Steps in the management of Financial Risk

Value at Risk Construction at a Glance

It is so easy to compute this number and even easier to let it strew up decision makings. Value at Risk definitely a double edged blade.

Value at Risk's Formula At a Glance

Eddy said: A summary of some prominent approaches to VAR. There are more out there. Basically VAR approaches can be broadly classified into 2 types: Local Valuation and Full Valuation. Full Valuation VAR includes Monte Carlo and Historical Simulation whereas Local Valuation covers Factors Methods and Diagonal Methods.

Linear VAR, Full Valuation VAR, Delta VAR, Delta-Normal VAR, Delta-Gamma VAR, Monte Carlo VAR, Historical Simulation VAR.

Sir, a sample please?

If ever we got unlimited monies, processing powers, complete coverages and assuming no constraints at all, we can ignore the idea of sampling since by then doing sampling is like perfoming double works if we can actually work on the population itself.

Down to earth, in every business decision we faced the quintessential requirements to take some trade-offs between many constraints, i.e. budget and time. When deciding on business directions, strategy or even a daily routine task, it is imperative that the person to understand the nature of the problem before formulating a proper solution. To understand the problem in context, usually it involves actions such as monitoring certain characteristics of items, obtaining input from people and etc. If we can do the data gathering on every single item of interest, then we are working directly on the population instead of sampling part of it. Some problems mandate sampling because it is impractical to deal with entire population, if ever it is possible. For example, to find out the average height/weight of asian adult male, it is time consuming and might be impossible to capture the height information from every matched candidates. It may be the case that some of them are hiding somewhere in the jungle and therefore your data is incomplete. In other words, at best efforts, you are only approximating the population, i.e. sampling. Other sampling scenarios include production process control mechanism that check the product characteristics randomly at certain intervals, market research surveys that targeting certain stratum of some geographical locations and anthopological studies.

We now know that a sample is a subset or part of a population and a sampling process is basically drawing that part from that population. By having a representative, non-biased and sufficient sample, we could draw (i.e. infer) conclusions about the underlying population.

In the statement above, it is obvious that the conclusion might be misleading or totally wrong if the sample is "non-representative", "biased" and "insufficient".

So that's why some more complicated sampling techniques other than simple random sampling exists to reduce the effects of some of these, e.g. stratified sampling, cluster sampling and multistep sampling. But for you, just need to remember that all these techniques are just ways to draw items from the population.

Once you have a good sample, the next logical step you might want to perform includes organizing, describing and summarizing the samples quantitatively and graphically. The important milestone in this step is to get a grasp of the sample's probability distribution, i.e. the random variation pattern in the sample. From the probability distribution, you can infer about the population probability distribution. Only by confirming the distribution, you can be sure that your choice of analysis tools are compliant and consistent.

In terms of formal terms, statisticians use the word "statistic" for numerical characteristics of sample and the word "parameter" for similar characteristic of population. The common symbols used are different too, e.g. lowercase s for sample's standard deviation and lowercase greek letter sigma for population's standard deviation.

Some common probability distributions include hypergeometric, binomial and Poisson for discrete random variables and exponential and normal for continous randon variables, among others.

Well, all the above are fundamental knowledge, I'm just put it down in words. Easy right?

Zero Coupon Bonds

Man, this is hilariously funny. I overheard an apparent "outsider" talking about some company issuing a zero coupon bonds in its capital structure.

This was roughly what he said

"The company XXX is so goooood, decided to do zero couple instead of these bonds that need to pay interest to bondholder, this saves the company many many bank interest".

By the way, sorry for the broken english, I tried to resemble the original wordings from that guy.

Perhaps any educated investor would point out the problem with his statement. Well, most of us could laugh at him after we did some studies on wth is zero coupon. And well, only if most of us aren't lazy.

Firstly, Yes, Zero couple bonds doesn't pay interest. Emmm, it really depends on how you define "interest". More precisely, I must say Zero Couple Bonds doesn't make Coupon Payment to Bond Holders. A Coupon is like an obligation of the bond issuer to make periodic interest give out to bond holders as a way to compensate investors for taking risks in buying the bonds.

So, if Zero Coupon Bonds doesn't do that, how do investors making profit from it?

It is just like U.S. Treasure Bills.

Fine! You might not know T-Bills. What about Pure discount instruments?

Ok! You have no idea what am I talking about.

Great, now I have to tell the story using my own words, and please don't whack me if my understanding deviates from those well established in the financial literatures.

Imagine a fictionous scenario that you want to eat an apple and an apple is selling at USD100 in the market. The problem is you don't have USD100 and now you hunting out to find ways to get your apple. And then there is another guy, who desperately want to grow apple trees and therefore he need some money to do his business. So he decided to offer a deal in the market. The deal is he will promise to pay USD100 at the deal maturity, let say 6 months, in return for USD80 that you provide to him immediately. If you can wait for 6 months and if you still want to eat your apple, then this is possibly a good deal that you might want to engage.

(At this point, if you know about Derivatives, you might think that the above scenario is also applicable to derivatives trading. No, you are wrong. In the above case, the amount of money exchanged hand/specified in the contract is fixed, hence the term Fixed Income Securities)

Assume that you signed up the deal, paid USD80 upfront and waited for 6 months for your USD100, your Holding Period Return (HPR) is

= (USD100 - USD80)/ USD80
= 25% (Not Bad huh)

The point here is Zero Coupon Bonds like the scenario, will allow you to purchase the bond at a discounted price, then by holding it to maturity, you shall redempt it at full value, i.e. par value/face value. No interim interest payment shall be made to you though.

Ok, Ok. I heard some noises at the back. What's that? Oh, you're asking what are reasons for corporates to choose between zero coupon and coupon bearing then.

Plenty of reasons, of course.

But, in my opinion, only one reason is significant: To manage/manipulate financial reports/ratios. To understand the implication of choosing amongst the two, we need to understand how companies record the bonds transaction in their book.

Oh boy, I've typed some many words and got lazied. So, I will just summarized this up.

Basically, coupon bearing bonds can be categorized into 3 groups: bonds at par, discount bonds and premium bonds and each is recognized by the different between coupon interest rate and market rate of interest at issuance; and each have impact on CFO and CFF.

Anywaym, because interest payments are recognized as interest expenses in income statement, therefore for zero coupon bonds, the profit is significantly overstated because CFO is significantly high due to the absence of substraction effect of coupon payments. "Interest" payment of zero coupon bonds is only realized the maturity and only in CFF. Other than this, ratios such as debt-to-equity will also be distorted.

Ok, that's all for now.

PE, Price Per Earnings, Price To Earnings, P/E.. Whatever

Who doesn't know this ratio? This is one of the few measures that even the most amateur investors look at when deciding their investment placements.

PE is useful. Yes, I agreed. But sometimes it tends to paint a very incomplete and skewed picture of the relationship between the performance of the stock price and business profitability.

There are at least 3 issues when making use of PE ratio.

• PE isn't meaningful when the earnings are negative.


• Some part of the earnings that're contributed by seasonal, cyclical or other volatibility factors can't be explained by PE ratio.


• Some accounting practices might results in different management discretion in treating same pecuniary items in their financial accounts might distorted the earnings amount and thus the PE ratio.

In the PE literature, there are 2 famous versions of PE ratio. Basically, they are different in their formula denominator.

1. Trailing PE

PE = (Market Price per Share) / (Most recent 12 months Earnings)

2. Leading PE aka Future PE or Prospective PE

PE = (Market Price per Share) / (Earnings in next expected period)

Trailing PE is the one we commonly seen in major newspapers, stock historical performance analysis, trading sites and etc. This PE is benchmarked to past performance, and all of us should know that past performance doesn't guarantee similar future achievements.

Constrast to Trailing PE, Leading PE is the one that is derived from Dividend Discount Model (DDM) when we divide the equation with expected earnings.

DDM Price Valuation Model

P0 = D1 / ( k - g)

P0 = Share Price at time 0
D1 = (Dividend at Time 1)
k = (Equity Required Rate of Return)
g = (Dividend Growth Rate)]

... Divide the equation with E1

Where E1 = Expected Earnings at Time 1

We get

P0/E1 = (D1/E1)/(k-g)

Which when described in words means,

Leading PE is equals to the Expected Dividend Payout Ratio (D1/E1) over the difference between the required rate of return and divident growth rate.

One precautionary note is to look out when considering firms to invest is to analyze other financial ratios might bring out the truth about the business.

Some ratios to observe:

• Price to Book Value, P/BV


• Price to Cash Flow, P/CF


• Debt Ratio


• Current Ratio, Quick ratio and Cash Ratio


• Not to forget also Asset Turnover

Besides that, some operational practices such as inventory methods (FIFO, LIFO, other) and OPEX/CAPEX expenditures must be thoughtfully considered.

Assumptions about Investor Behavior underlying Markowitz model

• Returns distribution. Every investment opportunity has a probability distribution that describes the expected return over the investment horizon.


• Risk and Return describes completely investment decisions.


• Risk represented by variability


• Utility maximization. Investment indifference curves are convex, i.e. their marginal utility of wealth is diminishing over time.


• Risk aversion. Lower risk is preferable than higher one holding expected return constant.

Capital Budgeting

Someone in a corporation who is mandated to make financial decisions need to engage in capital budgeting process. Obviously, capital budgeting process requires you as the financial controller or corporate planner to determine which capital projects to be undertaken. So what is capital budget? In layman term, these are projects which will affect the company financially in the long run, or more specifically they will impact your company future earnings and the forecasted cash flows usually spread over one year.

From a shareowner point of view, capital projects are aim to increase our wealth. Capital projects that cost money and doesn't bring value to shareowners are merely inreasing the company size. Imagine a person that eat alot (capital) and growing fat (company size) but doesn't really bring any significant good to the person (value).

Put it simple, capital budgeting process have 4 steps:

1. Idea generation

2. Analyzing project proposals

3. Create the enterprise wide capital budget

4. Monitor investments and analyze target-actual variations

Argh.. getting sleepy and too lazy to type. Continue next time when I got mood on this topic :p

Monetary Base, Monetary Multiplier and Money Supply

The following is derived from my understanding of the matters, any damages caused by the uses of it is none of my business, :p


According to M1 and M2 measures of money supply in the State,

M1 = Amount in Currency, Travellers' checks and Checking account deposits (non governmental)
M2 = Amount inclusive of M1, Time deposit, Savings Deposits and Money Money mutual funds.

Many of the banking system in the world, including the one used in U.S is basically a fractional reserve banking system. It means the central bank will decides as part of the monetary policy the reserve ratio of the bank deposits to be retained with the central bank for the purposes of liquidation/withdrawal by depositors.

This reserve ratio is one of the crucial instruments at central bank disposal to influence market determined interest rates, to increase/decrease money supply in the market and effectively controlling economy expansion or recession.

For every dollar you deposited in your preferred bank, the bank might pools the money and loans it out, after withholding the portion of the money as required by the bank reserve ratio. Then, the borrower who granted the loan might uses the loaned money to settle his/her debts or uses it to buy stuffs. One way or another, most probably some portion of the money will get bank to banks as deposits. The bank then can repeat the cycle again and again, until there is no more excess reserves.

The monetary base includes currency notes, coins, and reserve deposits at the central bank.

The change effect of one unit of monetary base is multipled by a number called the monetary multiplier because of the money circulation depicted above.

Basically, the monetary multiplier is dependent on the bank reserve ratio and the currency ratio. Currency ratio is the portion of money borrowers hold in cash without re-deposited it back to the system.

Money Multiplier = (1+c)/(r+c)

Where c is the currency ratio and r is the reserve ratio

And by that

Change in quantity of money = Change in monetary base x Money Multiplier

China stocks plunge as PetroChina falls below IPO price

Warren Buffett sold them like ages ago, do you think he's darn smart now? :p

There's reason why he's one of the most successful investors in mankind history: He definitely got access to material, non-public information or else his market sensitivity radar must be the state of the art.

Introducing the Mosaic Theory

Investopedia defines the Mosaic Theory as:

A method of analysis used by security analysts to gather information about a corporation. Mosaic theory involves collecting public, non-public and non-material information about a company in order to determine the underlying value of the company's securities and to enable the analyst to make recommendations to clients based on that information.

Applying the Mosaic Theory is as much art as it is science. You basically have to gather as many bits and pieces of information as you can, see if they tell a story that makes sense, and then decide whether there is enough profit potential to enter a trade.

China stocks plunge as PetroChina falls below IPO price

INTO THE BEAR'S PAWS: After enjoying a two-year bull run, Chinese investors are now suffering amid a downtrend that analysts say has yet to find a bottom.

The Straits Times, April 19, 2008

SHANGHAI - CHINA'S share market tumbled nearly 4 per cent to a 12-month closing low yesterday, as the biggest stock - PetroChina - dropped for the first time below its price in last October's Shanghai initial public offering (IPO).

After leaping more than sixfold in a two-year bull run, the market has been gripped for six months by a downtrend caused by high inflation, a threatened slowdown of the Chinese economy this year and heavy supplies of new equity.

The Shanghai Composite Index slid 3.97 per cent to end at 3,094.668 points, near its intra-day low of 3,078.174. It lost 11.4 per cent this week, its biggest weekly drop since 1996. It is now 49 per cent below last October's record peak.

Panic spread yesterday, as PetroChina broke its IPO price of 16.7 yuan. Since the oil giant was the most heavily weighted share in the index, the break was seen as negative for the whole market, implying institutions were so bearish that they were willing to take losses to exit the stock.

PetroChina closed 5.04 per cent lower at 16.02 yuan, after touching a low of 16 yuan, pressured by expectations that high global oil prices would cause losses at its refining operations.

In recent weeks, PetroChina repeatedly hit - but did not break - its IPO price, and traders said some institutions appeared to be mounting a support operation for the stock to prevent panic in the market. But yesterday, this support suddenly vanished.

PetroChina's Shanghai-listed A-shares have dropped 64 per cent since their first day of trade in November, when they more than doubled, causing the company temporarily to eclipse Exxon Mobil as the world's largest firm by market capitalisation.

The shares may fall further yet. Some traders talk of targets around 15 yuan. The A-shares still command a premium of more than 80 per cent over the firm's Hong Kong-listed shares.

Pressure for premiums to narrow has become intense. The average premium for dual-listed Chinese companies fell as low as 32 per cent yesterday.

Some analysts see support for the Shanghai index at around 3,000 points, but many do not rule out a break below 3,000 if PetroChina stays weak.

'Several shares have plunged below their net asset values for the first time in over two years. This shows how deep the panic is,' said Huatai Securities analyst Chen Jinren.

A Glimpse on Futures Contracts and Forwards Contracts

Basically, they are both:

• Either Deliverable or Cash Settlement Basis.


• Priced to have Zero value at the time of contract initiation.

And they differs by:

• Futures are trade on exchanges. Forwards are private contracts and not traded.


• Futures are standardized. Forwards are customized to individual needs.


• A single clearinghouse is the counterparty for all futures contracts. Forwards are contracts with originating counterparty.


• Futures are regulated by the government. Forwards are usually not.

The above are just summary of the characteristics. To understand more, definitely some readings are needed.

YTM, Yield to Maturity

Yield to Maturity which is one of the many summary measures for bond valuation is simply another application of Internal Rate of Return, IRR. Thus, it suffers from the same assumptions and limitations of IRR.

To recover return rate that is exactly equal to the YTM for the investment,

• The cash flows must be reinvested at the YTM rate


• The investment must be hold till maturity


• The bond must be redeem at par

Possible cash flows for a couple bond shall include,

• Coupon payments


• Principal recovery


• Reinvestment return

Due to the fact that the cash flows during the lifetime of most bonds (except for non-callable, non-convertible, zero couple bond) are hard to predict, YTM is really a guidance measure instead of exact forecast of the bond return.

• When a bond sells at a discount, YTM > current yield > coupon yield.


• When a bond sells at a premium, coupon yield > current yield > YTM.
• 
  
• When a bond sells at par, YTM = current yield = coupon yield.
• 
  

Primary and Secondary Markets

Just to post some excerpts I read from a book.

The primary market for debt (newly created debt securities) functions in a manner similar to the primary market for equities. Typically an investment banker (IB) is involved in advising the debt issuer and and in distributing(selling)the debt securities to investors.

When the IB actually purchases the entire issue and resells it, they are said to have underwritten the issue. This arrangement is termed firm arrangement while the deal is termed a bought deal.

In an underwritten offering of debt securities, the underwriter will typically put together a syndicate of many IBs to aid in distributing the securities. The underwriters can reduce their risk by preselling as much of the offerings as possible to their institutional clients and hedging the interest rate risk exposure of the issue for the period they anticipate holding owning the securities.

An alternative is for the IB to agree to sell all of the issue that they can and this is termed doing the offering on a best efforts basis.

In the above described process, since the price paid for the issue and the anticipated sale price is determined between the IB and the issuing company, the offering is termed negotiated offering.


And more....

Uncle Warren Buffett told me this

If you are a know-something investor, able to understand business economics and to find five to ten sensibly priced companies that possess important long-term competitive advantages, conventional diversification (broadly based active portfolios) makes no sense for you.

Regression Model Specification Principles

Model specification refers to the set of variables included in the regression and the regression equation's functional form. The principles below cal guide model specification:

• The model should be grounded in cogent economic reasoning


• The functional form chosen for each variable in the regression should be appropriate given the nature of the variables


• The model should be parsimonious


• Validate the regression model assumptions before accepting them


• Apply the model using out-of-sample observations

F-Statistic

RSS is the Regression Sum of Squared
SSE is the Sum of Squared Error
n is the total number of observations
k is the number of independent variables in the regression equation

k and [n - ( k + 1)] is the number of degree of freedom for calculating a F-statistic.

For unbiased MSE calculation, the number of regression coefficients need to be substracted from the n to form the number of degree of freedom for the denominator.

In my understanding, F-statistic aims to highlight the ratio of explained variation to unexplained variation for the regression equation.

The basic concept is roughly like this: Assuming the absence of such regression equation in estimating the value of a dependent variable, let say Y. We probably will use the arithmetic average, denoted Y-bar to estimate the value of Y. In other word, in such cases, all of the variations would be unexplained, which means you can't really tell what factors that causes your prediction deviates from the actual.

So now, some smart ass come out with an equation that claims to be a better estimation method than arithmetic average. Ideally, the RSS will be larger than SSE because now the regression cofficients in the equation would partially (might be fully) explains the deviation from the actual.

If the equation performs as good (as worse) as the arithmetic mean method, then F-statistic would give you a 0 value because RSS will be zero.

Standard VI (A) Disclosure of Conflicts. Directorship Issues.

In the investment industry, a conflict, or the perception of a conflict, often
cannot be avoided. The most obvious conflicts of interest, which should always
be disclosed, are relationships between the member, candidate, or their firm and
an issuer (such as a directorship or consultancy), investment banking, underwriting
and financial relationships, broker/dealer market-making activities, and
material beneficial ownership of stock. A member or candidate must take
reasonable steps to determine if a conflict of interest exists and disclose to clients any conflicts of the member or candidate’s firm when known. Disclosure of
broker/dealer market-making activities alerts clients that a purchase or sale might
be made from or to the firm’s principal account and that the firm has a special
interest in the price of the stock.

Service as a director poses three basic conflicts of interest. First, a conflict
may exist between the duties owed to clients and the duties owed to shareholders
of the company. Second, investment personnel who serve as directors may
receive the securities or the option to purchase securities of the company as
compensation for serving on the board, which could raise questions about trading
actions that could increase the value of those securities. Third, board service
creates the opportunity to receive material non-public information involving the
company. Even though the information is confidential, the perception could be
that information not available to the public might be communicated to a director’s
firm—whether a broker, investment advisor, or other type of organization. When
members or candidates providing investment services also serve as directors, they
should be isolated from those making investment decisions by the use of fire walls
or similar restrictions.

Reading while sleeping. Beat me.

Sickening illness wrapping me again. Sucks.

Spent the day repeating the same cycle of sleeping, eating, taking medicine and sleeping again. I believe I'm in the progress of incubating pharmacophobia. Darn, should I take the red or the blue one today?

Whatever. Lying on my 5 years old spring mattress with flatten topper, digging some pointers of what to do to keep myself awake.

Oh yeah, I can continue reading up stuffs for CFA paper 1 preparation. The quantitative section should be interesting enough.

............ (Reading while half eye closed)

Although it is possible to restate the yield convention in money market yield, quoting yield on US T-bills is generally calculated based on bank discount basis. The author pointed out that quoted yield in bank discount basis has 3 potential issues: Firstly, the yield is based on face value of T-bills. It is more meaningful to express the return in term of amount invested. Secondly, bank convention of 360 days in a year is differ from usual calendar period calculation. And lastly when annualizing the yield, it is assuming a simple interest and this prevent the incorportation of interest on interest possibilities.

To do the conversion, use the following formula:

r(mm) = r(bd) x F/D

or if the face value (F) is not available,

r(mm)= 360 x r(bd) / (360 - t * r(bd))

Because US T-bills are guaranteed face value payment at maturity by US federal government, they are shielded from default risk. Large volume of T-bills transaction avoided liquidity risk and less than 1 year maturity excluded maturity risk. Thus T-bills are considered the safest short term debt instrument in US money market. But still T-bills will be affected by monetary policy on interest rate among other factors.

Effective annual yield, EAR = (1+HPY)^(365/t) - 1

In general calculation for NPV and IRR (or other time value of money methods), US T-bills yield is the baseline for establishing a reasonable discount rate or opportunity cost of capital.

............ (Continue next time.)