

However, these rates cannot be obtained from market directly. Hence, portfolio managers have to rely on a model that tells how the interest rates change over time. This is known as interest rate mode.

There are many ways in which a dynamic model of the term structure can be derived. A term structure is defined as the set of interest rates derived from zero coupon market yields (which provide fixed and certain cash flows) by using a method called bootstrapping. The bootstrapping method is one of the basic and early methods used. The main problem, however, with this method is it can be used for bonds that have a fixed or certain cash flows (like government bonds), but most interest rate derivative securities do not have a fixed payoffs. Hence, for valuations of such interest rate derivatives we need to consider certain assumptions about the evolution of future interest rate.

Many term structure models have been developed considering these assumptions of interest rates. The models can be mainly divided into Arbitrage-free and equilibrium models.

Equilibrium Model

Equilibrium models are models that describe the dynamics of the term structure by using fundamental economic variables that are assumed to affect the interest rates. These models calculate the prices at which a market reaches equilibrium i.e. at what prices the supply and demand balance and the market clears. Equilibrium models also consider the current state of the economy and portray the behaviour of the term structure of interest rates in such economic situation.

Arbitrage- Free Models:

An arbitrage-free model is a financial engineering model that assigns prices to derivatives or other instruments in such a way that it is impossible to construct arbitrages between two or more of those prices. Arbitrage-free models used for trading are generally calibrated to one or more market prices to preclude arbitrages between prices assigned by the model and those quoted prices.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Understanding Exchange Traded Funds (ETFs)

What are Exchange Traded Funds?

Exchange Traded Funds (ETFs) are investment funds that are traded on stock exchanges like stocks. This is one of the major differences between Exchange Traded Funds and Mutual Funds, which are also investment funds.

An Exchange Traded Fund generally tracks an index or commodities. ETFs generally trade at the same price as those of the net asset value of their underlying assets. However, unlike Mutual Funds, ETFs do not calculate their net asset value on a daily basis. Their prices are determined much like those of stocks i.e. on the basis of demand and supply. But, the prices in most case will be close to the value of the underlying assets.

ETFs are a great way for investors to diversify their portfolio, without the need for active management. Also, ETFs have lower costs that other type of investment funds. This is because ETFs are not actively managed. Also, ETFs are very liquid investment products since they trade on regulated exchanges.

Types of ETFs

Index ETFs

ETFs that track a stock index are classified as Index ETFs. These ETFs are created to replicate the performance of a stock index such as the Dow Jones, the S&P 500 and FTSE 100.

Commodity ETFs

Commodity ETFs as the name suggests track commodities. There are commodity ETFs on Gold, Oil and Precious Metals. Commodity ETFs are a great way for investors to participate in the booming commodity markets, giving them a chance to diversify their portfolios.

Bond ETFs

Bond ETFs look to exclusively invest in bonds. Bond ETFs can employ different types of strategies, which could include investing in only sovereign bonds to investing in only high yield bonds.

Leveraged ETFs

Leveraged ETFs, like Index ETFs, track index. However, the idea is to enhance return by gearing up. Leveraged ETFs use debt to enhance return. This makes the riskiest form of ETFs.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Why Market Perception of Liquidity is more Important for Investment Banks

It has been almost two years since the collapse of Lehman Brothers, which was one of the big five pure play investment banks before the credit crunch. Just a few months before Lehman collapsed, Bear Sterns, another pure play investment bank, was sold to JP Morgan after it was struck with big losses sue to the collapse in the housing market. Bothe Bear and Lehman had only a small portion of their assets invested in the subprime mortgage market at the time of their collapse. In fact, Lehman had even been successful in raising fresh capital only few months before it went bankrupt. So what really went wrong? Liquidity.  Both Lehman and Bear Sterns collapsed as markets feared their liquidity.

The market perception of liquidity is more important for an investment bank than it is for a traditional manufacturing or distribution business. In order to understand why market perception of liquidity is more important for an investment bank than a traditional business, we need to understand how these two businesses operate.

In this case, we are only talking about pure play investment banks i.e. banks that do not raise money from retail depositors. The sources of funding for investment banks are long term debt, equity and the interbank markets. Most banks fund themselves in the interbank markets. This type of funding is short- term; however, the assets on the bank’s balance sheet are generally more long-term. This mismatch between assets and liabilities makes it very important that the assets that banks hold on their balance sheet are very liquid. This was main reason behind the collapse of many banks in the financial crisis as most of them were being funded in the interbank market and were holding illiquid mortgage backed securities. This had a contagion on the financial markets and slowly the crisis spread to the real economy as banks were not able to provide funding to businesses.

On the other hand, a traditional manufacturing or distribution business would generally be funded by equity or long-term debt and therefore they do not face liquidity issues like banks so long as they have steady cash flows from business operations. Even in the case of a collapse of such businesses, it would not have the same contagion effect as in the case of a bank.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

M&A Activity Soaring in the Second Half

In the first half of 2010, global M&A activity was slow. Many factors accounted for a slowdown in the M&A activity. One of them was the sovereign debt crisis in Europe. However, M&A activity has picked up in the second half of this year. And the push is coming from the emerging markets, especially India and China, two of the fastest growing economies in the emerging world. In the past week alone, takeovers worth $50 billion have been proposed. Most of the activity is being seen in the resources sector.

BHP Billiton, the mining giant, has proposed to take over PotashCorp for $39 billion. However, in what shows the growing strength of the Chinese economy, Sinochem, China-based chemical group, has shown interest in bidding for PotashCorp. Experts believe that a counter-bid from Sinochem is on its way soon.

The proposed takeover, which was announced this week, also shows that the boom in commodities is sustainable. The main reason is the hunger for commodities in the emerging world. Another reason why China’s Sinochem is interested in PotashCorp.

Also this week, Vedanta, the Indian mining company listed on the London Stock Exchange, has shown interest in acquiring a majority stake in Cairn India.

According to Financial Times, citing Deallogic, a data provider monitoring global M&A activity, in the first eight months of 2008, the resources sector, which includes mining, oil and gas and fertilizers companies, has seen deals worth a total of $316 billion launched so far. Certainly, any sign of slowdown or recession hasn’t had any impact on this sector. And a lot of the push is coming from resource hungry emerging world.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Update on the Global Economy

In the past few weeks, there has been small turnaround with the U.S. economy, which earlier this year had shown strong signs of recovery, stumbling, and the concerns about the Euro area economy, which at the beginning of this year faced a sovereign debt crisis, fading. However, this does not mean that the euro area’s economy is robust or that the U.S. economy is headed for a double-dip recession. But, it shows one thing, the global economic recovery is still fragile.

America’s GDP grew 2.4%, in the second quarter of 2010, which was much below expectations. Many economists believe that this may be an indication of the U.S. economy heading towards another recession. This might be an exaggerated reaction from economists; however, there are some areas of concern in the U.S. economy. One of them is unemployment, which is still at 9.5%. What is surprising is that even as Corporate America has returned to a healthy state, most companies are still not hiring.

Meanwhile, euro area’s economy grew faster than the U.S. in the second quarter, mainly due to impressive growth posted by Germany, euro area’s largest and most important economy. In fact, Germany’s GDP growth in the second quarter of 2010 is the fastest since reunification. However, it may still not be the time to celebrate in the euro area. Apart from Germany, other big economies in the euro are still struggling. Spain has barely shown any signs of growth.

In the emerging world, things are certainly brighter. Although growth slowed down in the second quarter in China, the second largest economy in the world still looks quite strong. Apart from concerns about the huge foreign capital inflow, the Brazilian economy is looking quite robust and is set to grow at 8% this year.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

China is now the Second Largest Economy in the World

China finally surpassed Japan to become the second largest economy in the world. According to the latest figures, China overtook the Japanese economy in the second quarter of 2010. Japan held its position as the world’s second largest economy for almost 40 years. China’s emergence as the second largest economy shows the country’s growing economic clout. It now only trails the U.S.

On per capita basis, however, China still lags behind Japan. Japan’s per capita GDP is still ten times that of China. According to an official with the Japanese government, Japan’s output in the second quarter of 2010 was $1,288 billion, whereas China’s was $1,337 billion.

In terms of purchasing power, the Chinese economy had overtaken Japanese economy almost a decade ago.

Although China became the second largest economy in the world, growth slowed in the second quarter of 2010. From a year-over-year growth of 11.9% reported for the first quarter of 2010, China’s growth in second quarter fell to 10.3%. This was mainly due to the brakes applied by the Chinese government to prevent the economy from overheating. The Chinese government is still concerned about the bubble in the property market and has taken appropriate measures to prevent the property markets from overheating. This has resulted in some slowdown in economic activity.

Japan, on the other hand, continues to disappoint. The Japanese economy grew 0.4%, in the second quarter of 2010, which is much lower-than-expected. Japan’s weak performance in the second quarter has raised questions on the country’s economic recovery, especially since other advanced economy grew at a much faster pace.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Using Fiscal Policy to Stimulate Growth

The recent recession saw governments in advanced economies use fiscal policy to stimulate growth. Governments in major developed economies implemented bailout plans and cut interest rates during the financial crisis. Interest rate in the US was cut to almost zero and it has stayed there since. In Europe, even though the European Central Bank (ECB) was concerned about inflationary pressures in 2008, it finally relented and cut interest rates to almost a percentage point. However, with interest rates close to zero, economies could not maneuver further on the monetary side and therefore they have implemented a coordinated effort on the monetary as well as the fiscal side.

Fiscal policy has the power to change the aggregate demand in an economy.  Using Fiscal policy can stimulate growth in an economy by increasing the aggregate demand. It is very important though that the fiscal stimulus provided by the governments is timely and large enough. As we have seen in Japan’s case previously, when the Japanese government provided a fiscal stimulus, which was a little late after the Japanese economy went into a recession in the early 90s, it resulted in a lost decade of growth.

One of the ways to stimulate growth is to increase employment. This can be done by increasing government spending. Lowering taxes is also another way to stimulate demand in an economy. With lower taxes, household will have more disposable income to spend, which will increase the aggregate demand in the economy.

Fiscal policy has certain limitations in that higher government spending and lowering taxes can lead to a budget deficit. Economies such as the U.S., UK and Spain have very large budget deficits, at the moment. However, these economies still require fiscal support to stimulate growth. In such a scenario, the use a more discretionary fiscal policy of spending and taxes aimed at reaching equilibrium of income, output and the employment, may be a better tool.

Increased spending by government can also cause the “crowding out” effect. Higher government borrowing can also cause interest rates to increase.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Country Report; Brazil

After many years fighting economic instability, Brazil, the biggest country in Latin America, is finally enjoying a period of stability and growth. It is hard to imagine that only a few years ago, Brazil was facing a financial crisis that led the country to devalue its currency and ask for $42 billion loan from the International Monetary Fund (IMF). It is quite ironic that only a few years later in 2009, Brazil loaned $14 billion to the IMF, amid the global financial crisis. Such has been the reversal in fortune for the country.

Some of the new found confidence stems from the demand for the country’s abundant commodities, especially from China. However, the commodity export-led boom has been backed by some sound economic policies, much of the credit for which should go to Brazil’s President, Luiz Inacio Lula da Silva. In fact, Brazil came out of the global financial crisis and the subsequent recession largely unscathed. Only a few years ago, such a situation would have created panic in the country.

Brazil expects to grow by 8% this year. The country’s unemployment levels are at an all time low. The country is attracting huge foreign capital, much of which is flowing in the renewable energy industry. Of course, the most important achievement for the country in this decade has been the remarkable reduction in poverty, much of the credit for this again goes to the President. What this has meant is a growing middle class that is creating a huge demand for goods and services, resulting in a more balanced economic growth.

However, there are some areas of concern. In a recent report, the IMF warned the country against the huge inflow of foreign capital. Also, there have been calls for a cut in government spending to prevent the economy from overheating.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Global M&A Activity Slow in First Half of 2010

Global M&A activity has been off to slow start in the first half of this year. According to data by Thomson Reuters, the global M&A activity, for the first six month of this year, was worth a little under $976 billion. This is well below the levels seen in the first half of 2007. However, this was just before credit crunch broke out and private equity firms were using massive amount of debts to finance buyouts. Most of these private equity firms have been quite since. And that is one of the primary reasons for the slowdown in global M&A activity this year. Also, financing big deals is still a difficult thing to do in the current market environment.

The other reason for the slowdown in M&A activity has been the macro environment. The crisis in the euro zone continues to worry investors and the economic recovery in the U.S. has been fragile so far. Also, China, which has become the new engine of global growth, is showing signs of slowdown.

M&A activity in Europe has been the most disappointing so far this year. M&A activity fell 23% in the first half of 2010 in Europe. The performance is U.S. is only slightly better, with M&A activity showing a 5% decline in the first half of 2010. Not surprisingly, it is the Asia Pacific region that has seen the least decline in the first half of this year. M&A activity has fallen only 1.1% in Asia Pacific.

One of the biggest deals in the first half of 2010 was Kraft’s (NYSE: KFT) acquisition of Cadbury. India’s Bharti outbid French company Vivendi for Kuwait-based Zain’s African telecom business, a clear sign that emerging market companies are increasingly participating in big deals and are also managing to outbid companies from developed world. Bharti’s deal also highlights another trend, which is the increasing amount M&A activity between emerging market companies.

The prospects for global M&A activity in the second half of 2010 don’t look much promising either. With Europe still struggling and fresh worries about the U.S. economy, it looks like Deal Street is going to have a quiet second half.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.

Understanding the Carry Trade Strategy

The currency market sees the exchange of billions of dollars on a daily basis. Most of the trading in the currency market is speculative in nature. Many hedge funds and trading divisions of big investment banks speculate on currency. In this article, we will look at one of the most popular currency trading strategy, the carry trade.

What is it?

The carry trade is an investment strategy that allows the manager to generate alpha from the currency market. Currency is an asset class that should be included in the sophisticated portfolios in order to improve the efficient frontier. The main reason is that the returns of these strategies are uncorrelated with the traditional ones.

Consequently, the carry trade strategy takes advantage of the mispricing between forward and spot prices, financing the exposure by borrowing in low yielding currencies and investing it in the high yielding ones. The idea is to increase the returns and decrease the volatility of the portfolio, enhancing this way the Sharpe Ratio free from a directional view on the currency. It is possible to develop the strategy with futures or forwards and also with different maturities.

Funding Currencies and Target Currencies

The Funding currencies are the ones that are sold in order to finance the strategy. In short, these currencies are the low yielding ones, with low interest rates such as the Japanese yen.

On the flipside the Target currencies are the ones that are bought in order to earn a margin between the spot price and the forward rate. In other words, we are trying to exploit inefficiencies.

To conclude, in the carry trade strategy, the investor is betting that the difference between interest rates will be bigger than the exchange rate movement because this will offset the possible gain. If the target currency depreciates more than the interest rates differential there will be a negative return on the strategy.

Note – If you want our team to write articles like these for you, please get in touch with us. Email Shas at indogeniclegal[at]gmail.com and we will respond within 24 hours.