Saturday, 29 December 2007

Life Cycle of a Trade (Part 3)

This post is the continuation of the post on life cycle of a trade. In this post, I’m going to discuss the last two steps, namely the Affirmation and Confirmation and Clearing and Settlement.

Affirmation and Confirmation

This step is present only when the trading client is an institution. Every institution engages the services of an agency called a custodian to assist them in clearing and settlement activities. The figure below illustrates this.

As the name suggests, a custodian works in the interest of the institution that has engaged its services. Institutions specialize in taking positions and holding. To outsource the activity of getting their trades settled and to protect themselves and their shareholder’s interests, they hire a local custodian in the country where they trade. When they trade in multiple countries, they also have a global custodian who ensures that settlements are taking place seamlessly in local markets using local custodians.

As discussed earlier, while giving the orders for the purchase/sale of a particular security, the fund manager may just be in a hurry to build a position. He may be managing multiple funds or portfolios. At the time of giving the orders, the fund managers may not really have a fund in mind in which to allocate the shares. To avoid a market turning unfavorable, the fund manager will usually give a large order with the intention of splitting the position into multiple funds. This is to ensure that when he makes profits in a large position, it gets divided into multiple funds, and many funds benefit.

The broker accepts this order for execution. On successful execution, the broker sends the trade confirmations to the institution. The fund manager at the institution during the day makes up his mind about how many shares have to be allocated to which fund and by evening sends the broker these details. These details are also called allocation details in market parlance. Brokers then prepare the contract notes in the names of the funds in which the fund manager has requested allocation.

Along with the broker, the institution also has to liaise with the custodian for the orders it has given to the broker. The institution provides allocation details to the custodian as well. It also provides the name of the securities, the price range, and the quantity of shares ordered. This prepares the custodian, who is updated about the information expected to be received from the broker. The custodian also knows the commission structure the broker is expected to charge the institution and the other fees and statutory levies.

Using the allocation details, the broker prepares the contract note and sends it to the custodian and institution. In many countries, communications between broker, custodian, and institutions are now part of an STP process. I’ll talk about STP in another post. This enables the contract to be generated electronically and be sent through the STP network. In countries where STP is still not in place, all this communication is manual through hand delivery, phone, or fax.

On receipt of the trade details, the custodian sends an affirmation to the broker indicating that the trades have been received and are being reviewed. From here onward, the custodian initiates a trade reconciliation process where the custodian examines individual trades that arrive from the broker and the resultant position that gets built for the client. Trades are validated to check the following:

  • The trade happened on the desired security.
  • The trade is on the correct side (that is, it is actually buy and not sell when buy was specified).
  • The price at which the trade happened is within the price range specified by the institution.
  • Brokerage and other fees levied are as per the agreement with the institution and are correct.

The custodian usually runs a software back-office system to do this checking. Once the trade details match, the custodian sends a confirmation to the broker and to the clearing corporation that the trade executed is fine and acceptable. A copy of the confirmation also goes to the institutional client. On generation of this confirmation, obligation of getting the trade settled shifts to the custodian (a custodian is also a clearing member of the clearing corporation).

In case the trade details do not match, the custodian rejects the trade, and the trades shift to the broker’s books. It is then the broker’s decision whether to keep the trade (and face the associated price risk) or square it at the prevailing market prices. The overall risk that the custodian is bearing by accepting the trade is constantly measured against the collateral that the institution submits to the custodian for providing this service.

Clearing and Settlement

With hundreds of thousands of trades being executed every day and thousands of members getting involved in the entire trading process, clearing and settling these trades seamlessly becomes a humungous task. The beauty of this entire trading and settlement process is that it has been taking place on a daily basis without a glitch happening at any major clearing corporation for decades.

After the trades are executed on the exchange, the exchange passes the trade details to the clearing corporation for initiating settlement. Clearing is the activity of determining the answers to who owes the following:

  • What?
  • To whom?
  • When?
  • Where?

The entire process of clearing is directed toward answering these questions unambiguously. Getting these questions answered and moving assets in response to these findings to settle obligations toward each other is known as settlement. This is illustrates with the figure below.

Thus, clearing is the process of determining obligations, after which the obligations are discharged by settlement. It provides a clean slate for members to start a new day and transact with each other.

When members trade with each other, they generate obligations toward each other. These obligations are in the form of the following:

  • Funds (for all buy transactions done and that are not squared by existing sale positions)
  • Securities (for all sale transactions done)

Normally, in a T+2 environment, members are expected to settle their transactions after two days of executing them. The terms T+2, T+3, and so on, are the standard market nomenclature used to indicate the number of days after which the transactions will get settled after being executed. A trade done on Monday, for example, has to be settled on Wednesday in a T+2 environment.

As a first step toward settlement, the clearing corporation tries to answer the “what?” portion of the clearing problem. It calculates and informs the members of what their obligations are on the funds side (cash) and on the securities side. These obligations are net obligations with respect to the clearing corporation. Since the clearing corporation identifies only the members, the obligations of all the customers of the members are netted across each other, and the final obligation is at the member level. This means if a member sold 5,000 shares of Microsoft for client A and purchased 1,000 shares for client B, the member’s net obligation will be 4,000 shares to be delivered to the clearing corporation. Because most clearing corporations provide novation (splitting of trades), these obligations are broken into obligations from members toward the clearing corporation and from the clearing corporation toward the members. The clearing corporation communicates obligations though it’s clearing system that members can access. The member will normally reconcile these figures using data available from its own back-office system. This reconciliation is necessary so that both the broker and the clearing corporation are in agreement with what is to be exchanged and when.

In an exchange-traded scenario, answers to “whom?” and “where?” are normally known to all and are a given. “Whom?” in all such settlement obligations is the clearing corporation itself. Of course, the clearing corporation also has to work out its own obligations toward the members. Clearing members are expected to open clearing accounts with certain banks specified by the clearing corporation as clearing banks. They are also expected to open clearing accounts with the depository. They are expected to keep a ready balance for their fund obligations in the bank account and similarly maintain stock balances in their clearing demat account. In the questions on clearing, the answer to “where?” is the funds settlement account and the securities settlement account.

The answers to “what?” and “when?” can change dramatically. The answer to “when?” is provided by the pay-in and pay-out dates. Since the clearing corporation takes responsibility for settling all transactions, it first takes all that is due to it from the market (members) and then distributes what it owes to the members. Note that the clearing corporation just acts as a conduit and agent for settling transactions and does not have a position of its own. This means all it gets must normally match all it has to distribute.

Two dates play an important role of determining when the obligation needs to be settled. These are called the pay-in date and the pay-out date. Once the clearing corporation informs all members of their obligations, it is the responsibility of the clearing members to ensure that they make available their obligations (shares and money) in the clearing corporation’s account on the date of pay-in, before the pay-in time. At a designated time, the clearing corporation debits the funds and securities account of the member in order to discharge an obligation toward the clearing corporation. The clearing corporation takes some time in processing the pay-in it has received and then delivers the obligation it has toward clearing members at a designated time on the date of pay-out. It is generally desired that there should be minimal gap between pay-in and pay-out to avoid risk to the market. Earlier this difference used to be as large as three days in some markets. With advancement in technology, the processing time has come down, and now it normally takes a few hours from pay-in to pay-out. Less time means less risk and more effective fund allocation by members and investors. The answer to “when?” is satisfied by the pay-in and pay-out calendar of the clearing corporation, which in turn is calculated depending upon the settlement cycle (T+1, T+2, or T+3).

Answers to “what?” depend on the transactions of each member and their final positions with respect to the exchange. Suppose a member has done a net of buy transactions; he will owe money to the clearing corporation in contrast to members who have done net sell transactions, who will owe securities to the clearing corporation. To effect settlements, the clearing corporation hooks up with banks (which it normally calls clearing banks) and depositories. It has a clearing account with the clearing bank and a clearing account with the depository as well. A clearing bank account is used to settle cash obligations, and a clearing account with a depository is used to settle securities obligations.

That is a very long post on the last two steps of the life cycle of a trade. Have a nice weekend my readers and have a happy new year.

Tuesday, 25 December 2007

Warrants - Basic Knowledge & Concepts

I have posted quite a lot of blogs on options, futures, forwards, swaps and warrants. In this particular post, I’ll like to discuss more about the basic knowledge and concepts about warrants in Singapore. I hope this will give novices like me more insight about warrants. You can also find a good archive of articles about warrant here.

A warrant gives the investor the right to buy or sell the underlying asset at a pre-determined price on (European warrant) or before (American warrant) a predetermined date. The underlying asset can be stock, index, currency, commodity or something else. Since the warrant derived its value from its underlying, it is known as a derivative instrument.
  1. Warrants give you a right but not obligation
  2. A warrant’s value is mainly affected by the underlying price
  3. The longer the maturity, the higher the value of a warrant
  4. The more volatile the underlying price, the higher the value of a warrant

Warrants give you a right but not obligation

Suppose you want to buy a 3-room apartment flat currently worth S$200 000 (that must be a very good location flat), and the investor has the right to it at S$250 000 one year later. With the inflation hike and the booming real estate market, the 3-room apartment is most likely to appreciate to S$300 000 one year later. In order to have the right of buying the 3-room apartment at S$250 000 one year later, the investor has to pay S$20 000 for it. Assuming one year later, the 3-room apartment appreciate to S$310 000, the investor holding the warrant now has the right to exercise the right and buy the apartment at only S$250 000. That is, the investor profit S$40 000 (S$310 000 – S$250 000 – S$20 000) straight away. However, if the apartment price rise to S$210 000 or drops to S$192 000, then it makes no sense for the investor to exercise the right as he or she can get the apartment at a cheaper price than to pay S$250 000 for it. In this scenario, the investor will suffer a loss of S$20 000.

A warrant’s value is mainly affected by the underlying price

Suppose you hold the right to purchase the apartment at exercise price of S$250 000 by paying S$20 000 for it. The value of this right is, naturally, mainly determined by the market price of the apartment (of course there are other factors as well). If the apartment is worth S$310 000, the value of the right will be S$60 000 (ignoring the amount you paid for the right). Yet if the price of the apartment falls to S$192 000, the right will become worthless, because it cannot be exchanged for any value. Hence the difference between the market value of the apartment and the strike or exercise price of the right to purchase determines the “intrinsic value” of the latter.

The longer the maturity, the higher the value of a warrant

If you are given another right to purchase the same apartment at exercise price of S$250 000 but two years later, which warrant will fetch a higher price?

Obviously, the current one will fetch a higher price. This is because it is much more likely for the property to rise above S$250 000 in two years than one year assuming the real estate market is still blooming. Hence the more likely the right will be exercised the more valuable it is. Or we can say this current warrant is more valuable than the original one because of its higher “time value”. You are able to resell the right to another buyer for a higher price if the property price is expected to skyrocket after one year or even a couple of months. Accordingly, the longer the maturity, the more valuable the right will be.

The more volatile the underlying price, the higher the value of a warrant

Now suppose you have a choice of two apartments, both worth S$200 000 now. Suppose one is located near Orchard road and the other one is located in Tuas (quite unlikely, but just example ok). You may find that from time to time, most probably the price of the apartment at Orchard will goes up and down and as you may guess, the apartment in Tuas will most probably not fluctuate much, if not, not at all. Once again, if you were to buy the warrant, which one will, you choose most likely? Well, I suppose you will choose to buy the warrant for the apartment located at Orchard road. It is because the apartment at Tuas is quite unlikely to rise further in price in one year time. In contrast, the one at Orchard road will most probably fetch a better price and may well appreciate to beyond S$250 000 in a year time. This means that the warrant for the apartment at Orchard road will be more valuable.

I’ll be posting more about warrants in my coming posts. Lastly, I would like to wish all my readers a Merry Christmas and Happy New year.

Saturday, 22 December 2007

Life Cycle of a Trade (Part 2)

In my previous post, I had mentioned about 5 steps involving in the trade’s life cycle. In this post, I shall discuss about the Risk Management and Order Routing and the Order Matching and Conversion into Trade.

Risk Management and Order Routing

Regardless of how an order gets generated or delivered, it passes through a risk management matrix. This matrix is a series of risk management checks that an order undergoes before it is forwarded to the exchange. The onus of getting the trades settled resides with the broker. Any client default will have to be made good to the clearing corporation by the broker. Credit defaults are thus undesirable from the point of view of the broker who puts money and credibility on the line on behalf of the customer. Hence, these credit and risk management checks are deemed necessary.

Institutions are normally considered less risky than retail customers. That is because they have a large balance sheet compared to the size of orders they want to place. They also maintain a lot of collateral with the members they push their trades through. Their trades are hence subjected to fewer risk management checks than retail clients.

The mechanisms followed when orders are accepted and sent to exchanges for matching are the same for both institutions and retail clients. However, for retail customers the orders are subjected to tighter risk management checks and scrutiny. The underlying assumption in all such risk management checks is that retail clients are less credit worthy and hence more susceptible to defaulting than institutions. A recent extension of retail trading has been trading through the Internet. This exposes brokers to even more risk because the clients become faceless. In the good old days of “call and trade” (receiving orders by phone), most brokers executed transactions of clients they knew. With the advancement in trading channels, the process of account opening became more institutionalized, and the numbers came at the expense of client scrutiny. Most brokers who operate on behalf of retail clients these days operate on the full-covered concept. This means that while accepting orders from retail clients, they cover their risks as much as possible by demanding an equal value of cash or near cash securities.

The steps below show how a retail transaction is conducted and the benefit provided by risk management. The method utilized is more or less the same in call and trade as in Internet trading. The order delivery mechanism changes, but the basic risk management principle implemented remains the same. Here are the steps:

  1. The client calls the broker to give the orders for a transaction (in Internet trading the client logs on to the Internet trading site, provides credentials, and enters orders).
  2. The broker validates that the order is coming from a correct and reliable source.
  3. In case the client gives a buy order, the broker’s system makes a query to ascertain whether the client has enough balance in a bank account or in the account the client maintains with the broker. In case the client does not have enough balance, the order is rejected even before forwarding to the exchange. If the client has the balance, the order is accepted, but the value of the order is deducted from the client’s balance to ensure that he does not send a series of orders for which he cannot make an upfront payment. Many brokers still do not have direct interfaces to a banking system. In such cases, they ask the client to maintain a deposit and collateral in the form of cash and other securities; they keep the ledger balances of a client’s cash and collateral account in their back-office system and query this system while placing the order to ensure that the client has enough money in his account. The figure below illustrates this process.

  4. In case a client gives a sell order, the broker checks the client’s custody/demats account to ensure that he has a sufficient balance of securities to honor the sale transaction. Short selling is prohibited in most countries, and brokers need to ensure that the client is not short of securities at the time of settlement, especially in markets that do not have an adequate stock-lending mechanism in place. Most markets have an auction mechanism in place for bailing out people with short positions, but such bailouts could be very expensive. Once the sale transaction is executed, the broker keeps a record and updates the custody balance’s system if it is in-house or keeps reducing the figures from the figures returned by the depository to reflect the client’s true stock account position. In many countries, brokers have a direct interface with the depository system that lets them query the amount of shares of a particular company in which the client has balances. Wherever a direct interface is absent, the broker maintains the figures in parallel; the broker then does a periodic refresh of this data by uploading the figures provided by the depository and maintains a proper intraday position by debiting figures in his system when the clients give sale orders that are executed on the exchange. The figure below illustrates this step.

  5. Once the risk management check passes, the client’s order is forwarded to the exchange.
  6. On receipt of the order, the exchange immediately sends an order confirmation to the broker’s trading system.
  7. Depending upon the order terms and the actual prices prevailing in the market, the order could get executed immediately or remain pending in the order book of the exchange.

You can appreciate the role technology plays when you consider that the entire process of receiving the order, doing risk management checks, forwarding the order to the exchange, and getting back the confirmation is expected to take a few hundredths of a second. Any performance not conforming to this standard is considered unacceptable and could be a serious reason for clients to look for other brokers who can transact faster and get them more aggressive prices.

One of the ways of implementing risk management is through margining. A margin is an amount that clearing corporations levy on the brokers for maintaining positions on the exchange. The amount of margin levied is proportional to the exposure and risk the broker is carrying. Since positions may belong to a broker’s clients, it is the broker’s responsibility to recover margins from clients. Margins make the client stand by trades in case the market goes against the client by the time the trades get settled.

To protect the market from defaulters, clearing corporations levy margins on the date of the trade. Margins are computed and applied to a client’s position in many ways, but the underlying philosophy of levying margins is to tie the customer to a position and preserve the integrity of the market even if a large drop in stock prices occurs.

Order Matching and Conversion into Trade

All orders are aggregated and sent to an exchange for execution. Stock exchanges follow defined rules for matching all the orders they receive. While protecting the interests of each client, the exchange tries to execute orders at the best possible rates. The broker’s trading system communicates with the exchange’s trading system on a real-time basis to know the fate of orders it has submitted.

A broker keeps a record of which orders were entered during the day, by whom, and on behalf of which client. A broker also maintains details of how many orders were transacted and how many are still pending to be executed. Using this system, a broker can modify the order and order terms, cancel the order, and also split the order if required depending upon the behavior of the market and instructions from the clients. Once the order is executed, it gets converted to a trade. The exchange passes the trade numbers to the broker’s system. The broker in turn communicates these trade details to the client either during the day or by the end of the day through a contract note or through an account activity statement. The contract note is a legal document that binds the broker and the client. Contract note delivery is a legal requirement in many countries. Apart from the execution details, the contract note contains brokerage fees and other fees that brokers levy for themselves or collect on behalf of other agencies such as the Clearing Corporation, exchange, or state.

On my next post, I’ll discuss about the last two steps. Have a nice day.

Friday, 21 December 2007

Put-Call Parity

If you have follow through my blog on Black-Scholes formula to derive the theoretical option price using Excel, you would have noticed I did it only for call option. I wanted to find how I can do it to find the pricing for put option too.

I was out last Friday to have dinner with my friends at City Hall. Since they were not there yet I decided to go to the MPH book shop. I was looking around and two books caught my attention. These two books namely, "Advanced modeling in finance using Excel and Vba" and "Option pricing models and volatility using Excel Vba", teach you how to perform a lot of text book written theories using Microsoft Excel. As I flipped through the books when I was waiting for my friends, I found the answer. It is so simple. It’s simply using the put-call parity. How could I forget about that? I knew I learnt that. As such, I decided to test out the theory and to my surprise, it works.

You may be wondering what is put-call parity? To put it in a very simple manner, it is a relationship between the price of a call option and a put option - both with the identical strike price and expiry. A derivation of the put-call parity is based on the payoffs of two portfolio combinations, a fiduciary call and a protective put.

A fiduciary call is a combination of a pure-discount, riskless bond that pays the exercise price X at maturity and a call with exercise price X. The payoff for a fiduciary call at expiration is X when the call is out of the money, and X + (S - X) = S when the call is in the money. S is the underlying share price of the stock.

A protective put is a share of stock together with a put option on the stock. The expiration date payoff for a protective put is (X - S) + S = X when the put is in the money, and S when the put is out of the money.

When the put is in the money, the call is out of the money, and both portfolios pay X at expiration.

Similarly, when the put is out of the money and the call is in the money, both portfolios pay S at expiration.

Put-call parity holds that portfolios with identical payoffs must sell for the same price to prevent arbitrage. We can express the put-call parity relationship as:

c + X / (1 + RFR) ^T = S + P

where X / (1 + RFR) ^T is the present value of the riskless bond that pays the strike price X at maturity.

Equivalencies for each of the individual securities in the put-call parity relationship can be expressed as:

S = c - p + X / (1 + RFR) ^T
p = c - S + X / (1 + RFR) ^T
c = S + P - X / (1 + RFR) ^T
X / (1 + RFR) ^T = S+ p - c

The single securities on the left-hand side of the equations all have exactly the same payoffs as the portfolios on the right-hand side. The portfolios on the right-hand side are the "synthetic" equivalents of the securities on the left. Note that the options must be European-style and the puts and calls must have the same exercise prices for these relations to hold.

Now that we understand what put-call parity is we can derive the put option price by using the following equation:

p = c - S + X / (1 + RFR) ^T

that is, the put option price is simply buying the call option with strike price X, selling the stock at share price S and buying the riskless bond that pays the exercise price X at maturity. Or using the Black-Scholes formula, the price of a put option is:

p = X*e^(-rT)* N(-d2) - S*N(-d1)

With that idea in mind, we can used what I have done in my previous post on Black-Scholes formula to derive the theoretical call option price using Excel to do it similar for the put option pricing.

I'm going to use Coca cola company put option chain as an example here again. Here is the based data I'm going to use and I recommend you use these data first before you used your spreadsheet to model other option chains. You can use OptionXpress to get most of the information required to compute the Coca cola put option price and do a comparison with what is shown on the Coca cola put option chain in OptionXpress as well.

Open an Excel workbook and on one of the worksheets, type in the following data;
  1. In cell A1, type in "Current Stock Value" and use this link provided to get the last traded Coca cola stock price. At this point of writing, the last traded price was US$62.28. Type in this value in B1.
  2. In cell A2, type in "Implied Volatility". Used the Coca cola put option chain link to get the implied volatility for the put option with symbol KONM - Feb 2008 put option with a strike price of US$65.00. At this point of writing, the implied volatility was 18.8%. Type this value in B2.
  3. In cell A3, type in "6-month CD rate (annualized)". You can use this link here to compare the different 6-month CD rate. What I did was I used the best rate available on the site as my 6-month annualized rate. You should look under the heading Annual Percentage Yield for this information. At this point of writing, the best Annual Percentage Yield was still provided by Country Wide Bank but with an Annual Percentage Yield of 5.5%. Type this value in B3.
  4. In cell A4, type in "Dividend Yield". Use the same link from step 1 to get the information. You need to do a little of computation here since the dividend yield is not provided. However, you can simply take the dividend payout per share and divide that value with the share price in step 1. At this point of writing, the dividend payout is US$0.34 per share and the last traded price was US$62.28. Hence the dividend yield is US$0.34/US$62.28 which gave us an approximate 0.55% dividend yield. Type this value in B4.
  5. In cell A5, type "Days to expiration". Use the same link from step 2 to get the information. At this point of writing, the number of days to expiration for KONM was 57 days. Type in this value in B5.
  6. In cell A6, type "Strike Price". Again, use the link from step 2 to get the strike price information. The put option we are using here is the KONM, which has a strike price of US$65.00. Type this value in B6.
  7. In cell A7, type in "Discounted Share Price". Type the following formula in cell B7. =B1*EXP(-B4*B6/365). Hit the Enter key and you should get a value of US$62.23.
  8. In cell A8, type in "Put Option Price (Approximate):". This is the most complicated formula in the entire process here. I suggest you copy what I have here and paste it in cell B8. The formula you should type in cell B8 is =-B7*NORMSDIST(-SUM(LN(B7/B6),SUM(B3,POWER(B2,2)/2)*B5/365)/(B2*POWER(B5/365,0.5)))+B6*EXP(-B3*B5/365)*NORMSDIST(-SUM(LN(B7/B6),SUM(B3,POWER(B2,2)/2)*B5/365)/(B2*POWER(B5/365,0.5))+B2*POWER(B5/365,0.5)). Hit the Enter key and you should get a value of US$3.20. At this point of writing, the last traded price for KONM is US$3.30 but the Bid price is US$3.20.

I guess it is coincident again, but the model does give a very close estimate. Hope you enjoy the exercise. By the way, anyone knows how to do it for Singapore warrants?

Sunday, 16 December 2007

Cents and Sensibility - How the upcoming CPF reforms will affect the way you plan your retirement

You use it to invest, buy property, to pay for your children’s university fees and to cope with medical bills. Now, the Central Provident Fund (CPF) system will be revamped to cater to a fast-ageing Singapore society.

The reason is simple: people are living longer, the average life expectancy today is 80 years old and a United Nations study thinks that Singapore will be the world’s fourth-oldest population by 2050.

“A system designed in 1955 for an average life expectancy of 61, left unattended would falter under the weight of needs as more grow old. It was never meant to support 20% of a population above 65, and numbering nearly 900,000 by 2030. The CPF system needs to be updated and strengthened,” said Dr Ng Eng Hen, Minister for Manpower and Second Minister for Defence at the close of parliamentary debate on the CPF reform in September. Details for the CPF overhaul are still being worked out, but they can be summarized into the following:

  1. Later draw-down for the CPF minimum sum. The Later Drawdown Age (DDA) will be raised progressively from 62 to 63 years in 2012, 64 in 2015 and 65 in 2018.
  2. Higher CPF returns and
  3. Compulsory annuities.

Withdraw Your CPF Minimum Sum at a Later Age (Also Means Work Longer Lah)
What it is – The age to withdraw from the CPF minimum sum account (called the draw-down age) will be raised from 62 years old currently to 63 years in 2012, 64 in 2015 and 65 in 2018.

This is in the form of monthly payouts after you have set aside the minimum sum at the age of 55. The rationale is this: if the account is drawn upon too early, a retiree may outlive his savings. Based on the current scheme earning 4 per cent in interest, the annual income from the minimum sum lasts 20 years, after which the account is depleted. So what will happen to you when the money runs out at a time medical bills are bound to pile up? With a later draw-down age, you will still be able to get a monthly income you need it most.

What this means to you – Because you will be taking out your CPF money at a later age, it means that you’ll probably not be retiring at the magic age of 62. The later draw-down age ties in with changes on the workforce in the form of re-employment laws. By Jan 1, 2012, employers have to offer to re-hire workers when they turn 62 years old, if their health permits. But it may not be in the same job or at the same salary.

When it kicks in – 2012

Key things to note – The minimum sum, which is adjusted yearly for inflation, currently stands at $99,600. It will be raised gradually to $120,000 in 2013.

If you are aged 50 to 57 this year, you will receive a Deferment Bonus (D-Bonus), as you will be affected by the delay in draw-down age. This one-off bonus is up to $1,500.

If you are aged 54 to 63 years old and choose to defer your draw-down, you can get a Voluntary Deferment Bonus (V-Bonus). This is up to $600 for every year deferred.

No bonus will be paid out to CPF members under 54 years old.

Get higher CPF returns
What it is – The first $60,000 of your combined CPF balances, with up to $20,000 from your Ordinary Account (OA), will earn an extra 1% interest. For example, $60,000 in the SMRA – Special, Medisave and Retirement accounts – will earn the member an additional $7,200 over 10 years and $17,900 over 20 years. The rate for the SMRA accounts will also be pegged to a new benchmark: the 10-year Singapore Government bond yield, plus an extra 1 percentage point.

What this means to you – Higher returns for your CPF savings. But from 1st April, 2008, you cannot use the first $20,000 in both the OA and Special Account for investment. Existing investments using CPF monies will not be affected. The re-pegging of the SMRA to bond rates means more room for higher returns, but also the potential for more volatility.

When it kicks in – January 1, 2008

Key things to note – The interest rate for the OA will continue to be guaranteed 2.5 per cent.

The government will grant, as a buffer, a two-year period whereby the SMRA rate is fixed at floor rate of 4 per cent.

After this transition period, the floor rate of 2.5 per cent will still hold. That means that even if the bond rate falls below 1.5 per cent, the rate you will get from the SMRA is fixed at the OA rate of 2.5 per cent.

Compulsory Annuities and Life-Long Pay-out
What it is – All CPF members aged 50 and below must, using a small portion of their CPF minimum sum, buy an annuity when they turn 55.

What this means to you – Premiums to the annuity – also dubbed longevity insurance – goes into a general pool. When you reach 85 years old, you will receive a monthly pay-out of about $250 to $300 until you die. The downside to this – if you pass away before 85 years old, your family will not see the money.

When it kicks in – This compulsory annuity proposal drew the most debate among the three key CPF changes. To address the concerns, the government has setup a committee to study public and professional views for this National Longevity Insurance Scheme. The committee will make recommendations to offer CPF members flexibility and options, such as the possibility of earlier annuity payouts at age 75, instead of 85. The report is expected to be ready in the first quarter of 2008.

Saturday, 15 December 2007

Implied Volatility, Historical Volatility and Volatility Smile

There are so many things I want to share in my blog as I learnt and I'm trying to prioritize what should I blog first. If you have follow through my blog on Black-Scholes formula to derive the theoretical option price using Microsoft Excel, you will noticed that at the end of the day, we are using the Goal Seek function to find implied volatility of the call option. If you have been trading warrants and/or options, chances are, you may come across historical volatility and implied volatility before. What is historical volatility and implied volatility then? And what is volatility smile?

If you understand what are warrants and options, you should know that there are seven factors that influence an option and warrant price. These factors are as follow:

  • The type of option or warrant (call or put)
  • The price of the underlying asset
  • The exercise price or strike price of the option or warrant
  • The expiration date
  • The Risk-free interest rate which is normally taken as the 3-months T-Bills rate
  • Dividends and stock splits
  • Volatility - Implied and Historical

When you trade stocks, you must be aware of volatility. Volatility is a measure of how a security’s price is moving. Volatility is recognized as a measure of risk. If a stock price fluctuates all over the place in wild swings, then you had find it uncomfortable because you would not have a clue what it was going to do next, and it would feel risky. On the other hand, if a stock price remains static all the time, then you might get a bit bored and feel that it might lack liquidity. Hence, higher volatility is predicted by wider and faster price fluctuations. This means greater risk. The greater the volatility, the more expensive options and warrants premiums become as there is higher chance that a currently out or at the money option or warrant may become in the money. However, the reverse is true as well.

Volatility is calculated by measuring the standard deviation of the closing prices, and then expressed as annualized percentage figure. Volatility is not directional. Vega measures an option’s or warrant’s sensitivity to the stock’s volatility. This volatility is known as the historical or statistical volatility. On the price charts, Bollinger Bands can provide a visual representation of volatility.

I shall give an example on how to interpret historical volatility. Suppose a stock is trading at $10 with a 30d historical volatility of 10%, then, based on the theories of statistics, there is a 68% probability of the time that the stock will be trading within the range of $10 +/- $10 x 10%, i.e. 1 standard deviation away from the mean. Similarly, there will be a 95% probability of the time that the stock will be trading within the range of $10 +/- $10 x 1.96 x 10%, i.e. 1.96 or approximately 2 standard deviations away from the mean. I purposely choose a 30d historical volatility so I can assume the distribution is normal, there are some books which actually used 20d historical volatility.

Recall from above the seven factors influencing the option and warrant price. Six of the variables are known with certainty. The only variable that is now known with certainty is the expected or implied volatility of the stock going forward.

Though there is a saying of history repeats itself, historical volatility does not necessary predict where the price of the underlying will move towards in future. This is what the weak efficient market hypothesis is trying to prove. As such, there are several mathematical models for calculating the theoretical value of an option or warrant. The Black-Scholes is one such model. To be more exact, the Black-Scholes option pricing model is really used for American-style options (I did not mention warrant here as warrants in Singapore are all European-style or rather a more exact term should be Asian-style, especially for stock warrants) and the Black’s option pricing model for European-style option and warrant. In general, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets.

Lastly, the volatility smile is a common graphical shape that results from plotting the strike price and implied volatility of a group of options with the same expiration date. A picture speaks a thousand words. The image below will provide a better illustration why is it known as a volatility smile. :)

Thursday, 13 December 2007

Option Ticker Symbol

Have you ever wonder how are those option ticker symbols being constructed? Is there a special way to name them? If you read my post yesterday, I used the Coca cola call option KOBM as an example to illustrate how the Black-Scholes model can be used to compute the call option price. Why do they named the Coca cola call option that expire in Feb 2008 with a strike price of US$65.00 as KOBM?

Simple as it seems, the option ticker symbol does tell us a lot of information if we know how to interpret it. Take a look at the three tables below.
I guess you may have guess how is the call option symbol being constructed after seeing these three tables. If you still do not have any clue, here is how the Coca cola call option that expire in Feb 2008 with a strike price of US$65.00 symbol is constructed. KO is the stock symbol for Coca cola company. From the Call/Put table, B represents a call option expiring in Feb. M represents the strike price of US$65.00 is our case here from Price Table 1. Interesting? Perhaps you can figure out what AQI means? If you say AQI is the Agilent Technologies put option that expire in May 2008 with a strike price of US$45.00, then BINGO! You got it right. Hope you have fun.

Wednesday, 12 December 2007

The Black-Scholes formula

I came across the Black-Scholes model many times and hence I decided to invest a little time to find out more about the Black-Scholes formula to derive the price of the call option using the excel spreadsheet today. I tried to apply what I learnt from this book “Financial Modeling for Managers with Excel Applications”, with real life call option chains and I’m surprise I can get a good approximate of the call option price with different maturity, strike price, dividend yield etc.

I was very excited and showed my colleague what I did on the spreadsheet with slight modification. I would like to share with the readers of my blog too. If you are interested, just follow the steps I’m going to illustrate here and put them onto a spreadsheet to see how it can work for you.

The Black-Scholes model derives the following equation for the price c of a call option:
where: N(d) is the value of the Normal distribution function at the point d; d = d1 or d2. The other symbols are defined as follows:

You will notice in this formula that the price does not depend upon the mean μ. In everyday language, investor expectations are irrelevant to the price of the option. This may seem like a startling statement. However, it is simply a reflection of the fact that investor expectations do play a role, but only in the price of the underlying physical. The option itself is purely a play on the physical, and the effects of changing expectations can be hedged away by means of the corresponding effect on the physical (the latter being the hedge).

However, this hedging process does not apply to the volatility σ, which appears unavoidably in the price of the option. You can see intuitively why this must be true. Compare two call options, one with a high volatility and the other with low. Suppose that the option is a call option, which is currently a bit out of the money. In other words, the current physical price is slightly less than the strike price of the option, so you would get nothing if you decided to cash in your chip at this point in time. Of course you wouldn’t decide to cash in now anyway, because though your chip is out of the money right now, it could well be in the money at some time in the future. It is definitely worth something because of that possibility; hence, the option price is by no means zero. The option with a higher volatility has more chance of getting back in the money next period than does the one with the lower volatility, so it makes sense that it is worth more.

Nevertheless, you do have to be able to form an estimate of the physical’s volatility, and we shall discuss this below. In the meantime, we note that if we knew what the option was currently trading for, then we could use an equation to reverse the process and solve for the implied volatility in terms of the current price of the option. This process is called backing out the implied volatility.

Backing out implied volatility using Goal Seek

I'm going to use Coca cola company call option chain as an example here. Here is the based data I'm going to use and I recommend you use these data first before you used your spreadsheet to model other option chains. You can use OptionXpress to get most of the information required to compute the Coca cola call option price and do a comparison with what is shown on the Coca cola call option chain in OptionXpress as well.

Open an Excel workbook and on one of the worksheets, type in the following data:

  1. In cell A1, type in "Current Stock Value" and use this link provided to get the last traded Coca cola stock price. At this point of writing, the last traded price was US$62.97. Type in this value in B1.
  2. In cell A2, type in "Implied Volatility". Used the Coca cola call option chain link to get the implied volatility for the call option with symbol KOBM - Feb 2008 call option with a strike price of US$65.00. At this point of writing, the implied volatility was 18.7%. Type this value in B2.
  3. In cell A3, type in "6-month CD rate (annualized)". You can use this link here to compare the different 6-month CD rate. What I did was I used the best rate available on the site as my 6-month annualized rate. You should look under the heading Annual Percentage Yield for this information. At this point of writing, the best Annual Percentage Yield was provided by Country Wide Bank with an Annual Percentage Yield of 5.35%. Type this value in B3.
  4. In cell A4, type in "Dividend Yield". Use the same link from step 1 to get the information. You need to do a little of computation here since the dividend yield is not provided. However, you can simply take the dividend payout per share and divide that value with the share price in step 1. At this point of writing, the dividend payout is US$0.34 per share and the last traded price was US$62.97. Hence the dividend yield is US$0.34/US$62.97 which gave us an approximate 0.54% dividend yield. Type this value in B4.
  5. In cell A5, type "Days to expiration". Use the same link from step 2 to get the information. At this point of writing, the number of days to expiration for KOBM was 65 days. Type in this value in B5.
  6. In cell A6, type "Strike Price". Again, use the link from step 2 to get the strike price information. The call option we are using here is the KOBM, which has a strike price of US$65.00. Type this value in B6.
  7. In cell A7, type in "Discounted Share Price". Type the following formula in cell B7. =B1*EXP(-B4*B6/365). Hit the Enter key and you should get a value of US$62.91.
  8. In cell A8, type in "Call Option Price (Approximate):". This is the most complicated formula in the entire process here. I suggest you copy what I have here and paste it in cell B8. The formula you should type in cell B8 is =B7*NORMSDIST(SUM(LN(B7/B6),SUM(B3,POWER(B2,2)/2)*B5/365)/(B2*POWER(B5/365,0.5)))-B6*EXP(-B3*B5/365)*NORMSDIST(SUM(LN(B7/B6),SUM(B3,POWER(B2,2)/2)*B5/365)/(B2*POWER(B5/365,0.5))-B2*POWER(B5/365,0.5)). Hit the Enter key and you should get a value of US$1.35. At this point of writing, the last traded price for KOBM is indeed US$1.35.

I guess it's really coincident to get an exact match for the option price for KOBM. Use the spreadsheet to test out the price of the other call options. The last step of this is to use the Goal Seek function to compute the Implied Volatility for different option prices. Click on Tools > Goal Seek or if you are using Excel 2007, click Data > What-If Analysis > Goal Seek. Follow the steps below and compute the implied volatility when the option price goes to US$2.00.

  1. In the "Set cell:", select the cell B9.
  2. In the "To value:", type in 2.
  3. In the "By changing cell:", select cell B2.
  4. Click Ok. You should see the implied volatility changed to 24.96% in cell B2.

Hope you have as much fun as I do. I'm trying to see how I can apply the same formula to put option as well as warrants in Singapore. Cheers

Monday, 10 December 2007

The Corporate Governance Of Listed Companies: A Manual For Investors (Part 3)

This is my last post of the Corporate Governance of Listed Companies. In this last post, I’m going to discuss about the companies’ policies relating to voting rules, share owner sponsored proposals, common stock classes and takeover defenses.

The ability to vote proxies is a fundamental shareholder right. If the firm makes it difficult to vote proxies, it limits the ability of shareholders to express their views and affect the firm's future direction. Investors should consider whether the firm:
  • Limits the ability to vote shares by requiring attendance at annual meeting.
  • Groups its meetings to be held the same day as other companies in the same region and also requires attendance to cast votes.
  • Allows proxy voting by some remote mechanism.
  • Is allowed under its governance code to use share blocking, a mechanism that prevents investors who wish to vote their shares from trading their shares during a period prior to the annual meeting.

Investors should determine if shareholders are able to cast confidential votes. This can encourage unbiased voting. In looking at this issue, investors should consider whether:

  • The firm uses a third party to tabulate votes.
  • The third party or the firm retains voting records.
  • The tabulation is subject to audit.
  • Shareholders are entitled to vote only if present.

Shareholders may be able to cast the cumulative number of votes allotted to their shares for one or a limited number of board nominees. Be cautious in the event the firm has a considerable minority shareholder group, such as a founding family, that can serve its own interests through cumulative voting. Information on possible cumulative voting rights will be contained in the articles of organization and by-laws and the prospectus.

Changes to corporate structure or policies can change the relationship between shareholders and the firm. Watch for changes to:

  • Articles of organization.
  • By-laws.
  • Governance structures.
  • Voting rights and procedures.
  • Poison pill provisions (these are impediments to an acquisition of the firm).
  • Provisions for change-in –control.

Regarding issues requiring shareholder approval consider whether shareholders:

  • Must approve corporate change proposal s with supermajority votes.
  • Will be able to vote on the sale of the firm, or part of it, to a third-party buyer.
  • Will be able to vote on major executive compensation issues.
  • Will be able to approve any anti-takeover measures.
  • Will be able to periodically reconsider and re-vote on rules that require supermajority voting to revise any governance documents.
  • Have the ability to vote for changes in articles of organization, by-laws, governance structures, and voting rights and procedures.
  • Have the ability to use their relatively small ownership interest to force a vote on a special interest issue.

Investors should also be able to review issues such as:

  • Share buy-back programs that may be used to fund share- based compensation grants.
  • Amendments or other changes to a firm's charter and by-laws.
  • Issuance of new capital stock.

Investors need to determine whether the firm's shareholders have the power to put forth an independent board nominee. Having such flexibility is positive for investors as it allows them to address their concerns and protect their interests through direct board representation. Additional items to consider:

  • Under what circumstances can a shareholder nominate a board member?
  • Can share owners vote to remove a board member?
  • How does the firm handle contested board elections?

The proxy statement is a good source document for information about these issues in the United States. In many jurisdictions, articles of organization and corporate by-laws are other good sources of information on shareholder rights.

The right to propose initiatives for consideration at the annual meeting is an important shareholder method to send a message to management. Investors should look at whether:

  • The firm requires a simple majority or a super majority vote to pass a resolution.
  • Shareholders can hold a special meeting to vote on a special initiative.
  • Shareholder-proposed initiatives will benefit all shareholders, rather than just a small group.

Investors should find out if the board and management are required to actually implement any shareholder approved proposals. Investors should determine whether:

  • The firm has implemented or ignored such proposals in the past.
  • The firm requires a super majority of votes to approve changes to its by-laws and articles of organization.
  • Any regulatory agencies have pressured firm s to act on the terms of any approved shareholder initiatives.

Different classes of common equity within a firm may separate the voting rights of those shares from their economic value. Firms with dual classes of common equity could encourage prospective acquirers to only deal directly with shareholders with the super majority rights. Firms that separate voting rights from economic rights have historically had more trouble raising equity capital for fixed investment and product development than firms that combine those rights. When looking at a firm's ownership structure, examine whether:

  • Safeguards in the by-laws and articles of organization protect shareholders who have inferior voting rights.
  • The firm was recently privatized by a government entity and the selling entity retained voting rights. This may prevent shareholders from receiving full value for their shares.
  • Any super-voting rights kept by certain classes of shareholders impair the firm's ability to raise equity capital. If a firm has to turn to debt financing, the increase in leverage can harm the firm.

Information on these issues can be found in the proxy, web site, prospectus, or notes to the financial statements.

Examine whether the investor has the legal right under the corporate governance co de and other legal statutes of the jurisdiction in which the firm is headquartered to seek legal redress or regulatory action to enforce and protect shareholder rights. Investors should determine whether:

  • Legal statutes allow shareholders to take legal actions to enforce ownership rights.
  • The local market regulator, in similar situations, has taken action to enforce shareholder rights.
  • Shareholders are allowed to take legal or regulatory action against the firm's management or board in the case of fraud.
  • Shareholders have “dissenters ' rights" which require the firm to repurchase their shares at fair market value in the even t of a problem.

Takeover defenses include golden parachutes, poison pills, and greenmail (use of corporate funds to buy back the shares of a hostile acquirer at a premium to their market value). All of these defenses may be used to counter a hostile bid, and their probable effect is to decrease share value. When reviewing the firm's takeover defenses, investors should:

  • Ask whether the firm requires shareholder approval to implement such takeover measures.
  • Ask whether the firm has received any acquisition interest in the past. Consider that the firm may use its cash to "pay off" a hostile bidder. Shareholders should take steps to discourage this activity.
  • Consider whether any change of control issue s would invoke the interest of a national or local government and, as a result, pressure the seller to change the terms of the acquisition or merger.

Although most of the points mentioned here are based in the US contact. However, the points served as a guideline to take note of when investing in stock anywhere in the world. Personally I feel that this is an area where investors will not spend much time with although it is equally important to know about the corporate governance as well as what and how the company is doing.

The few recent cases that happened here in Singapore are good examples. We may not be able to identify them and avoid it but some understanding how the corporate governance may help investors to be smarter in their next investment.

Sunday, 9 December 2007

The Corporate Governance Of Listed Companies: A Manual For Investors (Part 2)

This is a continuation of my previous post. Besides those points that I mentioned from my previous post, there are a few more things that investors need to look out for in the Corporate Governance of Listed Companies.

A code of ethics for a firm sets the standard for basic principles of integrity, trust, and honesty. It gives the staff behavioral standards and addresses conflicts of interest. Ethical breaches can lead to big problems for firms, resulting in sanctions, fines, management turnover, and unwanted negative publicity. Having an ethical code can be a mitigating factor with regulators if a breach occurs.

When analyzing ethics codes, these are items to be considered:
  • Make sure the board of directors receives relevant corporate information in a timely manner.
  • Ethics codes should be in compliance with the corporate governance laws of the location country and with the governance requirements set forth by the local stock exchange. Firms should disclose whether they adhered to their own ethical code, including any reasons for failure.
  • The ethical code should prohibit advantages to the firm's insiders that are not offered to shareowners.
  • A person should be designated to be responsible for corporate governance.
  • If selected management personnel receive waivers from the ethics code, reasons should be given.
  • If any provisions of the ethics code were waived recently, the firm should explain why.
  • The firm's ethics code should be audited and improved periodically.

In evaluating management, investors should:

  • Verify that the firm has committed to an ethical framework and adopted a code of ethics.
  • See if the firm permits board members or management to use firm assets for personal reasons.
  • Analyze executive compensation to assess whether it is commensurate with responsibilities and performance.
  • Look into the size, purpose, means of financing, and duration of any share-repurchase programs.

Beside the management, we have to be aware of the Audit committee, the Nominations committee and other Board committee. We need also to be aware of the remuneration and compensation package to analyze if they are tied with their responsibilities and performance.

The Audit committee ensures that the financial information provided to shareholders is complete, accurate, reliable, relevant, and timely. Investors must determine whether:

  • Proper accounting and auditing procedures have been followed.
  • The external auditor is free from management influence.
  • Any conflicts between the external auditor and the firm are resolved in a manner that favors the shareholder.
  • Independent auditors have authority over the audit of all the company's affiliates and divisions.
  • All board members serving on the audit committee are independent.
  • Committee members are financial experts.
  • The shareholders vote on the approval of the board's selection of the external auditor.
  • The audit committee has authority to approve or reject any proposed non-audit engagements with the external audit firm.
  • The firm has provisions and procedures that specify to whom the internal auditor reports. Internal auditors must have no restrictions on their contact with the audit committee.
  • There have been any discussions between the audit committee and the external auditor resulting in a change in financial reports due to questionable interpretation of accounting rules, fraud, etc.
  • The audit committee controls the audit budget.

Investors should be sure a committee of independent board members sets executive compensation, commensurate with responsibilities and performance. The committee can further these goals by making sure all committee member s are independent, and by linking compensation to long-term firm performance and profitability.

Investors, when analyzing this committee, should determine whether:

  • Executive compensation is appropriate.
  • The firm has provided loans or the u se of company property to board members.
  • Committee members attend regularly.
  • Policies and procedures for this committee are in place.
  • The firm has provided details to shareholders regarding compensation in public documents.
  • Terms and conditions of options granted are reasonable.
  • Any obligations regarding share-based compensation are met through issuance of new shares.
  • The firm and the board are required to receive shareholder approval for any share-based remuneration plans, since these plans can create potential dilution issues.
  • Senior executives from other firms have cross-directorship links with the firm or committee members. Watch for situations where individuals may benefit directly from reciprocal decisions on board compensation.

The nominations committee handles recruiting of new (independent) board members. It is responsible for:

  • Recruiting qualified board members.
  • Regularly reviewing performance, independence, skills, and experience of existing board members.
  • Creating nomination procedures and policies.
  • Preparing an executive management succession plan.

Candidates proposed by this committee will affect whether or not the board works for the benefit of shareholders. Performance assessment of board members should be fair and appropriate. Investors should review company reports over several years to see if this committee has properly recruited board members who have fairly protected shareholder interests. Investors should also review:

  • Criteria for selecting new board members.
  • Composition, background, and expertise of present board members. How do proposed new members complement the existing board?
  • The process for finding new members (i.e., input from outside the firm versus management suggestions).
  • Attendance records.
  • Succession plans for executive management (if such plans exist).
  • The committee's report, including any actions, decisions, and discussion.

Additional or other board committees can provide more insight into goals and strategies of the firm. These committees are more likely to fall outside typical corporate governance codes, so they are more likely to be comprised of members of executive management. Be wary of this-independence is once again critical to maintain shareowners' best interests.

I'll continue on my next post regarding the companies' policies with regard to voting rules. Cheers.

Friday, 7 December 2007

The Corporate Governance Of Listed Companies: A Manual For Investors (Part 1)

There are many times when investors invest, they do not really know what the companies they are investing in are doing, let alone if their managements are good in managing and sustaining the businesses. It is very important to know what are the directions of the management and if the managements have the best of shareholders' interests.

Corporate governance is the set of internal controls, processes, and procedures by which firms are managed. It defines the appropriate rights, roles, and responsibilities of management, the board of directors, and shareholders within an organization. It is the firm's checks and balances. Good corporate governance practices seek to ensure that:

  • The board of directors protects shareholder interests.
  • The firm acts lawfully and ethically in dealings with shareholders.
  • The rights of shareholders are protected and shareholders have a voice in governance.
  • The board acts independently from management.
  • Proper procedures and controls cover management's day-to-day operations.
  • The firm's financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner.

To properly protect their long-term interests as shareholders, investors should consider whether:

  • A majority of the board of directors is comprised of independent members (not management).
  • The board meets regularly outside the presence of management.
  • The chairman of the board is also the CEO or a former CEO of the firm. This may impair the ability and willingness of independent board members to express opinions contrary to those of management.
  • Independent board members have a primary or leading board member in cases where the chairman is not independent.
  • Board members are closely aligned with a firm supplier, customer, share-option plan or pension adviser. Can board members recuse themselves on any potential areas of conflict?
  • A non-independent board is more likely to make decisions that unfairly or improperly benefit management and those who have influence over management. These also may harm shareholders' long-term interests.

There is often a need for specific, specialized, independent advice on various firm issues and risks, including compensation, mergers and acquisitions, legal, regulatory, and financial matters, and issues relating to the firm's reputation. A truly independent board will have the ability to hire external consultants without management approval. This enables the board to receive specialized advice on technical issues and provides the board with independent advice that is not influenced by management interests.

The board election should be held frequently. Anything beyond a two- or three-year limit on board member tenure limits shareowners' ability to change the board's composition if board members fail to represent shareowners' interests fairly. While reviewing firm policy regarding election of the board, investors should consider:

  • Whether there are annual elections or staggered multiple-year terms (a classified board). A classified board may serve another purpose-to act as a takeover defense.
  • Whether the board filled a vacant position for a remaining term without shareholder approval.
  • Whether shareholders can remove a board member.
  • Whether the board is the proper size for the specific facts and circumstances of the firm.

An independent board member must work to protect shareholders' long-term interests. Board members need to have not only independence, but experience and resources. The board of directors must have autonomy to operate independently from management.

If board members are not independent, they may be more likely to make decisions that benefit either management or those who have influence over management, thus harming shareholders' long-term interests.

To make sure board members act independently, the firm should have policies in place to discourage board members from receiving consulting fees for work done on the firm's behalf or receiving finders' fees for bringing mergers, acquisitions, and sales to management's attention. Further, procedures should limit board members' and associates' ability to receive compensation beyond the scope of their board responsibilities.

The firm should disclose all material related party transactions or commercial relationships it has with board members or nominees. The same goes for any property that is leased, loaned, or otherwise provided to the firm by board members or executive officers. Receiving personal benefits from the firm can create conflicts of interest.

Board members without the requisite skills and experience are more likely to defer to management when making decisions. This can be a threat to shareholder interests.

When evaluating the qualifications of board members, consider whether board members:

  • Can make informed decisions about the firm's future.
  • Can act with care and competence as a result of their experience with:
    • Technologies, products, services which the firm offers.
    • Financial operations and accounting and auditing topics.
    • Legal issues.
    • Strategies and planning.
    • Business risks the firm faces.
  • Have made any public statements indicating their ethical stances.
  • Have had any legal or regulatory problems as a result of working for or serving on the firm's board or the board of another firm.
  • Have other board experience.
  • Regularly attend meetings.
  • Are committed to shareholders. Do they have significant stock positions? Have they eliminated any conflicts of interest?
  • Have necessary experience and qualifications.
  • Have served on board for more than ten years. While this adds experience, these board members may be too closely allied with management.

Investors should also consider how many board and committee meetings are held, and the attendance record of the meetings; whether the board and its committees conduct self-assessments; and whether the board provides adequate training for its members.

There are more things in the corporate governance that investors should be aware of. I shall mention them in my next post.

Tuesday, 4 December 2007

What are Treasury securities?

If you are new to the finance world and you have heard people saying things like T-Bonds, T-Notes or take the risk free rate as the 3-months T-Bills rate etc., you might be wondering what those things are. What exactly are Treasury securities?

Treasury securities (Treasuries) are issued by the U.S. Treasury. Because they are backed by the full faith and credit of the U.S. government, they are considered to be free from credit risk (though they're still subject to interest rate/price risk). The Treasury issues three distinct types of securities: bills, notes and bonds, and inflation-protected securities.

Treasury bills (T-bills) have maturities of less than one year and do not make explicit interest payments, paying only the face (par) value at the maturity date. T-bills are sold at a discount to par value and interest is received when the par value is paid at maturity (like zero-coupon bonds). The interest on T-bills is sometimes called implicit interest since the interest (difference between the purchase price and the par value) is not made in a separate "explicit" payment, as it is on bonds and notes. Securities of this type are known as pure discount securities.

  • There are three maturity cycles: 28, 91, and 182 days, adjustable by one day (up or down) due to holidays. They are also known as 4-week, 3-month, and 6-month T-bills, respectively.
  • Periodically, the Treasury also issues cash management bills with maturities ranging from a few days to six months to help overcome temporary cash shortages prior to the quarterly receipt of tax payments.

Treasury notes and Treasury bonds pay semiannual coupon interest at a rate that is fixed at issuance. Notes have original maturities of 2, 3, 5, and 10 years. Bonds have original maturities of 20 or 30 years. Although many bonds are still outstanding and still traded, the Treasury is not currently issuing new bonds.

Prior to 1984, some Treasury bonds were issued that are callable at par five years prior to maturity. The Treasury has not issued callable bonds since 1984.

Treasury bond and note prices in the secondary market are: quoted in percent and 32nds of 1% of face value. A quote of 102-5 (sometimes 102:5) is 102% plus 5/32% of par, which for a $100,000 face value T-bond, translates to a price of $102,156.25.

Since 1997, the Treasury has issued Treasury Inflation-Protected Securities (TIPS). Currently, only notes are offered but some inflation-protected 20- and 30-year bonds were previously issued and trade in the secondary market. The details of how TIPS work are as follow:

  • TIPS make semiannual coupon interest payments at a rate fixed at issuance, just like notes and bonds.
  • The par value of TIPS begins at $1,000 and is adjusted semiannually for changes in the Consumer Price Index (CPI). Even if there is deflation (falling price levels), the par value can never be adjusted to below $1,000. The fixed coupon rate is paid semiannually as a percentage of the inflation adjusted par value.
  • Any increase in the par value from the inflation adjustment is taxed as income in the year of the adjustment: TIPS coupon payment = inflation-adjusted par value multiply by 0.5 multiply by stated coupon rate.

Treasury issues are divided into two categories based on their vintage:

  • On-the-run issues are the most recently auctioned Treasury issues.
  • Off-the-run issues are older issues that have been replaced (as the most traded issue) by a more recently auctioned issue. Issues replaced by several more recent issues are known as well off-the-run issues.

The distinction is that the on-the-run issues are more actively traded and therefore more liquid than off-the-run issues. Market prices of on-the-run issues provide better information about current market yields.

Since the US Treasury does not issue zero-coupon notes and bonds, investment bankers began stripping the coupons from Treasuries to create zero-coupon securities of various maturities to meet investor demand. These securities are termed stripped Treasuries or Treasury strips. In 1985, the Treasury introduced the Separate Trading of Registered Interest and Principal Securities (STRIPS) program. Under this program, the Treasury issues coupon bearing notes and bonds as it normally does, but then it allows certain government securities dealers to buy large amounts of these issues, strip the coupons from the principal, repackage the cash flows, and sell them separately as zero-coupon bonds, at discounts to par value.

For example, a 15-year T-note has 30 coupons and one principal payment; these 31 cash flows can be repackaged and sold as 31 different zero-coupon securities. The stripped securities (Treasury strips) are divided into two groups:

  • Coupon strips (denoted as ci) refers to strips created from coupon payments stripped from the original security.
  • A principal strip refers to bond and note principal payments with the coupons stripped off. Those derived from stripped bonds are denoted bp and those from stripped notes np.

STRIPS are taxed by the IRS on their implicit interest (movement toward par value), which, for fully taxable investors, results in negative cash flows in years prior to maturity. The Treasury STRIPS program also created a procedure for reconstituting Treasury notes and bonds from the individual pieces allowing arbitraging opportunities.

That is a very brief introduction to the Treasury securities. Hope the introduction clarifies some doubts you may have. Cheers.

Monday, 3 December 2007

Commodities Investment

Hi it’s been a long time since I last updated my blog. I was busy preparing for my CFA examination. It’s over now and I'm back again :)

If you have flipped through the papers recently or have listen to the news, I guess the most commonly heard news beside the Cambodia tragedy was the rising prices of almost everything but not your salary :( If you have read about Dr Money column about inflation, he demonstrated a simple seven steps process of setting your own inflation rate to manage your expenses more efficiently. He mentioned in his step 6 that commodities and property do well in inflationary times. There are however many commodities related securities that one can invest in.

Investing in commodities gives an investor exposure to an economy's production and consumption growth. When the economy experiences growth, the demand for commodities increases, and price increases are likely. When housing starts to increase, the demand for sand, bricks, cement etc. increase; when automobile sales are high, the demand for steel is likely high as well. During recessions, commodity prices are likely to fall with decreased demand. Overall, swings in commodity prices are likely to be larger than changes in finished goods prices.

The motivation for investing in commodities may be as an inflation hedge as what Dr Money had mentioned or for hedging purposes or for speculation on the direction of commodity prices over the near term. Most investors do not invest directly in commodities that need to be transported and stored. Passive investors who hold commodities as an asset class for diversification or those who hold commodities as a long-term inflation hedge are more likely to invest in a collateralized futures position. A collateralized futures position or collateralized futures fund is a combination of an investment in commodity futures and an investment in Treasury securities equal in value to the value of the futures position. Active investors may invest in commodity futures in an attempt to profit from economic growth that is associated with higher commodity prices.

Commodity-linked equity investments also provide exposure to commodity price changes. Shares of commodity producing companies are likely to experience returns that are strongly tied to the prices of the commodities produced. This may be especially true for the shares of smaller, less diversified commodity producing firms.

Commodity-linked bonds provide income as well as exposure to commodity price changes since the overall return is based on the price of a single commodity such as gold or oil. Other commodity-linked bonds are linked to inflation through payments based on inflation or a commodity price index. These bonds may be attractive to a fixed-income portfolio manager who wants exposure to commodity price changes but cannot invest either directly in commodities or in derivative securities.

Having mentioned so much about commodities investment, some of you may be ready to seek out stock related to commodities and hope to profit from them when inflation kicks in. Inflation in 2005 was 0.5 per cent. It doubled to 1 per cent in 2006. This year, it will be about 2 per cent. Last month, the Government forecast 2008 inflation to be 2 to 3 per cent. Now, the official forecast is 3.5 to 4.5 per cent. These figures seem too good to let go of any investment opportunities in commodities.

Nevertheless remember that the short-term market is always irrational. For students from the WA08 class, remember what Conrad mentioned to us? In case you have forgotten, he told us to avoid oil, energy and utilities stocks as they move along with supply and demand of the economy and fluctuate with the prices of commodities. You should understand better why he said that now.