Derivatives Market: Is More Regulation Needed?

November 28, 2010 Leave a comment

“ … [They are devised by] madmen; [they are equivalent to] hell… easy to enter and almost impossible to exit… [they are nothing short of] financial weapons of mass destruction” (Anon, 2003a). These are the views of investment mogul, Warren Buffett, when it comes to derivatives. At that, one must stop and question: if derivatives are that bad, why do investors deal with them in the first place? Surely they must have some benefits! In that case, what if they were to be [more] regulated: would that negate their inherit risk factor? Prior to exploring the implications of further regulating derivatives, it would serve best to briefly talk a bit about derivative basics.

The Basics

The investment world is split into two camps; that of the traditional investment instruments [stocks, bonds, cash and properties] and the alternative investments instruments [everything else: stamps, commodities, etc]. Derivatives, which falls under the alternative investments scheme, “is a contract between two parties where the value of the contract is linked to the price of another financial instrument or a specified event or condition” (Min and Garofalo, 2010). There are many types of derivative contracts [ the more common ones are: swaps, futures, options, etc], each baring a unique set of terms and conditions. But essentially, all derivatives fall into one of two groups:

> Over The Counter (OTC) derivatives: these contracts are not traded in any exchange. They are privately executed contracts, where usually one of the involved parties is a bank or a hedge fund. Such derivatives are highly flexible, but “suffer  from  greater  counterparty  and operational risks, as well as less transparency”(Acharya et al., 2008)

> Exchange Traded Derivatives (ETD): “The most centralized form” (Acharya et al., 2008) for trading derivatives; as they are traded through specialized exchanges.  The derivative contracts are standardized. Such exchanges bring along with it higher transparency; yet more inflexibility is introduced.

Let’s Dig Deeper

So what are the advantages of investing in derivatives? I shall hold the answer to this question, as the advantages [and disadvantages] will be inferred from the subsequent Pros/Cons sections. What I want to touch upon is the raging debate on whether derivatives should be subjected to more regulations. On one side of the argument, since derivatives essentially have no value of their own, the call for more regulation is a result of genuine concern. As our free-world economy is profit centric, greed may derail our economies at any given time. The hardly regulated derivatives market is one of such greed channels; as we were reminded so, by the most recent pinch from the 2008 mortgage crisis.

The outcry on the other side of the argument, is that regulation will dampen profits. Essentially, the push for more regulation is just a way to channel the profits to other players.

This regulation debate, is really a modern twist on old philosophical debates regarding freewill and self-mastery discussed by the likes of Plato, David Hume and Thomas Aquinas: are there any benefits to control and regulations? And if so, how much much is deemed beneficial?

Pros: More Regulations of Derivatives

There are a lot of positive attributes when it comes to more regulations of the derivatives markets, which include:

> Better Risk Management: Derivatives are used as hedging tools; thus “companies and banks [may hedge] against unexpected developments, for example sudden falls or rises in the value of currencies or commodities” (Anon, 2003b). With more regulation, more information will be available; facilitating better hedging and risk mitigation.

> Protecting the Economy From Collapsing: this also hinges on the more information argument; which effectively brings with it more efficient markets. The higher levels of transparency, allow for easier identification of “systematic risk” (Min and Garofalo, 2010) build ups. This aids in steering away from economy crises.

> Reduction of Fraud: with regulation, comes higher levels of order and control

> Better tracking of the derivatives market: “investors be able to see the full array of trading in real time” (Gross, 2010)

> Higher levels of clarity regarding the complexities of the derivatives market

> Breaking the control of Wall Street firms over derivatives: they “want things to work the way they did in the last century, when you had to pick up a phone and call somebody to get a price and execute a trade” (Gross, 2010). Regulations facilities for buyers and sellers of such instruments to trade in more regulated exchanges.

Cons: More Regulations of Derivatives

Likewise, a lot of negative attributes surround more regulations of the derivatives markets. Those include:

> Reduction of Risk: A lot of investors are drawn to derivatives because of their higher levels of risk; to them, this means higher profit potential. More regulations mean striking at the very foundations of the derivatives concept; “disguised bets” (Min and Garofalo, 2010). In such case, what’s the benefit of playing poker, when everyone can see your hand?

> Removal of the element of speculation: more regulation might mean the shrinking of the derivatives market. Robert Pickel, chief executive of the International Swaps and Derivatives Association, welcomes more regulations, yet he urges policymakers to make sure that such “reforms help preserve the widespread availability of swaps and other important risk-management tools” (Cho and Goldfarb, 2009).

> Lower profits: “The more transparent a marketplace, the more liquid it is, the more competitive” (Min and Garofalo, 2010). Though this may be good for the economy, but higher levels of competition, will ultimately result in lower profits to the dealers of derivatives.

Concluding Remarks

In the end, when a crisis does fall upon an economy, the most affected people are the investors; all the other individuals are temporarily inconvenienced [to varying degrees]. Given that fact, higher regulations of the derivatives market do bring with them added benefits to the investors. Interestingly enough, for the past several decades “Wall Street has continually told Washington that if the Street can’t do things the way it always has, and if the government changes the rules to mandate greater transparency and customer protection, [they] won’t be able to make money, and it would stunt the industry. They’ve been wrong every time” (Gross, 2010). So in the spirit of more efficient markets, higher levels of regulations should be introduced; but only in controlled doses, as you never know what’s waiting for you in the unknown.

~ Youssef Aboul-Naja 

Investment Anomalies: The Home Bias Puzzle

October 31, 2010 1 comment

“Home is a name, a word, it is a strong one; stronger than magicians ever spoke, or spirits ever answered to, in the strongest conjuration” (Charles Dickens). From a very early stage in life, individuals are bombarded with the constant theme of unity; the sense of belonging to a group. This theme manifests itself in our institutional structures: families, schools, places of employment, and on a grander scale, nations. Perhaps the theme is best captured in Aesop’s famous tale, where a father shows his children that, it is only when you gather separate sticks in a bundle, does it become hard to break them. War generals know this all too well, as their strategies always pivot on the concept of divide and conquer. This theme, which stems from our tribal ancestral times, did prove successful on countless occasions; though it does have its shortcomings. Albert Einstein once noted that “nationalism is an infantile disease. It is the measles of mankind”.

If we may narrow our perspective to a more investment oriented one, it may be argued that such a theme did inject itself in the investment field, as observed by investors’ portfolio compositions. “Investors appear to invest only in their home country, virtually ignoring foreign opportunities” (Coval ad Moskowitz, 1999). This phenomenon is dubbed the home bias puzzle. In theory, it is assumed that investors are looking to achieve the highest possible returns, all the while reducing their risks to a minimum. But while achieving such returns, an investor’s portfolio is constrained with restrictions that define the assets they may be added into it. The  various portfolios that may result from the inclusion/exclusion of the different allowable assets, is referred to as the “potential possibility set” (Levy and Post, p. 205, 2005). Such portfolio restrictions are either levied onto the investor or self-imposed; for example: government assets, quotas, or the decision to invest  only in ethical companies. Such restrictions effectively reduce the investor’s potential possibility set, impacting potential diversification; in other words, increasing the potential risks and decreasing the potential returns.

Returning to the home bias puzzle, when investors elect to invest mainly in their home countries, they shrink their potential possibility set, since they are discarding away all the foreign investment opportunities. This of course is bad for the investor, since “the fortunes of different nations do not always move together. Investors can diversify their portfolio by holding assets in several countries” (French and Poterba, 1991); potentially lowering a portfolio’s risk while increasing its returns.

The question of, why would investors limit their potential possibility sets?, was first put forth by French and Poterba. They noticed the home bias puzzle while observing that the domestic “ownership shares of the world’s five largest stock markets [were]: United States, 92.2 percent; Japan, 95.7 percent; United Kingdom, 92 percent; Germany, 79 percent; and France 89.4 percent” (French and Poterba, 1991). The ramification of this home bias is best illustrated through a later study conducted by the Center for European Economic Research, where it was concluded that had the German investors held zero domestic stocks and the UK investors only held 10 percent domestic stocks in their portfolios in the past 20 years, their returns would have risen by “82 per cent and … 54 per cent” (Mawson, 2002) respectively; all other variables held equal. What was more puzzling was that “geographic proximity seems to be an important ingredient in the international portfolio allocation decision” (Tesar and Werner, 1995); in the sense that if an investor does decide to invest internationally, then the probability of investing in companies of neighboring countries was much higher than in companies located further off; even if better returns could be achieved in the further locations. Naturally, the question that complements that of the home bias puzzle was, why should geographic location have precedence over asset returns for an investor?

Various explanations were put forth in answering the above questions, most notable of which were:
> Investor behaviour: as explained in the beginning, an investor might feel that it is their moral duty to promote advancements in their own country, opposed to foreign countries; even if that means earning lower returns. It could also be the case that an investor feels more in control when they are investing in something that they know about; as opposed to something completely foreign to them. Investing locally could also be the result of mimicking the investor’s surrounding peers. Therefore, an investor’s behaviour is most influenced by: nationalism (sense of unity), illusion of control and surrounding peers.
> Information asymmetry: as the idiom goes, knowledge is power, and access to it may be influenced by location. Therefore, “asymmetric information between local and nonlocal investors may drive the preference for geographically proximate investments” (Coval and Moskowitz, 1999).
> Institutional factors: capital immobility may result due to institutional factors, which include: taxes, transaction costs and government quotas.
> Other factors: other risks that could be faced by an investor, which have not been mentioned above, such as: foreign exchange risk, country risk, etc.

Upon analyzing the above arguments, it could be concluded that institutional along with other factors do not play a direct role in explaining the home puzzle theory. The reason for this conclusion is that as markets open up due to globalization, and technologies continually advance, a lot of the factors/costs/risk should have become less influential, and as a result, investor portfolios should have shown an increased portion of foreign shares in their composition. Yet, since the investors’ portfolios are still dominated by domestic shares, then such factors could not possibly shed a complete explanation on the home bias puzzle. Various studies confirm such conclusion. For example, “Tesar-Werner [concluded that] transaction costs cannot explain the observed home bias” (Watnock, 2002). Though it should be noted that such conclusion could one day be open for debate, as more recent studies hint at a possible “indirect relationship” (Watnock, 2002) between institutional factors and the home bias puzzle.

A more sensible explanation of the home bias puzzle, brings together two of the above explanations: investor behaviour and information asymmetry. The explanation, put forth by Van Nieuwerburgh and Veldkamp (2009), classify investors into two types:
> Investors who do not account for the “effect of learning on portfolio choice”:  such investors do not make any correlation between information and returns. Thus, when such investors build their investment portfolio, they are naturally attracted to domestic assets, as they are guided by their instinct behaviour. Therefore, their portfolio will be dominated by domestic assets.
> Investors who take into account information when making investment decisions: such investors will want to “reinforce informational asymmetries. Investors learn more about risks they have an advantage in because they want their information to be very different from what others know”. And thus, such investors believe that they are gaining an advantage over other foreign investors who invest in their local market. This of course is false, since by investing only in domestic assets, these investors are limiting their potential possibility set.

— Youssef Aboul-Naja

Understanding Investment Diversification

October 24, 2010 1 comment

“Diversification is a time-honored investment principle” (Gibson, 2004). Early documentation of diversification may be traced back as far as 1200 BC, where the Jewish Talmud preached that “every man divide his money into three parts, and invest a third in land, a third in business, and a third let him keep in reserve” (Gibson, 2004). People have recognized, from an early stage, the benefits of risk spreading brought upon by diversification; even if that was at an intuitive level. And as the world continues to take on varying forms, as a result of changes brought upon by one generation inheriting it from the next, part of what remains constant across time, is that “investors want high returns, [all the while not incurring] risk in securing those returns” (Gibson, 2004).

But why do investors want returns in the first place? And what risks are they trying to avoid? In answering these questions, we must first establish that when investing in any asset, an investor is taking on a certain level of risk. This degree of risk, may be divided into two parts: systematic and non-systematic. The systematic portion is association with market risk, and is ingrained in each asset; meaning it cannot be diversified away. As for the unsystematic risk portion, this type of risk is asset specific. Unsystematic risk is the amount of possible deviation between the expected and actual return on an asset. The higher the possible deviation, the higher the unsystematic risk. As a result of the risk investors take when giving up their capital to invest in a given asset, they expect to be compensated. Naturally, the higher the associated risk, the higher the compensation; or in other words, the expected returns.

Diversification, refers to the selection and investing in various assets, so as to spread the risks associated with investing in each asset. Since each asset inherently contains the same market risks, that is systematic risk, then diversification “could be conceptualized as a reduction in unsystematic risk” (Hight, 2010). The selection criteria for the assets when achieving diversification, includes [but not limited to]:
– Geographic location [i.e. different international markets]
– Industry [i.e different industry types]
– Asset type [i.e. Bonds, stocks, treasury bills, etc].
– The relationship between the returns of the different assets [also known as correlation]

So up until this point, we have determined that:
> Any type of asset bares some form of risk [systematic and non-systematic]
> Investors, whom are giving up their capital to invest in assets, want returns to be compensated for the risk they are baring. Preferably, the investors want as high a return as possible; and as low a risk as possible.
> What diversification does effectively is spread an investor’s capital across a portfolio of assets, reducing the “risks that bear no compensation” (Wagner and Lau, 1971). Generally, the “more securities in a portfolio, the greater the likelihood that sufficient good fortune will appear to balance off the bad fortune” (Sharpe, 1995). This gives the investor the benefit of higher predictability when if comes to the expected return on investment. Diversification facilities for less investment volatility.

But so far, this discussion has only tackled diversification from a very theoretical point of view. In the real world, certain impediments exist, as to lessen the benefits gained from diversification. Such hurdles include:

> Markets are not as uniform as mathematical formulas make them to be: the diversification process relies on formulas and probabilities [such as the quadratic formula and normal distribution] that provide good approximations of the expected asset returns. Also, these formulas rely on data input that is based on sample historical data; as it would be too costly and difficult to take into account all of the historical data. Thus, given that formulas are not exact, and the underlying data is only a partial set, a lot of estimation error is introduced.
> Returns are not symmetric: what diversification aims to achieve, is to create a portfolio of assets, where the correlation between the different assets is low; as when one asset goes down, the other goes up. But “paradoxically, [the correlations of] well-diversified portfolios… tend to increase during crisis situations, reducing the effectiveness of diversification when it is needed most” (Levy and Post, p.237, 2005).
> The diversification effect has become less due to globalization: lower costs in information and capital accessibility, has had the effect of increasing the correlation between the various markets. This dampened the diversification effect, as “economic events in one part of the world affect markets on the other side of the globe” (Gibson, 2004)
> Limited possibility sets due to regulations: investors may have to adhere to certain rules and regulations when it comes to investing; for example: a set percentage limit in investing in a given asset type,  or investing in only environmentally friendly companies. Such restrictions, whether enforced or voluntary, end up reducing the diversification effect as the number of investment options [the possibility set] shrinks.
> Market timing: a lot of underlying variables in the diversification formulas must be ‘tweaked’ to reflect the best diversification strategy. But such tweaking is highly dependent on the market conditions, and thus timing is crucial. Yet, since we still do not have a way to tell how future events may unfold, market timing is at best a guess-timate!
> The human factor: steering away from all the mathematics and number crunching, there are some human elements that cannot be capturing by formulas, such as: what defines an acceptable risk level? what defines an acceptable return for a given risk level? etc. Each person may answer these questions different, and as such, a given diversification strategy/formula may not apply to everyone.

Warren Buffett once said, “diversification is a protection against ignorance. It makes very little sense for those who know what they’re doing”. But then again, diversification does have some merits, so as long as its effectiveness is not over estimated. It has been proven that as more assets are included in the diversified portfolio, the marginal benefits diminish quickly. Thus wide-diversification is essentially harmful to the investor. This theme extends to all types of investments, regardless of the underlying asset. For example, in the real estate business, “marginal risk reduction from expanding into more cities diminishes quickly, making the choice of staying geographically concentrated a sensible portfolio strategy” (Ping and Roulac, 2007).  Effectively, it might be best if one utilizes a more focus-diversified strategy.

— Youssef Aboul-Naja

Who Cares About Regulations?

October 17, 2010 Leave a comment

American journalist Mignon McLaughlin once said that we humans are “…all born brave, trusting and greedy, and most of us remain greedy”. This has some truth to it, even if at certain levels of greed. For the most part though, the majority of individuals have control over their ‘greed’ (for a lack of a better word) by adhering to certain censorship codes, whether be it: religion, morals, ethics, social norms, etc. That doesn’t mean though, that there does not exist individuals who allow greed to consume them, and guide their decisions. With all the dangers surrounding the decisions taken by such individuals, perhaps the most of which, are those that have negative effects on other individuals. If we project such dangers onto the financial industry, then greedy decisions maybe referred to as systematic risk; “the unscrupulous actions of a few market participants could undermine public confidence in the entire financial system” (Levy and Post, p.896, 2005).

Given the potential fragility of financial markets, due to vulnerability from information asymmetry, agency problem, and transaction costs, lies the importance of regulating them. Regulations sometimes are viewed as tools, or deterrents, that “address systemic risk” (Schapiro, 2010). The main issue with financial markets is that incentives are misaligned on the “micro-level;  which [could result] in numerous potential conflicts of interest” (Kumpan, 2009). Regulations of financial markets are especially important in our current times, as when “financial institutions get bigger, markets move faster and investments grow more complex” (Schapiro, 2010), introducing potential cracks that ill-guided individuals may exploit. But one must not latch onto such negative view of regulations, as the main reason they are put there is to bring along with them added benefits to the financial industry; regulations are not closed doors. They attempt to align interests, effectively promoting for more efficient markets. They may also act as springboards in promoting more connected and expanded markets. The net effect is further industry stablility and stronger economies.

In deciding how much regulation should be put in place, one has to understand the reasons behind regulating the financial industry, and the implications that may be brought along with it. The benefits have been discussed above; which simply boil down to providing a better market platform that offers stability, efficient movement of capital and potential of growth. Many authors coined the term economic safety in describing such benefits. But “economic safety is more elusive than military safety …. too much safety undermines the very stability that safeguards promise” (Amity, 2010). Issues that should be taken into account when deciding on the level of regulation to be put in place, include:
> Available infrastructure: would a country’s given financial market infrastructure support such regulations? Whether the the answer is a yes or a no, how much will it cost to have such regulations put in place?

> Acceptability of local financial market: do such regulations actually benefit the players in a given financial market? [the point of these regulations in the first place is to benefit such users of the financial market — not burden them with no added benefits]

> Foreign investors: Given the interconnectedness of international financial markets, as a result of globalization trends, any regulation put in place by a specific country’s financial market could bare effects on other international markets. Thus, when drafting such regulations, financial market synergies along with foreign investors must be take into account; else the regulations would solve a specific issue while introducing more problematic issues.

> Market transparency and efficiency: the effect of such regulations on the market’s transparency and efficiency.

> Culture: on a more non-financial level, the regulations have to take into account social and cultural norms. These regulations, and the authorities who issue them, may find themselves in the spotlight, if for example, foreign investors are favoured over what is socially acceptable.

> … and many more issues

The degree of how much regulation should be put in place may seem like an simple task; one can argue that it borrows a page from the it ‘costs versus benefits’ theme. At the end of the day, there must exist certain goals and objectives for a given country’s financial industry; much like the goals and objective of companies. Regulations should promote and facilitate the achievement of such goals. For the most part, this is true, but what is different here is that the both internal and external environment that the financial industry interacts with is ever changing. And this change is a result of many variables, a lot of which are unknown territory for us: for example, our interpretation of the financial industry with advancements in technology, our definition of incentives, our understanding of ethics, etc.

“… it is managements’ job to organise, manage and control their businesses in a way which meets a set of high level principles … to safeguard the interest … and secure the safety and fairness of [financial] markets” (Tiner, 2005). Regulations are there to make sure that happens.

— Youssef Aboul-Naja

The Pros & Cons of Financial Globalization

October 10, 2010 4 comments
Kofi Annan, the seventh Secretary-General of the United Nations, once stated that “… arguing against globalization is like arguing against the laws of gravity”. “From a historical perspective … globalization is not a new phenomenon” (Schmukler, 2004); though given the technological advancements in the most recent decade or two, globalization has manifested itself in all fields, “flattening the world” (p.51)  as Thomas Friedman called it. Technological advancements facilitated cheaper means of communication and transportation, effectively bridging the distance disparities between nations. From a financials’ industry perspective, this brought good news to both investors and businesses alike; or so it appeared from first glance!

There is no denying the advantages that are brought upon by financial globalization. Due to the interconnectedness of the world markets, a given country’s market will gain a “deeper degree of financial integration” (Schmukler, 2004). This translates to further market stability and regulation, strengthening investors’ trust in a given country’s market. Thus, businesses seeking to raise funds, will have a larger pool of investors to chose from. Due to the access of a larger pool of investors, “increased competitiveness” (Moldovan, 2010) will drive down the cost of funds for businesses. So not only will businesses have access to more funds, but the cost of raising the funds will be lower. From a global perspective, this will lead to “better allocation of capital” (Moldovan, 2010). From a specific business perspective, this may lead to businesses raising their required capital at the very least; it might even accelerate the business’s growth plans and funding requirements. This is most notable in low income countries, where a study conducted by the International Monetary Fund shows that private flows have “grown more than fourfold since the 1980s” (Dorsey, 2008).

 

 

 

 

 

 

 

(Dorsey, 2008)

 

 

Financial globalization also bares benefits to investors.  For example, it does promote for a “better financial infrastructure” (Schmukler, 2004). As a result, lenders and borrowers operate in a financial system that is more “transparent, competitive, and efficient” (Schmukler, 2004). This leads, from the investor’s perspective, to more trust in the financial system. It also enables the investor to make varied investments; allowing for the spreading of risk via  diversification.

But just like falling to the ground due to gravity, globalization has its dark side. Kofi Annon continued elsewhere to say that although “… globalization is a fact of life … we have underestimated its fragility”.

As the financial markets of the world become ever connected due to globalization, if a problem occurred in one part of the globe, it would “cascade [and echo] uncontrollably” (Beinhocker et al., 2009) in other corners of the world. The latest of such crises is the housing bubble burst in the United States. Therefore, the risk of financial globalization is market disturbance due to factors beyond that of the domestic market. What this may mean for businesses seeking capital at such times, is that it will not find any; or if it does, it will be at a very high cost. This will always be true, even in the case if a given country’s government takes necessary precautionary measures to support its financial market in times of needs

For example, Saudi Arabia has been preparing its yearly budget with the assumption that the price of the oil barrel is USD 40; though in reality, the oil barrel was being sold for over USD 100.  This created a lot of surplus for the Saudi government. When the housing bubble burst in end of 2008, the Saudi government tried to inject a lot of liquidity in its market. And although, Saudi Arabia was able to recover much quicker than other countries, the truth of the matter is that liquidity dried up in the country, and businesses seeking capital at that time, had to pay a higher premium to obtain it.

One benefit that was cited in regards to financial globalization is that capital, on a global scale, is distributed in the most efficient manner. But this same benefit may be viewed in a negative light by some business owners whom are seeking capital, due to the emerging trend of “imbalances in trade and financial flows” (Wyss, 2009). To such business owners, financial globalization dried up their pool of potential investors; or increased substantially their cost of capital.

Looking at things from an investor’s point of view, it can be argued that globalization of financial markets aid in spreading their risk via diversification, but when a crisis does occur, no financial market or industry is shielded. Thus, the spreading of risk efforts would be dampened due to globalization of financial markets. Sort of a double edge sword.

Another aspect that must be analyzed, from an investor’s point of view, is that due to the globalization of financial markets, capital is allocated in the most efficient manner; irrespective of other non profit oriented criteria. Rarely is a criterion such as the likes of morality, humanitarianism and environmentalism are incorporated in the definition of efficiency. Thus globalization of financial markets will penalize investors who don’t regard profits as their only priority.

— Youssef Aboul-Naja

Income: It’s Definition, Measurement and Importance

July 11, 2010 1 comment

As per the American Institute of Certified Public Accountants (AICPA), accounting is the “the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of financial character, and interpreting the results thereof” (Wikipedia). Thus an accountant must be able to capture a company’s financial interactions and present it in such a manner that will aid management in their decision making activities. The sensitivity of an accountant’s role comes in the form of deciding which financial data to capture, and the means of presenting them. This of course is dependant on management’s ever changing requirements, stemming directly from the owner’s objectives.

As the art of accounting has been around for thousands of years, it intricacies have been ever evolving, catering to the needs of its users. Brinberg (1980) has classified the accounting’s evolution into four periods, naming them the: Pure Custodial Period, Traditional Custodial Period, Asset Utilization Period, and Strategic Stewardship Period. With each period, the requirements of the business owners, or financiers, progressively became more thorough. The thoroughness were a result of complexities in the financial domain, brought upon by advancements in technology. These requirements manifested themselves in the financial reporting practices of the accountants.

In understanding our current financial reporting practices, one must focus on the current accounting period, along with the one that have lead up to it; the strategic stewardship and asset utilization periods. During those times, given the evolution of the investment markets, the external capital finance was released from the exclusivity grip of “bankers, other lenders and trade creditors” (Elliotte & Elliotte, p. 40, 2009). Reporting priorities shifted from liquidity to profitability, and as such, “the balance sheet data on its own was no longer sufficient; hence, the income statement emerged” (O’Connell, 2007). Central to this shift is the concept of income.

Income may be defined in many different ways, though the different conceptional notions are “reconciled in the long term” (Elliotte & Elliotte, 2007). The two dominant income views is that of the accountant and the economist. From an accountant’s perspective, income is defined as the residual portion of revenue which is the result of subtracting total revenues generated from the total expenses incurred by a company during the revenue generation phase. An economist though, would beg to differ, by defining income in terms of residual expected cash flows available from consumption, after dividends and equity appreciation has been taken into account.

Although the accountant’s and economist’s view of the income concept differ, in that one deals with historical values and the other in future expected cashflows, its importance is of vital use. Effectively, management has been entrusted with funds from various sources [shareholders, financiers, etc.] to appreciate its value, and as such, income is an effective indicator of measuring that. Management’s stewardship on its operating effectiveness of working capital may be best monitored by charting a company’s income patterns. From a managerial point of view, income will aid in highlighting the disparities between actual and predicted performance targets. As for governments, income is a benchmark of a company’s asset appreciation for a given period, that they may apply taxes on. Investors on the other hand, may use income in assessing a company’s commitment to seeing through theirs stated dividend and retention policies. As for financiers, income history may be used in predicting future performances.

With the vast benefits of income, extending beyond the aforementioned examples, its users must be aware of some drawbacks in its measurement process. The accountant’s view of income suffers from the following:

  • Revenue/loss is recorded for only certain assets [such as land and building] as they appreciate/depreciate in value (whereas the remainder of the assets are recorded according to their cost value)
  • Capital profits go unrecorded until they are realized
  • Unrealized profits are not recorded until their date of realization, whereas unrealized losses are recorded immediately
  • The allotted depreciation depreciation expense, is an accountant’s estimate.

As for the economist’s view of income, it suffers from the future unpredictability element and differing investor expectations:

  • The predicted cash flows are not concrete (thus the expected income to be generated is at best a guesstimate)
  • As investors have differing risk thresholds and time preferences, so does the variables used in finding the present value of the future cash flows; resulting in varying income figures. Therefore, the value of the economic income is user dependant; making it difficult to produce financial statements under the economist’s view of income.

Given the various definitions and drawbacks of measuring income, it uses is still of vital role in the ever evolving “sophisticated capital market[s]” (Elliotte & Elliotte, p. 55, 2009). With “‘the need for both retrospective and prospective data” (O’Connell, 2007) from the various users of the financial statements, income may provide just that.

Youssef Aboul-Naja

Measuring Financial Performance: Is the Cash flow Method Superior to that of the Accrual Basis?

Around two thousand five hundred years ago, the Greek philosopher Heraclitus noted that “nothing endures but change” (Wikiquote, 2010). This simple axiom, if I may, is the main underlying factor that influences our behavior when it comes to interacting with the outside sphere at any point of time. Given man’s inquisitive behavior, sciences were devised to explain the outside world. However, since these sciences are nothing but a mere reflection of what we know, it is by no coincidence that they are in a continual state of work-in-progress.  From an accounting perspective, whether the art of bookkeeping is maintained according to the rules devised by “stone counters [as was the practice some 10,000 years ago]” (Atkinson, 2002), or the more complex accrual basis, accounting will continually change to better serve the needs of the stakeholders. Accountants, essentially, are communicators.

But, one must humbly observe, that words have the power of changing the world; thus the duties of an accountant are ever so important. Within this ever-changing, sensitive, backdrop does the latest accounting contention arise: is the cash-flow method superior to that of the accrual?

In a nutshell, the cash-flow methods calls for recognizing transactions as cash is physically exchanged between two parties. Proponents of this method claim that the figures provided by the accountants are more factual, since they are backed by already executed transactions. As for the accrual basis of accounting method, transactions are recognized as their execution is earned [regardless of whether or not cash has been exchanged]. The proponents on this side of the camp claim that “accrual accounting information more fully reflects the overall effects of periodic managerial decisions” (Kwon, 1989).

To that respect, according to the two dominant, non-governmental, accounting bodies, the FASB [Financial Accounting Standards Board] and IASB [International Financial Reporting Standards], companies that claim adherence to either standard must provide statements that have an accrual and cash-flow outlooks. It is to be noted that adhering to one of the standards signifies that the financial statements have been prepared in accordance to accepted bookkeeping practices; facilitating comparability. This is of utmost importance to a lot of companies, as they seek capital from various sources.

Given the high-profile, “cooking the books” (Datar, 2002), scandals of companies in recent years, it has been proposed, by the cash-flow method advocates, that if accountants drop the accrual method as they prepare the financial statements, confidence would once again be restored in the financial reporting profession. They also claim that the difficulties, and controversies, of devising a unified set of global accounting standards would be a thing of the past.

To test this claim, it is best to start by clarifying the term confidence in a financial reporting context. “The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements” (Dechow,1994). The beneficiaries of these excess cash receipts are essentially the stakeholders of the company; most probably the shareholders, but could include employees, other parties, etc. [this is a company/country/culture specific]. These stakeholders are the financiers of companies. The commitment of backing a company is highly influenced, along with other factors, by the stake-holders’ confidence that the financial statements have been prepared in manner reflective of the actual financial reality of the company.

To that accord, if the cash-flow method was the only prevalent way of transmitting financial information to the stakeholders, that would not necessarily restore confidence in financial reporting. “If people [managers] are dishonest, any system [or method] is vulnerable” (Quinn, 2003). Managers may time cash disbursement to their benefit; especially that management compensation is closely tied to performance. Also, since projects could extend beyond one-year, inaccuracies creep into the cash-flow method. For example, this method will falsely portray a loss for a company in the first year on a given project and a profit on the second; provided that revenue will come only on the second year. This scenario shows the superiority and flexibility of the accrual basis method since it more accurately reflects the reality of the financial situation.

However, many successful companies that are profitable on paper declare bankruptcy, as they mismanaged their handling of cash, the bloodline of any organization. Each method complements the other. If we liken the cash-flow method to short-term war skirmishes and the accrual method to the overall war result, a war general should be concerned with winning both; as each is dependant upon the other. The way to restore confidence in the financial reporting sector, should lay along the lines of needing “good ethics and a good system of governance“ (Quinn, 2003).

Coming back to the claim, dropping the accrual method will remove the controversies surrounding a unified set of global accounting standards, it could be argued either way. The cash-flow method is more clear cut when it comes to what constitutes a completed transaction. Thus any issues related to cultural views, status of national accounting profession, taxation (to name a few) automatically become more or less irrelevant. Though if bookkeeping is handled in such a clinical fashion, other sets of issues will arise. For example, profit seeking investors will have a problem with financial statements that deal only with liquidity. Therefore, it may seem that controversies surrounding a unified set of global accounting standards might be lessened if the cash-flow method  is solely used; this claim is not entirely true. Needless to say, given the improvements in technology, a unified set of global accounting standards is required  regardless of which method is put in use; as various economies are linked via global transactions. “No man [or in that regards a country/economy] is an island” (Donne, 1839). “The rapid spread of the financial crisis” (Anon, 2009) in 2008 is a testament of that.

Youssef Aboul-Naja

Working Capital: Benefits of the Money Market

March 14, 2010 Leave a comment

In the Beginning: The Balance Sheet

It all starts, when a couple of entities decide to pool their resources together to generate more resources. They do so by creating a company; and they inject it with their pooled resources [known as equity] along with some long-term debt; the combination of equity and long-term debt consitutes the company’s capital strucutre. The company then converts this capital “into assets [and operates it] to earn economic returns by fulfilling customer needs” (Groth and Anderson, 1997).

Thus, we have established that a company has assets financed through equity and long-term debt. The company’s assets are made up of current assets [which are more liquid: in the sense that they can be converted into cash more readily] and fixed assets [which are more illiquid assets: such as factories]. Like wise,  part of the longer-term debt will be short-term (or current liabilities), to enable day to day financing operations. Therefore, we conclude that current and fixed assets are financed with current liabilities, long-term debt and equity; which are the constitutes of the balance sheet. This is captured in the below formula:

Current Assets + Fixed Assets = Current Liabilities + Long-term Debt + Equity   (equation 1)

Working Capital: What Is That?

In a nutshell, “working capital is the [difference] between current assets and current liabilities” (Pass and Pike, 1987). Current liabilities represents the debts or obligations that must be paid by the company within the duration of one year; whereas, current assets are those assets that will be converted into cash within one year. Therefore, working capital represents the supposed excess cash on hand “to continue business operations” (Needles and Powers, 2004, p.259). The importance of this quantity is that it gages a company’s liquidity; the availability of cash to continue operations and meeting debt obligations.

Ideal World View: Working Capital

In an ideal world, the management of a company would be able to identify all the debt obligations it shall incur in the upcoming year. By knowing such information, management would match the current liabilities with the same amount of current assets; effectively having a net working capital of zero. Referring back to (equation 1) from the previous section, since current assets and current liabilities are equal, they can be dropped from the equation. Therefore, in an ideal world, fixed assets (which have a longer nature of usability) would be financed by long-term debt and equity. So we notice that, there is a matching of the “maturity dates of the assets with the liabilities” (Pass and Pike, 1987). This ideal world view is best captured in the below diagram:


Real World View: Working Capital & Money Markets

Though the ideal world view conceptually makes sense, it is flawed for two reasons. The first of which is that it is very hard to predict with certainty the debt obligations for the upcoming year. The second, and more important issue, is that “current assets cannot be expected to drop to zero … [as] long-term rising level of sales will result in some permanent investment in current assets” (Ross et al., 2008, p.755). This permanent investment in current assets comes partially in the form of accounts receivables, inventories, accruals, etc. Therefore, the real world view diagram will look something like:

A company will want to maintain a working capital such that it would minimize the sum of the carrying and shortage costs; it would do so by “minimizing the amount of funds tied up in current assets” (Filbeck and Krueger, 2005). Why a company would do so, is because short-term debt is much cheaper than long-term debt &/or equity, especially since working capital is financed by their of the latter two.  But if a company wants to maintain a set working capital, its must be able to predict accurately future inflow/outflows of transactions (cash); which as previously discussed, not possible. Thus a company might have, at anytime, a bit more or less cash relative to the optimal capital structures, running costs up; as depicted in the below diagram:

(Pass and Pike, 1987)

That’s were the role of the Money Market (MM) comes in. If a company has excess cash, it would invest it in the MM. Likewise, if it requires additional money, it would obtain it from the MM; which is short-term in nature, meaning cheaper than long-term debt or equity. In that regards, the more developed the MM of a given country, the easier it is for companies to obtain short-term finances, and maintain a working capital that would result in the least amount of costs.

~ Youssef Aboul-Naja

Capital Structure: Optimal Composition

March 7, 2010 Leave a comment

The Bigger Picture:

To start our discussion on how do companies decide on their composition of capital structure, it would be beneficial to take a step backwards, and glance at the bigger picture; prior to jumping into the details. Any company is brought into existence to increase the wealth of its owners; the shareholders. The company does so by generating economic returns through the process of taking “financial capital and [converting it] into assets…[to fulfill] customer needs” (Groth and Anderson, 1997). The financial capital utilized by the company, which becomes its assets, comes from shareholders’ funds (equity) and debt. It is the different percentage claims of the financiers (shareholders and debtors) that make up the capital structure of a company.

As companies are established to increase shareholder’s wealth, managers want to put in place a capital structure to achieve just that. Thus an “efficient mixture of capital reduces the price of capital … [and in doing so] increases net economic returns which, ultimately, increases firm value” (Groth and Anderson, 1997).

But reducing the price of capital is not the only task a company faces as it increase the wealth of its shareholders. A company face other variables such as:

-> Government taxes on the revenue it generates
-> Indirect bankruptcy claim costs, rendered through “higher interest rates” (Ross et al., 2008, p. 463), should the company default on its debts.
So, in selecting a capital structure, taxes and bankruptcy claims must also be taken into consideration; along with reduction of capital costs. Given such qualitative framework, the following questions arise: Is there an optimal capital structure for companies? Is a company’s capital structure a result of its operating context, or underlying principles?
In Principle:

Each company does have an optimal capital structure; and such structure is a result of underlying principles.

As stated briefly, four parties have claims over a company’s earnings: the shareholders (equity), the bondholders (which shall represent the debt portion), the government (taxes), and bankruptcy claims (indirect costs). As companies cannot influence directly the claims of the latter two [taxes and bankruptcy claims], it must do so by optimizing the debt-to-equity mix. “Stockholders choose the debt level to maximize the value of their equity taking into account the cost of default” (Harris and Raviv, 1990).

Modigliani-Miller (1958) have proved that the “value of [a] firm is completely independent of [its] capital structure” in the absence of taxes and bankruptcy costs. It was later demonstrated that “high leverage capital structures” (Miller, 1988) reduce corporate income taxes, as accounting principles require interest expense to be subtracted from earnings prior to tax calculation. With higher leverage [debt] capital structure, more money ‘in theory’ finds its way to shareholders/bondholders; since less of it goes to taxes. But one side effect of increased leverage is the increased risk of bankruptcy. Thus as a company’s leverage increases, so does its bankruptcy claims costs; which is reflected through increased interest rates on debts. With the increase of bankruptcy claims due to higher leverage, less money finds its way to shareholders/bondholders.

So in principal, the optimal capital structure of a company is when the tax shelter gains minus the bankruptcy claims costs is maximized. This should bring about the most wealth to the shareholder’s of the company. Effectively, “the use of the right amount of debt lowers the companies weighted cost of capital” (Groth and Anderson, 1997).

In Reality:

Though the above explanation of how to decide on an optimal capital structure makes perfect sense, it is all academia. “No equation exists to determine the optimal capital structure for a company” (Groth and Anderson, 1997). The actual market environment is much more complex to capture in mathematical formulas. Some factors that make it difficult to arrive to an optimal capital structure include (the list is not exhaustive):

-> “Investors’ receptivity to debt” (Milken, 2009): This is mainly influenced by the current market conditions.
-> A culture’s acceptability of debt: Culture plays a big role in “influences our values, which in turn affects our attitudes, and then behavior” (Chui et al., 2002).
-> Country factors: “Aggarwal (1981) [analyzed the] 500 largest European firms” (Chui et al., 2002) and concluded that country factors play a role when companies decide on their capital structure.
-> Free cash flow problem: Whereby if a company generates a lot of cash flows from the optimal capital structure, it would “waste it rather than pay it out to investors” (Myers, 1993) considering that a conflict of interest would be present between management and shareholders.
-> Deviation from industry norm issues: If a company structures its capital in a way where it deviates substantially from its industry norm, it might be frowned upon by lenders, making it difficult for the company to attain debt-financing.

Closing Notes:
Given the complexities of capturing all the variables that effect the optimal capital structure formula, then the capital structure composition is left to an educated guess at best: industry standards, operating context of the firm, stakeholder’s preference, etc. But as companies experiment with various capital structures, they would be inching ever closer or further to the optimal point. One statement that rings true, regardless of capital structure composition, is “it doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will” (Milken, 2009).
~ Youssef Aboul-Naja

Capital Budgeting, Real Options, & Bending Grass

February 28, 2010 3 comments

Trees, no matter how well rooted they are, topple over from gusts of winds due to their inflexibility. But Confucius noted that “when the wind blows, the grass bends”. Thus, adaptability to the surrounding environment, plays a big role in survival. Against such backdrop, do I put into perspective the topic of Real Options; and how that aids management in better project selection; making them more adaptable.

Companies are established to generate wealth to its stakeholders. In doing so, a company must be working towards a vision; which is synonymous to the company’s central theme. By working towards their vision, companies take on and execute various projects. But since a company’s main object is to maximize the wealth of its stakeholders, management must have a way [or a tool] to help them select the most profitable projects. This is where Capital Budgeting comes into play.

In a nutshell, capital budgeting is the process of “making and managing expenditures on long-lived assets” (Ross et. al, 2008, p.2). Management must determine the cash inflows and outflows of a given project to determine its suitability relative to:

  • How the cash flows affect the stakeholders’ overall wealth
  • How the cash flows measure against the cash flows of other potential projects that management could undertake instead

Given that companies have limited funds (or fund sources), management must select those projects that create the most financial benefit to the shareholders.

But the process of selecting projects is not as trivial as portrayed above. A company exists in a complex environment, whereby a lot of factors are interconnected and in play. In fact, market environments are so complex, that they are semi-deterministic; they cannot be modeled with 100% accuracy, yet they are not chaotic. Thus uncertainty complicates the project selection process, as future cash inflows and outflows are only known with a given degree of accuracy.

In solving the project selection problem, various investment decision tools have been devised to assist managers; most prominent of which are:

  • Net Present Value (NPV): whereby the future cash inflows and outflows are discounted back to present money and all added up. The project with the highest NPV value will be the clear winner, as it maximizes shareholder’s wealth.
  • Internal Rate of Return (IRR): the IRR is the rate were a project does not contribute any gains or losses to the shareholders’ wealth – thus management would be indifferent about executing it. With this tool, managers compare the rate of return of a given project against its IRR to determine its level of profitability. The project that produces that highest profitability is selected.
  • Payback Period: Projects are determined on how quickly the cash inflows payback the initial investment [cash outflow]. The fastest project is selected.

Though this is by no means an exhaustive list, each method has its short comings. These methods were “designed for relatively stable environments… As a result, business strategy … turn out to be flawed because something outside their control doesn’t go as planned” (Trigeorgis et al., 2007). What was need is another method, that accounts for uncertainty and management’s ability to respond to future events; thus the method of Real Options came about.

“At its core, the real option perspective is like other theories of investment in that it is concerned with identifying the factors that influence the investor’s threshold —the point at which investors choose whether to invest or not” (Miller and Flota, 2002). What the real options method did differently, is that it introduced the concept of “the possibility of contingent decisions” (Amram and Kulatilaka, 1999). The method was a bit more chaotic compared to other methods, in the sense that it was more reflective of reality. Thus it accounted for situations of project expansion, contraction, abandonment, timing of events, and “sequential [growth] options [of other projects]” (Wyant, 2009). By explicitly accounting for the future flexibility inherent in capital investment opportunities, the real option method would better portray the real financial effect of a given project on shareholders’ wealth.

The main benefits of the real options method is that it facilities for better planning and in taking strategic decisions. Other methods might be too conservative in analyzing the benefits of a project, which would result in its rejection. The reason why the other methods suffer from such consevatism, is because they commit project decisions at the beginning stages, which results in “sacrificing flexibility and increasing exposure to … uncertainties of new markets” (Miller and Flota, 2002). Therefore with the real options method, better strategic modeling is conducted, which results in flexible project variability, a more informed management and lower costs [cash flows].

At my current place of employment, a financial leasing company, we constantly use the real options method. Since our funds are limited, we are selective with the clients we are willing to finance. In determining the risk profile of the client, we attach probabilities to our future relationship directions with the client: increase/decrease/or cap the exposure, perform repossession in the event of a payment defaults, file a lawsuit, etc. Based on such analysis, we are able “to better quantify the value of each contingency” (Trigeorgis et al., 2007) and effectively better handle our client base and overall company risk and returns.

~ Youssef Aboul-Naja