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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 

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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

Why do companies need to understand risk?

February 22, 2010 2 comments

“If you have a pilot flying a plane who doesn’t understand there can be storms, what is going to happen?” (Nocera, 2009). Against this backdrop, I commence my discussion regarding the importance of understanding the nature of risk, and its profound effect on the returns of long and short term investments undertaken by businesses. The thought of escaping risk is an impossible feat. As with every action, there is an attached element of risk to it; ‘avoiding risk can itself be risky’ (Salzberg, 2010). Effectively, to survive and achieve growth, a business must learn to embrace risk by understanding its intricate elements, and the impact it brings about its operations. Thus risk, if handled properly, may very well be a source of opportunity. The Chinese captured such a concept, by denoting the symbol for risk as “a combination of two symbols—one for danger and one for opportunity (Damodaran, 2005).

What is risk? Though there is no verdict on an exact definition, Elroy Dimson proposed a rather interesting version, which states that “risk means more things can happen than will happen” (Farrell, 2007). So in that sense, risk is the anticipation of future events that will have an adversary effect on a given business; though not all events will take place. Also, not all events can be anticipated. If we can foretell the future, the element of risk would simply diminish to zero. Thus, risk is our interpretation of how the future events will unfold, given the current factors we have at hand.

From an Investment’s point of view, taking on risk will result in some form of return. How high or low the return is depends on how the predicted risk element pans out with the actual future events. Nonetheless, a return is composed of two elements: an expected part and a ‘surprise’ (Ross et. al, 2008, p.322) part. The expected part further breaks into a:
– Systematic element: a surprise element that is applicable to almost every asset
– Unsystematic element: a surprise element applicable only to a single asset

As companies go about their everyday business, they constantly engage with various activities; each having an element of risk. And as discussed earlier, each risk has a return associated to it. Thus, as companies go about their daily business, they are maintaining a portfolio of returns:
-> They must achieve a certain return to shareholders
-> They might have invested in other companies (thus they expect a certain return)
-> They might be undertaking a project (thus they need to achieve a certain return margin for the project to be profitable)
…etc
So for companies to survive, they must understand risk (the systematic and unsystematic elements), as this affects the returns generated, and would, in turn, affect the company’s return/investment portfolio on the short and long runs.

In understanding systematic risk, I bring upon an example from the company I currently work for. I work in a financing house in Saudi Arabia. Though it is a privately held company, they are constantly engaged in loan extending transactions, which bears an element of risk. The rates that are offered to the clients’ partly accounts for the systematic risk element [though it cannot be predicted precisely]. Examples include:
-> The prevailing SIBOR in the Kingdom
-> The death of King Fahd in 2005: “the market opened at a decline” (Akeel, 2005), which resonated across the whole Saudi economy, resulting in our company receiving delayed payments from its clients, and a lower overall return.
-> During the end of 2008 and throughout 2009, bearing in mind the global crisis, the oil prices fluctuated from “$98 per barrel, rose to $147 per barrel in July, then ended the year at $44 per barrel” (Anon, 2010). Such swings had an effect on government spending (especially in the early part of 2009), and effectively also affected client payments to our company.

Now, in understanding unsystematic risk, we continue upon the example of my company. Unsystematic risk examples include:
-> The change of our General Manager – the older one suddenly decided to resign. As the new GM is not tested [came from outside], this raised the risk factor to the company’s owners, thus requiring higher returns (meaning a higher cost of capital on our company) [short-term issue]
-> Changes in the leasing laws, as per directions from the Saudi Arabian Monetary Agency. This drove up the cost of doing certain parts of our business [short-term issue]
-> A conflict of interest issue, which required us to create two operational units (instead of one), and essentially drove the prices up [long-term issue]

Thus, in order to continue surviving, the company must understand how these systematic/unsystematic risks affect it – whether they are long or short term in nature. Once it understands, it will be able to minimize its risks [i.e. maximize its returns]. Also, by understanding how the various risks impacting the company and its effect on its overall returns [from current projects], they will be able to determine whether or not to “add a new project to its existing portfolio… [By] estimating the coefficient of correlation between the cash flows [returns] from the new project and the total cash flows [returns] from existing projects … it can [thus] determine the effect of the new project on the means and standard deviations of the total cash flows” (Hull, 1986) and decide on its overall benefit to the portfolio.

Understanding how risk [its systematic and unsystematic elements] impacts a company’s activities is of crucial importance to its survival in the short/long term. Failing to comprehend and incorporate such risk elements in business activity will lead to catastrophic results. Referring to the 2008/2009 global economic meltdown would suffice.

~ Youssef Aboul-Naja