Neaven's Corner

Happy "牛" Year

2009-01-26T08:11:00.005+08:00

給您拜個年

祝您

身体健康, 春风满面

吉祥如意, 恭喜发财！

Interesting Market Statistics - Market Crash and Power Shift

2009-01-14T14:09:00.003+08:00

Hi my readers, it has really been a super long time since I last blogged. All this while, I have been thinking what I should be blogging? For the past few months, I have been learning about option trading and practicing on the virtual account on the Think or Swim (TOS) platform. The more I learnt about option trading, the more I find it more flexible than warrants and stocks trading in term of risk management, cost efficiency and how quickly I can morph my losing trade to a winning trade or at least minimize my loss. I have thought of sharing about option trading on my blog here but I realized there have been a lot of other blogs blogging about option trading. In fact, I find the option university blog one of the best blogs I read so far. It is really a good place to start learning about option fundamental and its application in the market.

The market has been going down since last October 2008 except for the period during Christmas where we see the Christmas rally. However, since the beginning of this year, the market is about 6.5% down from the close of January 01, 2009. If the January barometer is anything to go by, it looks like 2009 is going to be worse than 2008.

On top of that, there is something which I would like to share with my readers. This is something that Conrad had shared with us. 40 years ago in 1969, a year after the 1968 election year that saw a power shift, the market crashed. Yet another 40 years before that, back in 1929, a year after the 1928 election year, we also have a power shift and the market also crashed, it is likely that history will repeat itself in 2009, a year after a power shifting election year and 40 years after. Isn’t it interesting to see how numbers and statistics play out in the market?

The global recession and meltdown in world markets has more than halved the STI from 3,800 (its high) to 1,880 over 2008. The 50% decline in the STI was the largest annual fall in its 42-year history. From October 2007 through November 2008, the S&P 500 declined 52%, making it the third- worst bear market since the 1929crash. What is most amazing is the speed at which the markets declined. In history, it generally takes 2 years for the market to decline by 40%-50%. This time, it took only ONE YEAR. Reasons being the de-leveraging of hedge funds that were super highly geared and also because computerized trading and the speed at which information travels.

It is the general consensus that continued problems in the credit markets and the ongoing recession, means that 2009 will likely be even a worse year for the economy than 2008 as effects of the financial crisis spreads to the rest of the economy. The economy is expected to continue to contract, residential construction and prices should continue to decline, and the unemployment rate is continued to rise.The good news is that there will be a huge stimulus package which could total as much as $500 billion or even more. This in addition to the slashing of interest rates should turn the economy around by end 2009 to early 2010 (cross my finger). However, seeing that the stock market precedes the economy, stocks should start to recover before then (cross my finger again).

Actual Operation of Warrant Trading (Part 6)

2008-07-14T06:44:00.001+08:00

This is the last post of the Actual Operation of Warrant Trading. In our last post, we will talk about the last trading day, expiry date and payout date.

If an investor waits until the maturity to ask the broker to sell his warrant holdings on hand, the instruction may be rejected. It is because that the last trading day has passed!

If it is only at the last minute that you find out the last trading day is before the expiry date, you might have lost the last chance for selling. Under the requirements of the Singapore stock exchange, the last trading day of a warrant must be the fourth trading day (excluding any Saturday, Sunday or public holiday) before its expiry date. In fact, investors may work that out for themselves with reference to the expiry date disclosed by the issuer.

Let us look at the example of SPCSGAECW081013. From the code, the expiry date is on the 13th October 2008 and the last day of trading will be on 7th October 2008 that is fourth trading day before expiry. Based on these terms, the trading came to an end after 7th October 2008.

When a warrant has expired, the issuer will transfer the settlement amount to the securities settlement account of the investor through the Central Depository (CDP). Generally, the payout date is around three working days afterwards when the money is transferred to the CDP (depending on the specific arrangements of the issuer concerned). The money will then be redirected to the investor by his or her broker or bank.

There will always be 5 valuation dates. In other words, the closing price of a valuation date may be used twice should there be a Market Disruption Event (MDE) on the previous valuation date. The Macquarie Warrant Hotshot competition begins today at 0900H, all the best for those who have sign up for the game.

Actual Operation of Warrant Trading (Part 5)

2008-07-13T12:42:00.011+08:00

With the Macquarie Warrant Hotshot Competition starting tomorrow, it is time for me to post the last two posts on Actual Operation of Warrant Trading. In this post, we will focus on the calculation of settlement price.

The method of calculation of settlement price differs for stock warrants, index warrants and other types of warrants. In general, it is not as complicated as one might think. We will discuss only the calculation method for standard warrants. We will not be touching on the settlement for exotic warrants.

Stock Warrant

The settlement level of a stock warrant is the average closing price of its underlying for the five trading days immediately preceding the expiry date. This is true across most of the warrant issuers that I have studied. Take for example, the call warrant OCBCSGAECW080707 which is issued by Société Générale (SGA) on the underlying OCBC counter which expires on 7th July 2008 with a strike of S$8.00. The conversion ratio on this warrant is 1:3 which means we need three warrants to convert into a single OCBC stock.

The settlement calculation is computed as follow,

For call: Max { [(Settlement Price – Strike Price) ÷ Conversion Ratio ] ÷ Exchange Rate., 0 }

For put: Max { [(Strike Price - Settlement Price) ÷ Conversion Ratio ] ÷ Exchange Rate., 0 }

Based on the above formula, we need to know how to compute the settlement price so we can do the computation for the settlement at expiry.

From the screen capture above, the last five trading days prior the expiry date of the call warrant on 7th July 2008 are 30th June, 1st July, 2nd July, 3rd July and 4th July. Notice 5th and 6th July are weekends and are not consider part of trading days. The settlement price is calculated as follow, based on the closing price at the end of each trading day.

(S$8.17 + S$8.07 + S$8.15 + S$8.08 + S$8.05) ÷ 5 = S$8.104

This is above the strike of S$8.00 which is ITM and hence the settlement calculation is

Max { [(S$8.104 - S$8.00) ÷ 3] ÷ S$1.00, 0 } = S$0.034667 per warrant.

Hence if you have bought 10 lots of OCBCSGAECW080707, you will have receive a payment of S$0.034667 X 10 X 1000 = S$346.67.

Let’s take a look at the call warrant SPCSGAECW080707 on the underlying SPC counter which expires on 7th July 2008 too with a strike of S$7.88. The conversion ratio on this warrant is 1:5 which means we need five warrants to convert into a single SPC stock.

The screen capture above showed the last five trading days prior the expiry date of the call warrant. Again, the settlement price is calculated as follow, based on the closing price at the end of each trading day.

(S$6.60 + S$6.72 + S$6.83 + S$6.95 + S$6.91) ÷ 5 = S$6.802

Notice this is below the strike of S$7.88 which is OTM and hence the settlement calculation is

Max { [(S$6.802 - S$7.88) ÷ 5] ÷ S$1.00, 0 } = S$0.00 per warrant.

Hence if you bought 10 lots of SPCSGAECW080707, you will not receive anything in return.
Option trader might find the settlement of warrant is quite different from that of the option. The different being the settlement price is taken from the average of the last five trading days of the underlying rather than the last closing price of the underlying one day prior to the expiry of option.

The rationale behind such approach is to prevent anyone who has enough capital to move the stock price of the counter through market manipulation such that the warrant will become ITM at expiry. Take for example in the case of the SPC call warrant above. Suppose the strike of this warrant is S$7.00 instead of S$7.88 and if the settlement calculation is computed based on the last closing price on the trading day prior to the expiry of the warrant. If a person or an institutional investor has enough capital to buy into the SPC stock at near the closing bell of the day to push up the price of the SPC counter to be above S$7.00, say S$7.10, then for each warrant the investor holds, he or she will receive S$0.02 per warrant at settlement.

Of course this is a hypothetical situation but it is not possible in real life. Having the average of the last five trading days’ closing price as settlement price is to prevent such market manipulation from happening cause it is more difficult to move the stock price for five consecutive days than in a single time frame at closing bell. However, if the investor does have the capability to move the stock price for five consecutive days, the Singapore Exchange may already halt the trading of the underlying before further manipulation happens.

Index Warrant

The settlement level of an index warrant differs across different issuers. I have listed the method of settlement for the Straits Time Index (STI) for various issuers below based on my findings.

For Société Générale (SGA), the settlement for the STI is based on the final settlement of the future contract of the STI. The future contract settlement for STI can be found here.
For Deutsche Bank (DB), the settlement for the STI is based an amount equal to the reference level on the valuation date or an amount equal to the arithmetic average of the reference levels on all the valuation dates, as determined by the issuer and without regard to any subsequently published correction.
For BNP Paribas (BNP), the settlement for the STI is based on the five days average closing price of STI.
For Macquarie Capital Securities (MBL), there is no warrant issued for STI that I can find.
For Rabo Bank (RB), I cannot find any settlement details on how they compute for both equities and index.

The formulae used to compute the settlement calculation for index is the same as the ones used to calculate for stock. For example, the settlement for put warrant STI3200SGAEPW080627 on the underlying STI which expires on 27th June 2008 with a strike of 3200 and conversion ratio of 500 is as follow,

Max { [(3200 – 2947.8) ÷ 500] ÷ S$1.00, 0 } = S$0.504400 per warrant.

The settlement level 2947.8 is gotten from the Singapore exchange website. See the screen capture below.

Please do take note that the settlement for HSI index listed in Singapore exchange by various issuers may have a different settlement procedure compared with STI. I have listed the links below where you can find the calculation of the settlement for all the expired warrants by different issuers.

For Société Générale (SGA), the settlement details can be found here.
For Deutsche Bank (DB), the settlement details can be found here.
For BNP Paribas (BNP), the settlement details can be found here.
For Macquarie Capital Securities (MBL), the settlement details can be found here.
For Rabo Bank (RB), I cannot find any settlement details on how they compute for both equities and index.

I hope this post has given my readers an idea on the settlement for both Singapore equities and Index. The same formula can be used to compute for plain vanilla warrants issued on equities or index in Hong Kong or Japan. We just need to pluck in the exchange rate in this case and also find out on how the settlement level is determined.

Exploring the Precursor to Straight Through

2008-07-03T10:24:00.001+08:00

I miss out the portion on Straight Through Processing (STP) earlier on and take the opportunity now to post it here, thanks to Shashank Mahajan who reminder me. I seriously didn’t expect someone from New York to be reading my blog. Thanks for your support.

To understand STP, you need to understand the concepts of the front office, middle office, and back office. These are, role-wise, the segregation in a member’s office or trading institution’s office.

The front office is responsible for trading. In a broker’s office, the front office speaks to various customers and solicits business. The front-office staff is also responsible for managing orders and executing them.

The back-office staff is responsible for settling transactions. The back office ensures that all obligations toward the clearing corporation are met seamlessly and that the member receives its share during pay-out.

While this entire process is happening, the middle office monitors all limits and exposures, and thus risks that the firm is assuming. The middle office is also responsible for reporting, especially where corporate-level reporting is required.

Since a broker’s office is organized into front, middle, and back offices, solution providers structure their products in the same fashion in the form of modules. Although many vendors provide solutions for all three sections, it is not mandatory for a broker to buy all three modules from the same vendor. If a broker goes for different vendors, though, then they have an issue of inter-module communication. Most brokers want all the three modules to be integrated. If they are not, then data will have to be entered multiple times in these modules. To obviate from this problem, brokers rely on a concept called STP.

STP, as defined by the Securities Industry Association (SIA), is “...the process of seamlessly passing financial information to all parties involved in the transaction process, spanning the investment manager decision through to reconciliation and statement production, without manual handling or redundant processing in real time.”

Two types of STP exist: internal and external. In the case just discussed, internal STP is required because you need to connect modules installed in a broker’s office. But some other entities such as custodians, fund managers, and so on, play an equally important role in settlement. To achieve true STP, even these need to be connected to each other. Any attempt to connect such entities beyond the organization in pursuit of STP is called external STP.

The industry wants to put processes in place that will allow an order to flow right from deal entry to conversion to trade to affirmation and confirmation and finally through settlement and accounting without manual intervention. This is because the industry wants to move toward T+1 settlement. This means trades done on one day will get settled the next day. This is an ambitious plan because it will call for a lot of process change, technology change, and industry change. Applications will have to come together and orchestrate the entire business process.

STP provides a lot of benefits to industry participants:

STP reduces settlement time. This essentially reduces risk because transactions will be settled faster and will be irrevocable. Settlements are said to be irrevocable when they are considered to be final and cannot be reversed. Reduced settlement time also means better utilization of capital.
Less manual intervention will mean fewer operational risks and errors. It will also mean fewer costs.
STP will force the entire industry to move toward standard communication protocols. This will mean standardized systems and fewer system development and maintenance costs. Interoperability will be a prerequisite for this to happen.
Increased automation will lead to increased throughput in transaction processing, thereby enabling institutions to achieve greater transaction volumes.

Equity trading and STP by itself are vast subjects, and understanding every minute business detail in a single go is not possible; furthermore, the functioning of every stock exchange is different from one another (though the concepts are fairly standard).

Macquarie Warrant Hotshot Competition

2008-06-30T10:42:00.008+08:00

For those who have been trading options, you will realize that there are a lot of virtual trading platforms out there for you to practice your strategies and polish up your skills. Unfortunately, this is not so true for warrant trader. I do my own virtual trade on a spreadsheet I created but then it lacks the real time data feed.

Macquarie is organizing the second Warrant Hotshot competition which is a real-time simulated trading contest designed to improve your knowledge of warrant investing without risking any capital. In fact, you could stand to win the S$20,000 Grand Prize if you are crowned Singapore's Warrant Hotshot.

The Hotshot contest is suitable for investors of all skill levels from newcomers to experienced warrant traders. Participants will begin the contest with S$100K Hotshot dollars and prizes will be awarded to those who are able to generate the largest profits by trading Macquarie warrants in the simulated trading environment. Warrant prices in the contest will mirror the real warrant prices on the SGX.The competition will be segmented into four main categories: dealers, investors, media and students, with participants from each category competing against each other for the weekly and group prizes. There will also be a grand prize winner for the investor with the largest portfolio at the end of the competition.The contest is scheduled to start on 14 July 2008 and will run for a period of 8 weeks. Please click here to register.

You can register under the appropriate category. For convenient sake, I have re-posted the Rules and Regulations here for your reference.

Introduction

Macquarie is pleased to present the second Macquarie Warrant Hotshot contest to investors. The contest is designed to give new and existing warrant investors the opportunity to experience trading warrants in a real-time simulated environment. Live pricing for both warrants and their respective underlying will mirror those seen on the SGX main board.

Eligibility

Participants must be aged 21 years or above at the time of registration.
All staff and their immediate family members of Macquarie Capital Securities (Singapore) Pte. Limited (Registration Number 198702912C) and Macquarie Capital (Singapore) Pte. Limited (Registration Number: 199704430K) and their related body corporate are not eligible to receive any prizes in this Macquarie Warrant Hotshot contest.
Participants can be of any nationality.
Participants must be residing in Singapore.
To be eligible for any prize, the following conditions must be met:

The Participant must have complied with the rules and regulations stated.
The Participant must have completed at least one (1) buy trade (using the virtual cash in the Hotshot Account) during the term of the contest.
The Participant must not have been disqualified from the contest.

Registration

Participants can sign up for only one Hotshot Account. Participants must register their own personal particulars, and not use another person's particulars to register for the contest. Participants must not trade using another participant's Hotshot Account.
Participants must register using their names as stated in their NRIC or Passports. NRIC or Passport numbers registered must be valid and accurate to be eligible to win a prize. Participants who fail to produce a valid form of identification will not be awarded cash prizes should they be declared winners for the respective prizes. Driver licenses will not be acceptable.
Participants must register in their appropriate category i.e. Remisiers and Dealers, Private Investors, Media and Students. Any participant competing in the Remisiers and Dealers, Media or Student categories will be asked for proof of their employment within these industries (or proof of study for the student category) before any prizes are awarded. A letter from their respective companies and institutes of learning, along with their NRIC or passport may be required for verification. Participants working in any publishing, or broadcasting company qualify as Media participants. Participants who have doubts as to whether they qualify for a particular category may contact the warrants team at 1800 288 880. Any participant competing in the wrong category will not be eligible for any prizes.
Participants must agree to be bound by the Rules & Regulations set by Macquarie Capital Securities (Singapore) Pte. Limited.
Macquarie Capital Securities (Singapore) Pte. Limited reserves the right to change the Rules & Regulations of the contest, and will disqualify any participants breaching the rules stated herewith.
Macquarie Capital Securities (Singapore) Pte. Limited also reserves the right to disqualify any participants attempting to tamper the trading system or influence the warrant prices by manipulating the underlying prices. Any breach of market misconduct will be reported to the SGX and / or the Monetary Authority of Singapore.
Participants can sign up for the contest anytime from 30 June 2008 9am by completing the registration form online at http://www.warrants.com.sg/.
In case of any dispute, Macquarie Capital Securities (Singapore) Pte. Limited will have the final discretion in the award of any prizes.

Contest & Prize Details

The contest will last for 8 weeks, starting at 9:00 am on 14 July 2008 and ending at 4:59 pm on 5 September 2008.
Each participant will start the contest with an initial credit of 100,000 points, with every one point being the hypothetical equivalent of one Singapore dollar.
There is a "reset" option (My Portfolio -> Personal Portfolio), where players can start over with a credit of 100,000 points, and have their previous trades deleted. They will not be eligible for the Weekly Hotshot Prize for that particular week. However, they will still be eligible for the Grand Hotshot Prize as well as the Category Hotshot Prize.
There will be 4 categories: 1) Remisiers and Dealers 2) Private investors 3) Media 4) Students. Participants can track the names of the top 5 Hotshots in each category on the contest website.
There will be four winners for the Weekly Hotshot Prize each week. The weekly winners will be the participants in each of the four categories with the highest percentage gain in his or her portfolio that week. The percentage gain in the portfolio is measured from the close of market on Friday that week, and comparing it to the Friday before. E.g. For the week starting 21 July 2008 and ending 25 July 2008, the percentage gains for that week will be calculated as:
(P25 - P18)/ P18 x 100%
where P25 is the total credits of the portfolio at the close of 25 July 2008 and P18 is the total credits of the portfolio at the close of 18 July 2008.
For warrants over Singapore stocks, the market value of a participant's holdings will be calculated based on the warrant bid price at 4:59 pm.
For warrants over Hong Kong stocks, the market value of a participant's holdings will be calculated based on the warrant bid price at 3:59 pm. For warrants over Hang Seng Index ("HSI"), the market value of a participant's holdings will be calculated based on the warrant bid price at 4:28 pm.
After 8 weeks, there will also be one Category Hotshot Prize winner in each category. This will be the participant with the largest portfolio value in terms of credits from each category, regardless of when the participant joined the contest.
After 8 weeks, there will be one Grand Hotshot Prize. This will be the participant with the largest portfolio value in terms of credits, regardless of when the participant joined the contest. Do note that the winner of the Grand Hotshot Prize will also be the winner of his or her Category Hotshot Prize, and could potentially be the winner of the Weekly Prize for the last week. However, only the cash value of the Grand Hotshot Prize will be awarded.
The cash value for each of the prizes is stated below:

Grand Hotshot Prize: S$20,000 for the grand winner.
Category Hotshot Prize: S$3,000 per winner (total 3 winners)
Weekly Hotshot Prize: S$200 per winner each week (total 32 winners)

Participants are allowed to win weekly prizes more than once.
To be eligible for any prize, the following conditions must be met:

The Participant must have complied with the Rules & Regulations stated herewith
The Participant must have completed at least one buy trade (using the credits in the Hotshot Account) during the duration of the contest.
The Participant must not have been disqualified from the contest.

In the case of a tie, the prize will be split equally among the relevant participants. For example, in relation to the Grand Prize, a tie for Grand Prize between two Participants means that both will share the cash prize of $20,000 equally between themselves i.e. S$10,000 each.
All winners will be notified by mail at their registered address in Singapore. Prizes must be collected within a month from notification.
If a participant's portfolio ranks among the top weekly or overall portfolios in each category in terms of performance, their registered name in their NRIC or Passports and/or their portfolio/holdings may be displayed on the contest website or in the newspaper. All Participants who win a prize shall agree to allow their names and photographs to be used in public communication medium such as, but not limited to newspaper, internet or television.

Trading Details

Orders placed to buy or sell Macquarie warrants can be executed at any time of the day during trading hours (9:00 am - 12:30 pm, 2:00 pm - 4:59 pm). Participants will not be able to execute orders during the pre-open matching period (8:30 am - 8:59 am) and the pre-close matching period (5:00 pm - 5:05 pm).
For warrants over Hong Kong underlying stocks, these will trade according to the Hong Kong market trading hours: 10:00 am - 12:30pm, and 2:30pm - 3:59pm. Participants will not be able to execute orders during the pre-open and pre-close matching periods also.
For warrants over the HSI, these will trade according to the Hong Kong Hang Seng Index Futures trading hours: 9:45 am - 12:30 pm, and 2:30 pm - 4:28 pm.
Price quotes for Hong Kong stocks will not be displayed on the contest website. There will be a link to take participants to the relevant webpage on the Hong Kong Stock Exchange website, where prices are quoted with a 15 minutes delay. However, the price quotes for warrants over Hong Kong stocks will be live.
Quotes for HSI will not be displayed on the contest website. There will be a link to take participants to the relevant webpage on the HSI website. The price quotes for warrants over the HSI will be live.
All orders for the day will expire if they are not matched by the end of the trading day. However, orders placed after markets close will be saved in the system and matched at the first minute after the respective markets open.
Should a participant execute a large order, such as buying 1 million warrants on the offer when there is only 200,000 on the screen, the contest trading platform will execute the order in multiples of 200,000 with a 2 second lag e.g. Buy 200,000 warrants, and the next 200,000 warrants will be bought only after a 2 second lag. This feature attempts to simulate the real world, where issuers will replenish the volume on the offer at the same price in the warrants should the underlying share price not move and there is sufficient volume in the underlying for issuers to hedge their positions.
Orders executed in the contest will be done immediately to simulate real time trading. However, participants should note that if the bid / offer quote in the warrant is $0.20 / $0.205, and if participants wish to buy the warrant and get their order filled immediately, they should pay the offer and buy the warrant at $0.205. If they choose to bid at $0.20, their order will be filled only when the warrant ticks down to $0.195 / $0.20.
Participants can cancel or reduce the quantity of their buy and sell order if such an order has not been filled, i.e. in the 'Pending Orders' section.
To increase the quantity of an order, a new order entry has to be made.
Once an order has been filled, the order cannot be cancelled or amended.
No odd lots may be traded. The minimum volume is set at 1,000 warrants or 1 board lot.
Short selling of warrants will not be allowed. Participants can only sell warrants which they own, as there will not be a buy-in market for participants with overnight net short positions for the duration of the contest.
In the event that an underlying stock is placed on a trading halt, the corresponding warrants will be placed on a trading halt in the contest.
If an order is placed for a warrant whose underlying is on a trading halt or suspension, the order will not be processed until the trading halt or suspension is lifted.
If a Participant holds a warrant whose underlying is on a trading halt or suspension, the warrant cannot be sold until the trading halt or suspension has been lifted. If there is a trading halt or suspension on an underlying stock at the end of the contest, the last quoted bid / offer price in the warrant before the trading halt or suspension will be used for the final valuation of the warrant.
If an underlying stock is delisted on the SGX market, the corresponding warrants will be delisted in the contest.
If a company and its corresponding warrants are delisted, a Participant's warrants will hold no value and its value will be removed from the Participant's portfolio.

Payments & Sale Proceeds

There are no brokerage commissions, clearing fees, GST and any other miscellaneous charges in the simulated trading environment of the contest. Participants' profits and losses will be based on the capital gains and losses from trading the warrants.
There will be no margin financing option in the contest.
There will be no contra period for any warrants purchased. The payable amount will be immediately deducted from the participants' 'Cash Balance'.
When submitting a buy order, there will be a check for sufficient funds (credits) in the participant's Cash Balance. Once a buy order is completed, the required amount will be immediately deducted from the participant's Cash Balance. If the order is rejected because the participant does not have enough 'Cash Balance', the participant needs to adjust the quantity of warrants or the limit price.
When the participant's sell order has been executed, the sales proceeds will be immediately credited into the participant's Cash Balance. Under Realized Profit/ Loss, the participant can monitor the amount of realized profits or loss, if any.

Adjustments to Warrant Terms

Ordinary dividends are incorporated into the price of a warrant so that on the ex-dividend date when the share price falls by the amount of the forecast dividend, the warrant price should not change.
Special dividends, capital reduction and or any other corporate measures undertaken by a company may affect the price of the warrants. Macquarie will issue an official announcement on the SGX, stating the details of the adjusted strike prices and entitlement amounts on both the SGX website and Macquarie's Warrants Homepage. The adjusted strike prices and entitlement amounts will be automatically updated in the contest.

Investment Warrants

Investment Warrants are a new type of warrant that Macquarie introduced to Singapore early in 2008. Different from conventional 'trading' warrants currently traded on the SGX, which typically have a contract expiry of three to six months, Investment Warrants have lower exercise prices and longer expiry dates, therefore giving them lower holding costs and a lower risk profile than conventional trading warrants.
Investment Warrants allow investors to receive net ordinary dividend equivalent payments. Thus if a company declares a 50 cent net ordinary dividend, the investor will receive the full 50 cent equivalent payment if you purchase the proportionate number of Investment Warrants to entitle you to 1 underlying share. For example if you were holding an investment warrant with a warrants per share number of 10:1 and the underlying share announced a dividend of 50 cents, each warrant that you hold would be entitled to 5 cents (i.e. 50 cents divided by 10)
On the SGX these dividend payments are distributed to the holder within 5 days of the dividend payment date. In the contest they will be credited to the investors account on the day of the ex-dividend date as the contest will only last eight weeks while the dividend paid date may be longer than the duration of the contest.
Special dividends, capital reduction and or any other corporate measures undertaken by a company may be adjusted in the same way as a conventional trading warrant (see section above)

All the best to those who are participating in the contest.

Actual Operation of Warrant Trading (Part 4)

2008-06-21T12:32:00.002+08:00

In this post, I’ll discuss a rather simple topic on the “Actual Operation of Warrant Trading”. This post will focus on the continuous quote of warrant trading. In Singapore, market makers provide liquidity to the market under a continuous quote system.

There are however under some circumstances that market makers will not be able to provide any quotation. The following is a list of such situations.

When the warrant is suspended from trading for any reason, including, without limitation, as a result of its underlying being suspended from trading;
In the event of the occurrence of a market disruption event, including, without limitation, any suspension of or limitation imposed on trading (including but not limited to unforeseen circumstances such as by reason of movements in price exceeding limits permitted by the SGX-ST or any act of god, war, riot, public disorder, explosion, terrorism or otherwise ) in a stock, or any warrant, option contract or futures contract relating to the stock;
When the issuer and/or the guarantor hold(s) less than 5% of the total issue size of the warrant (in which event, quotes will be for bid price only), that is, when the guarantor and its group of companies hold, in their proprietary position, less than 5% of the total issue size of the warrant, which, for the avoidance of doubt, shall exclude any unit of the warrant held by the guarantor and/or its groups of companies in a fiduciary or agency capacity;
During the period of five business days immediately prior to the expiry date of the warrant;
If the stock market experiences exceptional price movement and volatility, that is to say, during fast market; and
Where the market maker faces technical problems affecting the ability of the market maker to provide bid and offer quotations.

The most commonly seen situation is case 4 when the warrant is not tradable any more. I hope this post will give a rough idea to investors to the different situations why there are times when warrants do not have any quotes. In the next “Actual Operation of Warrant Trading” posting, I’ll be discussing about the calculation of warrant settlement price for both equities and index.

How to compute the historical volatility of index and equities?

2008-06-19T23:34:00.009+08:00

In this post, I’ll divert from the discussion of the “Actual Operation of Warrant Trading” and talk about how various issuers of warrant compute the historical volatility of index and equities. In fact, what I am going to illustrate later can also be applied to the US market to compute the historical volatility of index and equities.

Some of my readers may be wondering why we should ever bother about computing the historical volatility since these events had already happened. I have the same thoughts too until my last WAT gathering when Greekman shared with us the expected move formula and it struck me that why did I not think of that? Let me go through the computation before we move on to make some modification to the formula and see where we can go from there.
I am using the Straits Time Index (STI) as an example here to compute the historical volatility. I have done some screen captures from different issuers to show what the historical volatility of STI is after market closed today.

From the above screen captures, we can see that the historical volatility is around 15.01%. We are not concern about the different terms of warrant chosen as long as they all have the same underlying; their historical volatility should be approximately the same.

The screen capture below is a spreadsheet where I used to compute the historical volatility of STI index. Notice the value I got is quite close to the one shown on the previous screen captures.

Let walk through how each value is being computed. Under the column with the heading showing “Straits Time Index”, the value in each of the cell shows the closing STI index value on that day. Take note that we do not include weekend or any non trading day. For example, we do not include 19th May 2008 as it is Vesak day.

Under the column with the heading showing “Percentage Change”, the value in each cell is computed based on the natural logarithm of the prior day closing index and today closing index. Take for example, the percentage change on 18th June 2008 is computed as follow, Ln(3040.09/3028.24) = 0.39%.

Once we have all the various percentage change calculated for the last 30 days, not including the one on 19th June 2008, since this is a historical volatility. To compute the historical volatility for last 30 days, we first find the standard deviation of the percentage change from 8th May 2008 to 18th June 2008 and then multiply it with the square root of 250 or 252; the number of trading days in a year. That is Stdev(-1.78%, -0.31%, 0.57% ….-0.29%, 0.39%)*Sqrt(250) = 15.02%. The reason why we multiply the standard deviation with the square root of the number of trading days is to annualize the historical volatility.

Based on the theory of statistic, if the sample is 30 and above, we can assume the distribution to be normal. This is why I have chosen 30 days and nothing less. Assuming if the STI index does follow the normal distribution, then there is a 68% of the time the STI index will fall within 2992.66 * (1 ± 15.02% * Sqrt (30/250)), which gives us a range of 2836.95 to 3148.37. We multiply the historical volatility with the Sqrt(30/250) to de-annualize it. For those who attended the last WAT gathering, do you find this formula familiar? What happen if we substitute the 2992.66 with half the current equity share price, the 15.02% with the ATM option implied volatility and the 30 with the days to expiration of the option? Effectively, this gives us an idea of how much the share price will move towards the expiration date.

I certainly hope you enjoy this as much as I do. I shall be posting the “Actual Operation of Warrant Trading (Part 4)” soon.

Actual Operation of Warrant Trading (Part 3)

2008-06-16T23:37:00.001+08:00

This is the third part of the Actual Operation of Warrant Trading. In this post, I’ll discuss about the face value of warrant. Some investors prefer warrants with a smaller face value, because they cost less to buy and the tick value is lower, and they are more sensitive to the movement of the underlying price. However, other investors prefer warrants with a bigger face value, on the grounds that, with their higher tick value, one tick will be enough to pay the brokerage commission.

So, is it a better strategy to buy warrants with smaller face value or those with a bigger face value? Lets us find it out by comparing transaction costs and how closely the warrant price will follow the movement of the underlying price.

Let us start with transaction costs. Assume that the bid/ask spread of the warrants is one tick across the board. For a warrant with a face value of no more than S$1.00, say S$0.50, the tick value is S$0.005. This is also the minimum transaction cost for buying and selling the warrant, with the underlying price remaining unchanged. For another warrant with a face value within the range between S$1.00 and S$9.99, say S$5.00, the tick value of the warrant is S$0.01. It seems that the warrant with a bigger face value is more costly. In fact, this is not true. In percentage terms, the transaction cost is actually higher for warrants with a smaller face value. In the case here, the warrant with a smaller face value, S$0.005 / S$0.50 * 100 = 1%, compared with the warrant with a bigger face value, S$0.01 / S$5.00 * 100 = 0.2%. Hence, the trading risk is relatively lower for the latter.

Besides, a warrant with a smaller face value is more likely to follow closely the movement of its underlying. Say, we have two warrants, both with a delta of 0.05 and a conversion ratio of 10:1. For the one with a smaller face value, its tick value is S$0.005. When its underlying goes up by S$0.10, the warrant will in theory, climb by 1 tick (S$0.1 * 0.05 = S$0.005). As for the warrant with a bigger face value, its tick value is S$0.01. When the underlying goes up by S$0.10, the warrant will appear to be not moving at all, as the increase in its price is less than a tick (S$0.005 = ½ tick).

Face value may be more relevant to investors looking for fast money. For ordinary investors, it does not mean much whether it is S$0.005 or S$0.01 a tick. Of course, we always want to buy something at a lower cost if possible. Nevertheless, you are advised not to be too concerned with the tick value, but spend more time studying the terms such as effective gearing, to find out the most suitable warrant for your portfolio.

Actual Operation of Warrant Trading (Part 2)

2008-06-15T15:38:00.008+08:00

This post is a continuation from where I stopped back in April. In this post, I will discuss about the bid/ask spread or in option trading world, it is commonly known as the slippage, of warrant trading.

Short term investors will find warrant trading attractive only if at least two conditions are satisfied. Firstly, there must be sufficient liquidity in the market so that warrants can easily change hands. Secondly, the bid/ask spreads must be narrow enough to keep transaction costs low. Since market making was introduced, liquidity is no longer a problem. Besides, as competition gets more and more intense, market makers are also maintaining their bid/ask spreads within a tight range. However, at times some warrants do trade with a rather wide spread. Well, then, how are bid/ask spreads determined?

The first factor to consider is delta. Given a conversion ratio of 1:1, the higher the delta (that is, close to 1 or 100%), the narrower the gap in the bid/ask spread between a warrant and its underlying. Let us say that the bid/ask spread of the underlying is S$0.02. If the warrant has a very high delta, it’s bid/ask spread will be close to S$0.02. However, if the conversion ratio is 10:1, the bid/ask spread of the warrant will be around S$0.002.

Let use an actual example to see if that is the case. The screen capture below shows the bid/ask price of some warrant with delta close to 100% on June 13, 2008. The next screen capture shows the buy and sell price of some counters from SGX on the same date. Noticed in the first screen capture, three out of the four warrants in the screen capture that are very close to expiration have delta close to 100%. This should be the case since the three warrants are deep ITM with around two weeks to expiration. The only warrant with a delta close to 100% and more than two months to expiration is DBS BNP ECW080905. We shall use this as an example.

Based on the second screen capture, the bid/ask spread of DBS is S$19.10 – S$19.06 = S$0.04 and the entitlement ratio is 8. This means we should expect the bid/ask spread of the warrant to be around S$0.04/8 = S$0.005. However, based on the first screen capture, the bid/ask spread for DBS BNP ECW080905 is S$0.535 - S$0.51 = S$0.025. This is 5 times more than what we expected. How about the theoretical bid/ask spread of a warrant? We can compute this by multiplying the delta of the warrant with the tick value of the underlying. Hence, the theoretical bid/ask spread for DBS BNP ECW080905 is 90.22% * S$0.02 / 8 S$0.002. Since the bid/ask spread of the warrant is also subject to the different tick values of different price ranges set by the stock exchange, we will expect the warrant bid/ask spread to be S$0.005 (the minimum bid size for price range up to S$0.99) which is consistent with the expected S$0.005 bid/ask spread we calculated earlier on. Hence we need to find out why is the actual bid/ask spread 5 times more than the theoretical spread? This will lead us to the second factor.

The second factor to consider is the liquidity of the underlying. Once a warrant is issued, the issuer has to make the necessary hedging arrangements. Buying some holdings of the underlying is one of the methods. If the liquidity of the underlying is inadequate, the cost of hedging will be high. Hence, issuers will work out an estimate of the size of the float of the underlying they can buy or sell at the optimal price before setting the bid/ask spread of the warrant.

In the case of DBS BNP ECW080905, the delta is 90.22% and the bid/ask spread of the underlying (DBS) is S$0.04; therefore the warrant bid/ask spread should be around S$0.005. Since the conversion ratio is 8:1, this means for every 8 units of warrant the issuer needs 1 unit of DBS share to hedge its position. The outstanding warrant as on June 13, 2008 was 50, 000, 000. This is shown in the screen capture below.

Assuming this value is accurate, this means that the accumulated overnight positions, held by investors rather than the issuer at the close of trading was 50 million units. This means if the issuer needs 50 000 000/8 = 6.25 million units of DBS shares to hedge its position since the listing of this warrant.

Let’s assume due to the insufficient liquidity in the market, the issuer can only buy 6 million units of DBS shares to hedge its position at optimal price says at its average price of around S$18.80, computed based on the closing price of DBS since beginning of this year. This means the issuer has to pay an extra cost for the remaining 0.25 million units of DBS shares. If the issuer needs to pay the price of S$19.00 to buy those units for hedging, the bid/ask spread of the warrant will widen to (19.00 – 18.80)/0.02 * 0.02 * 90.22% / 8 = S$0.023 or about 5 ticks more.

The above are only assumptions made for the purpose of discussion and may not be necessary be true. Of course, sometimes an issuer may want to maintain a narrow spread for a particular warrant. So if the investors can spend a little time to observe how different issuers deal with the bid/ask spreads of their warrants, it would not be difficult to compare them and choose the most appropriate warrant to trade.

Investment Warrants

2008-06-14T11:08:00.019+08:00

I came across this special type of warrant few months ago and I find it was quite an interesting derivative instrument that is very different from the usual plain vanilla warrant.

From what I know now is that the only issuer for Investment Warrant is Macquarie. I have gathered some information from their website and re-posted it here. If you are interested to know more, there is an upcoming free seminar on the 18th June 2008 talking about Investment Warrant. You can register here.

Macquarie’s Investment Warrants allow you to get exposure to shares at a fraction of the price. With Investment Warrants you can:

gain long term exposure for a fraction of the share price
limit your capital at risk
increase your effective dividend yield

Investment Warrants have longer expiry dates, lower holding costs and a lower risk profile than Trading Warrants. They are suitable for both short term and long term investment horizons.

If you recall the first post on Analysis of Warrant Data I posted in early January this year, you will notice the warrant name has an additional “I” to indicate that it is an investment warrant, e.g. COSCOCORP MBL ICW90403. Also note that by its definition, there is only investment call warrant and no such thing as investment put warrant.

What is an Investment Warrant?

An Investment Warrant enables you to buy shares in two payments. You pay a fraction of the share price up front and get exposure to the capital movements in the underlying share and all of the ordinary dividends over the life of the warrant.

Generally, the price of an Investment Warrant will move in line with movements in the underlying share and, because warrants are only a fraction of the price of the underlying share, they tend to move in greater percentages than the share price.

Investment Warrants also give you a payment equivalent to 100% of the ordinary dividends of the underlying shares. This is something that normal derivative instruments do not offer. Hence, in a way Investment Warrants therefore allow you to potentially earn a greater return than you might achieve by owning the share itself (see example below).

Investment Warrants give you:

the right to buy a share
at a specific price (called the exercise price)
on a specific date (called the expiry date)
the equivalent of 100% of the ordinary dividends throughout the life of the warrant

Investment Warrants are listed on the SGX so you can buy and sell them at any time, just like shares.

At the expiry of the warrant you have the option to either pay the exercise price and take delivery of the shares or simply receive the cash settlement amount (if any).

Beneﬁts of Investment Warrants

Greater return potential – through the effect of gearing, price movements are magniﬁed
Longer term exposure – lower holding costs mean Investment Warrants are suitable for both short and long term investments
No Margin calls - increase your exposure to shares without the risk of margin calls
Physical settlement – option to exercise and take delivery of the fully paid shares at expiry
Enhanced Dividend Yield – holders receive the equivalent of 100% of the ordinary dividends of the underlying share for less outlay

Warrants enable investors to spend less up front, diversify their investments, potentially accelerate their growth and meet their investment objectives sooner.

Who would use Investment Warrants?

You might use Investment Warrants if:

you are a long-term investor looking for a lower risk way to increase your investment returns
you are a trader with a positive view on an underlying share and you want a moderately geared alternative
you are an existing shareholder and want to unlock some capital from your portfolio by switching from shares into Investment Warrants

How Investment Warrants work

If you believe DBS shares will rise, you may wish to leverage your view by buying Investment Warrants over DBS shares. A hypothetical example is shown below:

Instead of purchasing the DBS share at $21.00 you can buy the Investment Warrant for only $7.30 to gain exposure to the performance of the DBS shares. During the life of the DBS Investment Warrant, the warrant price will tend to move up and down in line with the DBS share price. Investors may increase or exit their investment at any time by buying or selling the Investment Warrants on the SGX. The investor will also receive the equivalent of 100% of the ordinary dividends paid by DBS throughout this term.

At the expiry, if the investor is still holding the warrant they may either pay the exercise price of $15 and take delivery of the DBS shares or they can choose to receive the cash settlement value (if any).

The cash settlement at expiry is calculated using the following formula:
(Share price - Exercise price) x conversion ratio
For example, if DBS is at $24 at expiry the warrant value would be:
($24.00 - $15.00) x 1 = $9.00

How gearing can boost your return

One of the main advantages of warrants is ‘gearing’, meaning a warrant provides the holder with an increased exposure to the underlying share. Therefore, a small percentage change in the price of the share can lead to a large percentage change in the value of the equity warrant.

The added advantage of Macquarie’s Investment Warrants is the increased effective dividend yield. The holder of an Investment Warrant is entitled to a payment equivalent to 100% of the ordinary dividends in the underlying share; however as the warrant price is only a fraction of the share price the effective dividend yield to the holder is increased.

Here is a hypothetical example:

It’s important to remember leverage works in both directions, so a fall in the share price would also cause a greater percentage fall in the value of the warrant. It is also important to be aware that Investment Warrants will expire worthless if the share price is at or below the exercise price at expiry.

Using Investment Warrants to release capital from your portfolio

Investment warrants are a convenient and lower risk alternative to release capital from your portfolio. If you have an existing share holding you can switch into a Macquarie Investment Warrant by selling the shares and buying Warrants. By doing so you will maintain exposure to the share movements and dividends while releasing capital for other investments.

Here is a hypothetical example:

Advantages of Investment Warrants over other ﬁnancing facilities

Ability to leverage above 70%
Limited downside
No margin calls

There is always some risks in any kind of investment may it be stock, plain vanilla warrant or option etc. Hence the same goes for Investment Warrant. Please do some homework and understand the risks and rewards of this new derivative instrument better before risking your hard earned money in it.

The Time Is Now

2008-06-11T22:52:00.007+08:00

It has been almost two months since I last posted my blog entry. I must apologize to my readers who may think I have gone missing and decided not to blog again. In fact, so many things have happened within my family in these two months so much so that I feel very depress and helpless at certain point in time. But I guess I need to be strong, for my family needs me more than ever now.

My mum was diagnosed with ovarian cancer and the doctor said it is most probably in stage 3c or 4. I read up a lot on ovarian cancer since the day my mum got admitted to the hospital and I knew stage 3c and 4 are the last two stages of ovarian cancer. The gynecologist doctor who saw my mum was actually a secondary school mate of mine and he did mention to me that the prognosis of ovarian cancer is not very optimistic. At that point of time, I really cannot hold back my emotions anymore and I cried. I knew for the very fact that crying would not help and I should not have cried especially in front of my mum. But I simply cannot control myself. I cleared all my FTOs during that period of time to accompany her in the hospital. I was in the hospital early in the morning and would not leave till late at night. I know my mum needs a lot of family support especially at this point in time.

Sometimes I really wonder what have my mum done wrong to deserve this. Her life as a child was not an easy one. Being the eldest daughter in the family, she got to help out at my grandfather stall at a very young age and she did not even have a chance to go school like her other siblings. As such, she does not even know how to write her own name. Yet, as a mum of us, she has given us unconditional love throughout our bringing up, taking care of us and ensuring we are always given the best and working long hours for some miserable paycheck just so as to lessen the burden of the family. Finally when my sister got married and had her first child this year, we advised her to retire so she can help to take care of my nephew. I was happy that she can finally relax and enjoy a little after all these years of hard work and can lead a better life at old age now. But then…why should she be stricken with this? I regretted very much not bringing her to do annual checkup. I hate myself for not noticing the first time she complained about her abdomen discomfort. I am really very angry with myself.

As the day passes by and I see her getting thinner and thinner and her hairs starting to drop because of the chemotherapy she is undergoing, my heart aches a lot. The very fact that I am so helpless seeing her suffering but not able to share with her the pain she is undergoing really make me very useless. The fact that she has to take a blood test every time she goes down to the hospital made my heart aches even more. The fact that she lost her sister few years back and her father the very next year made me realized one thing - this world has not in any way be kind or fair to her. Why must her life be so tough?

I once came across a poem when I first learnt to design my own webpage and I can appreciate that poem more than ever now. I would like to share that poem here with my readers. This poem titled “The time is now”. I hope my readers would forward it to anyone who they think might benefit them in one way or another. This poem was written by a mum to her son.

THE TIME IS NOW

If you are ever going to love me
Love me now while I can know
The sweet and tender feelings
Which from true affection flow

Love me now while I am living
Do not wait until I am gone
And then have it chiseled in marble
Sweet words on ice cold stone

If you have tender thoughts of me
Please tell me now
If you wait until I am sleeping
Never will be death between us
And I won't hear you then

So if you love me, even a little bit
Let me know while I am living
So that I can treasure it

Please feel free to bless anyone with this poem. I would like to take this opportunity to thank my friends, my colleagues and my readers that have given me a lot of support and encouragement during this very tough time of mine. Due to my mum condition, I have missed out some of the WAT gatherings and I have decided to take my CFA level II exam next year instead. Lastly, I will be back blogging and sharing things I learnt. Thanks everyone.

Actual Operation of Warrant Trading (Part 1)

2008-04-15T20:37:00.006+08:00

It has been a really long time since I last blog. I am very sorry for my readers who visited my site and got nothing new to read. I was held up with a lot of things recently. Nevertheless, despite being busy, I have also been reading a lot on the Heston Stochastic Volatility Model and Model-Free Implied Volatility. I have dived a little more in depth on how to adjust a financial report to better value a company. There are simply too many things which I want to share as I read but I need some times to digest and further verify those things I read with real life examples before I share with my readers. As such, I have decided to continue another series of warrant trading posting but this time round, I’ll be posting on the actual operation of warrant trading.

In this posting, I’m going to discuss about the effect of tick value on warrants. With effect from 24th December 2007, SGX had revised the minimum bid sizes for its various financial instruments products. I am interested in the revised minimum bid size for securities. Under the new revised schedule, any securities trading below $1.00 have a minimum bid size of $0.005. Securities trading between $1.00 and $9.99 have a minimum bid size of $0.01. Securities trading $10.00 and above have a minimum bid size of $0.02. With this new revised minimum bid sizes in mind, I’m going to use Singapore Exchange (SGX) as an example for my discussion.

When SGX is trading at close to $10.00 in January this year, we can see that some of the warrants derived from it are lagging behind, while some others follow closely but with a bigger bid/ask spread. You can easily verify this by randomly looking at how closely the warrant price follows the stock price under the Data & Chart > Historical Price at SG Warrants. For easy reference, I have randomly capture three images for some SGX call warrants.

The examples I used here are not really perfect and one will be right to argue that there are some other factors (e.g. such as trading volume on that particular day) that causes the charts to be difference. Nevertheless, they are good enough to illustrate the point I’m going to discuss.

From the screen captures I have done, you will notice that for some warrants, the price of the warrant will follow very closely with that of the underlying stock while on the other hand, some of them do not follow as closely. Of course, for put warrants, the prices move in opposite direction of the underlying stock.

Assuming SGX is trading close to $10.00 at this point of time. The next tick will either bring the stock price up to $10.02 or $9.98. Hence, in this example here, a $0.02 change will mean a 0.2% increase or decrease in the underlying price. If the warrant has an effective gearing of 10 times, this $0.02 change in the underlying will be enlarged to a 2% (10 X 0.2%) change in warrant price.

Looking at another perspective, suppose we have a SGX warrant with a delta of 40% and a conversion ratio of 1:1, then for every $1.00 change in the underlying price, the warrant should, in theory, rise or fall by $0.40. So, for every $0.02 change in stock price, the warrant should move by $0.008 ($0.02 X 0.4). If the face value of the warrant is above $1.00, its tick value will be $0.01. For each tick ($0.02) of movement in the underlying price, the warrant will move by $0.008, which is not enough to make a tick in the warrant price. It appears that the warrant is lagging behind. However, if the warrant’s face value is below $1.00, its tick value will be $0.005. In this case, for every tick ($0.02) of movement in the underlying price, the warrant price will move by 1.6 ticks. Hence, if one goes for a warrant with a high delta and smaller face value, one may expect to see some movements in the warrant price.

In the face of technical issues, different issuers opt for different treatments. Some leave their warrants to swing up and down with the underlying securities, which indirectly increases the trading risk. Others take action to even out the fluctuations and make their warrants move up and down in an orderly manner (so that the warrant price will follow the underlying price to take on the ask side or the bid side). Still others choose to widen the bid/ask spreads of their warrants.

Investors should understand that there exist various technical issues in the market. We should not hastily jump to the conclusion based on the varied performance of different warrants that this or that issuer is not doing a good job. The truth may boiled down to the different treatments adopted by the issuers.

Greeks Computation for Put Option

2008-03-18T10:48:00.005+08:00

The day before yesterday, I posted the computation of the Greeks for call option. In today’s posting, I will continue to discuss how to do the computation of the Greeks for put option (I have purposely waited for two days to do this posting so we can see how the formulas work for us). I have also tried the formulas for the computation of Greeks for put option and compared the results to those on OptionXpress. Well, once again I cannot really say that these formulas gave very good results but they are close enough like in the case of the call option.

I am going to put down the steps for computing the Greeks for put option. You can simply follow through the steps and try out on your own if you are interested. I am going to do the Greeks for put options on the same worksheet that I used yesterday and I am going to list down the step of what you should key in each cell. If you follow exactly the cell reference I am using (which once again, I seriously encourage you to do so if you wish to try out), you should be able to just copy the formulas I have and paste them correctly into the cell reference to get the results. I am also going to include the formulas for computing the put option pricing here as well together with the computation of the Greeks.

Open the same Excel worksheet that we used yesterday, type in the following data;

In cell E2 and F2, perform a merge cell and type in “Put Option Pricing”.
In cell E3, type in “Stock Symbol”. Again, I am going to use Agilent Technologies as an example; hence I am going to put the symbol “A” in cell F3.
In cell E4, type in “Link”. Copy and paste this formula =IF(ISBLANK(F3),"",HYPERLINK("https://www.optionsxpress.com.sg/quote_detail.asp?symbol="&UPPER(F3)&"&SessionID=0",F3)) in cell F4. Hence cell F4 will update every time to provide you with the hyperlink to the stock based on the stock symbol you input in cell F3. You can click on the hyperlink to get the stock information for Agilent Technologies in this case.
In cell E5, type in “Stock Option Chains”. Copy and paste this formula =IF(ISBLANK(F3),"",HYPERLINK("https://www.optionsxpress.com.sg/quote_option_chain.asp?SessionID=&symbol="&UPPER(F3)&"&Page=V&lstMarket=0&Range=ALL&AdjNonStdOptions=OFF&lstMonths=13",UPPER(F3)&"'s Option Chain")) in cell F5. Hence cell F5 will update every time to provide you with the hyperlink to the stock option chain based on the stock symbol you input in cell F3. You can click on the hyperlink to get the stock option chain information for Agilent Technologies in this case.
In cell E6, type in “Option Symbol”. Type in “AQF” in cell C6. I am going to use the May 08 put option with strike price of USD$30.00 for my illustration purpose.
In cell E7, type in “Current Stock Value”. If you have click on the hyperlink in cell F4, you should be able to get the last traded stock price for Agilent Technologies. At this point of writing, the last traded price was USD$29.67. Type in 29.67 (without the dollar sign symbol, you can format it later) in cell C7.
In cell E8, type in “Implied Volatility”. If you have click on the hyperlink in cell F5, you should be able to get the option chain for Agilent Technologies. You should be able to find the implied volatility for AQF. At this point of writing, the implied volatility for AQF is 38.1%. Type in 38.1% (including the percentage symbol) in cell F8.
In cell E9, copy and paste the following formula: =HYPERLINK("http://cdrates.bankaholic.com/","6-month CD rate (annualized)"). This should provide you with the hyperlink to get the 6-month CD rate (annualized). At this point of writing, due to the recent Fed rate cut, the 6-month CD rate (annualized) is 4.05%. Type in 4.05% (including the percentage symbol) in cell F9.
In cell E10, type in “Dividend Payout per Share”. Using the same hyperlink from cell F4, you will realize that Agilent Technologies does not pay out dividend. You should see under the Dividend heading on the website with n/a. Agilent Technologies does not pay out dividend but instead they do stock repurchase from open market. Hence, type in 0 in cell F10 in this case.
In cell E11, type in “Days to expiration”. Using the same hyperlink from cell F5 which provides you the link to the option chain for Agilent Technologies, the May 08 put option has another 60 days to expiration. Type in 60 in cell C11.
In cell E12, type in “Strike Price”. Again, using the same hyperlink from cell F5, the strike for AQF is USD$30.00. Type in 30 (without the dollar sign symbol, you can format it later) in cell F12.
In cell E13, type in “Put Option Price (Approximate)”. Copy and paste the formula =IF(F7<>0,-F7*EXP(-F10/F7*F11/365)*NORMSDIST(-SUM(LN(F7*EXP(-F10/F7*F11/365)/F12),SUM(F9,POWER(F8,2)/2)*F11/365)/(IF(F8=0,0.00000000001,F8)*POWER(F11/365,0.5)))+F12*EXP(-F9*F11/365)*NORMSDIST(-SUM(LN(F7*EXP(-F10/F7*F11/365)/F12),SUM(F9,POWER(F8,2)/2)*F11/365)/(IF(F8=0,0.00000000001,F8)*POWER(F11/365,0.5))+F8*POWER(F11/365,0.5)),0) in cell F13. You should get a value of USD$1.897. This is the theoretical value for the put option for AQF. At point of writing the bid-ask prices for AQF are USD$1.92 and USD$1.96 respectively. The last traded price was USD$1.85.
I now move on to do the computation for this put option Greeks. The formula I am going to show may appear very complicated. The good thing is, you can just copy and paste them to your cell reference. I have done the tough portion for you. In cell E15, type in “Delta”. Copy and paste the following formula =NORMSDIST((LOG(F7/F12)+F11/365*(F9+0.5*F8^2))/(F8*SQRT(F11/365)))-1 in cell F15. You should get a value of -0.464. Using the link from step four, navigate to the top of the website and change the "Type" to "Pricer" and "Expiration" to "May 08" and click the "View Chain" button to get the Greeks for AQF. You need to select the “Puts” radio button too. Change the various values on the website and click on calculate. For example, in the “Current Imp Vol”, you should change to 38.1%. In the “Days Until Exp”, you should change to 60. Lastly, in the “Int Rate”, you should change the value to 4.05%. Click on the calculate button and you should get the Greeks value for all the May 08 put option updated. Leave this page as it is as we will be comparing the remaining values later. Note that the delta is -0.487 and the “Theo Value” (which is the theoretical value for the call option price) is 1.919.
Let’s move on to do the computation for the remaining Greeks. In cell E16, type in “Gamma”. Copy and paste the following formula =EXP(-((LOG(F7/F12)+F11/365*(F9+0.5*F8^2))/(F8*SQRT(F11/365)))^2/2)/SQRT(2*PI())/F7/F8/SQRT(F11/365) in cell F16. You should get a value of 0.087. The Gamma value on the website from step 13 is 0.091.
In cell E17, type in “Vega”. Copy and paste the following formula =F7*EXP(-((LOG(F7/F12)+F11/365*(F9+0.5*F8^2))/(F8*SQRT(F11/365)))^2/2)/SQRT(2*PI())*SQRT(F11/365)/100 in cell F17. You should get a value of 0.048. Again the Vega value on the website from step 13 is 0.048.
In cell E18, type in “Theta”. Copy and paste the following formula =(-F7*EXP(-((LOG(F7/F12)+F11/365*(F9+0.5*F8^2))/(F8*SQRT(F11/365)))^2/2)/SQRT(2*PI())*F8/2/SQRT(F11/365)+F9*F12*EXP(-F9*F11/365)*NORMSDIST(F8*SQRT(F11/365)-((LOG(F7/F12)+F11/365*(F9+0.5*F8^2))/(F8*SQRT(F11/365)))))/365 in cell F18. You should get a value of -0.014. The Theta value on the website from step 13 is -0.014.
Lastly, let compute the “Rho”. In cell E19, type in “Rho”. Copy and paste the following formula =-F11/365*F12*EXP(-F9*F11/365)*NORMSDIST(F8*SQRT(F11/365)-((LOG(F7/F12)+F11/365*(F9+0.5*F8^2))/(F8*SQRT(F11/365))))/100 in cell F19. You should get a value of -0.026. The Rho value on the website from step 13 is -0.027.

Once again I really hope you all enjoy this as much as I do. I hope this modeling can help you in better choosing your option in future.

Greeks Computation for Call Option

2008-03-16T14:29:00.013+08:00

The beginning of March 2008 is a wonderful day for my family. On 1st March, my nephew had finally arrived to this world. This is really a happy occasion for my whole family. The first week of March was also my last two lessons for the Wealth Academy Trader tutorial. Unfortunately, I fell sick and I missed my fourth lesson which Conrad taught about his 5DPEG. I heard from my course mates that that the lesson was one of the most interesting of all. I am now waiting anxiously for my makeup lesson in April.

Nevertheless, I did attend the last lesson and Lawrence taught about option trading. I have some basic knowledge about option trading and its Greeks. The thing that I am not too sure is how do I make use of the Greeks? I have been waiting for this lesson to learn on the interpretation of the Greeks and most importantly, their applications. Lawrence illustrated the usage of the Greeks with examples and this has really intrigued me. My first thought in my head was then how can I compute the Greeks myself and how can I apply them to warrant trading? The next thing I was asking myself is the relationship between historical and implied volatility. I have figured out how I can compute the historical and implied volatility but I do not know if there is a relationship between them?

I actually went on to do my own research on the computation of the Greeks and the relationship between historical and implied volatility. Well, my hard work did pay off and I manage to find the ways to compute the Greeks but unfortunately, the relationship between historical and implied volatility is not so straight forward and it required the understanding of regression model to understand how the relationship is being model. Furthermore, I believe the parameters to the model have to be tuned and changed accordingly as time goes by and whenever the underlying of the model is changed. As such, I decided to post my finding of the computation of the Greeks which can be easily done using Microsoft Excel.

I have tried the formulas for the computation of Greeks and compared the results to those on OptionXpress. Well, I cannot really said that these formulas gave very good results as compared with my previous posting of option pricing using the Black Scholes formula but at times they gave very close estimates. I have been trying to figure out how can I use these same formulas to compute the Greeks for warrant trading? This is because information on warrant Greeks is not so easily available as compared with option. Sad to say, I did not succeed. My original intention was to blog on how we can compute the Greeks for warrant? This also explains why I have not been blogging for so long. Hence I decided that I should post my finding on the computation of the Greeks for option and perhaps some of my readers can go ahead and figure out how to do so for warrant and it would be great if he or she can share the finding with us.

I am going to put down the steps for computing the Greeks for option. You can simply follow through the steps and try out on your own if you are interested. I am going to do both the Greeks for call and put options on the same worksheet and I am going to list down the step of what you should key in each cell. If you follow exactly the cell reference I am using (which I seriously encourage you to do so if you wish to try out), you should be able to just copy the formulas I have and paste them correctly into the cell reference to get the results. I am also going to include the formulas for computing the option pricing here together with the computation of the Greeks.

I will start doing with the Call option first and later for the Put option in another posting. Open an Excel workbook and on one of the worksheets, type in the following data;

In cell B2 and C2, perform a merge cell and type in “Call Option Pricing”.
In cell B3, type in “Stock Symbol”. I am going to use Agilent Technologies as an example; hence I am going to put the symbol “A” in cell C3.
In cell B4, type in “Link”. Copy and paste this formula =IF(ISBLANK(C3),"",HYPERLINK("https://www.optionsxpress.com.sg/quote_detail.asp?symbol="&UPPER(C3)&"&SessionID=0",C3)) in cell C4. Hence cell C4 will update every time to provide you with the hyperlink to the stock based on the stock symbol you input in cell C3. You can click on the hyperlink to get the stock information for Agilent Technologies in this case.
In cell B5, type in “Stock Option Chains”. Copy and paste this formula =IF(ISBLANK(C3),"",HYPERLINK("https://www.optionsxpress.com.sg/quote_option_chain.asp?SessionID=&symbol="&UPPER(C3)&"&Page=V&lstMarket=0&Range=ALL&AdjNonStdOptions=OFF&lstMonths=13",UPPER(C3)&"'s Option Chain")) in cell C5. Hence cell C5 will update every time to provide you with the hyperlink to the stock option chain based on the stock symbol you input in cell C3. You can click on the hyperlink to get the stock option chain information for Agilent Technologies in this case.
In cell B6, type in “Option Symbol”. Type in “AEF” in cell C6. I am going to use the May 08 call option with strike price of USD$30.00 for my illustration purpose.
In cell B7, type in “Current Stock Value”. If you have click on the hyperlink in cell C4, you should be able to get the last traded stock price for Agilent Technologies. At this point of writing, the last traded price was USD$29.64. Type in 29.64 (without the dollar sign symbol, you can format it later) in cell C7.
In cell B8, type in “Implied Volatility”. If you have click on the hyperlink in cell C5, you should be able to get the option chain for Agilent Technologies. You should be able to find the implied volatility for AEF. At this point of writing, the implied volatility for AEF is 36.9%. Type in 36.9% (including the percentage symbol) in cell C8.
In cell B9, copy and paste the following formula: =HYPERLINK("http://cdrates.bankaholic.com/","6-month CD rate (annualized)"). This should provide you with the hyperlink to get the 6-month CD rate (annualized). At this point of writing, due to the recent Fed rate cut, the 6-month CD rate (annualized) is 4.05%. Type in 4.05% (including the percentage symbol) in cell C9.
In cell B10, type in “Dividend Payout per Share”. Using the same hyperlink from cell C4, you will realize that Agilent Technologies does not pay out dividend. You should see under the Dividend heading on the website with n/a. Agilent Technologies does not pay out dividend but instead they do stock repurchase from open market. Hence, type in 0 in cell C10 in this case.
In cell B11, type in “Days to expiration”. Using the same hyperlink from cell C5 which provides you the link to the option chain for Agilent Technologies, the May 08 call option has another 62 days to expiration. Type in 62 in cell C11.
In cell B12, type in “Strike Price”. Again, using the same hyperlink from cell C5, the strike for AEF is USD$30.00. Type in 30 (without the dollar sign symbol, you can format it later) in cell C12.
In cell B13, type in “Call Option Price (Approximate)”. Copy and paste the formula =IF(C7<>0,C7*EXP(-C10/C7*C11/365)*NORMSDIST(SUM(LN(C7*EXP(-C10/C7*C11/365)/C12),SUM(C9,POWER(C8,2)/2)*C11/365)/(IF(C8=0,0.00000000001,C8)*POWER(C11/365,0.5)))-C12*EXP(-C9*C11/365)*NORMSDIST(SUM(LN(C7*EXP(-C10/C7*C11/365)/C12),SUM(C9,POWER(C8,2)/2)*C11/365)/(IF(C8=0,0.00000000001,C8)*POWER(C11/365,0.5))-C8*POWER(C11/365,0.5)),0) in cell C13. You should get a value of USD$1.725. This is the theoretical value for the call option for AEF. At point of writing the bid-ask prices for AEF are USD$1.64 and USD$1.77 respectively. The last traded price was USD$1.73.
I now move on to do the computation for this call option Greeks. The formula I am going to show may appear very complicated. The good thing is, you can just copy and paste them to your cell reference. I have done the tough portion for you. In cell B15, type in “Delta”. Copy and paste the following formula =NORMSDIST((LOG(C7/C12)+C11/365*(C9+0.5*C8^2))/(C8*SQRT(C11/365))) in cell C15. You should get a value of 0.535. Using the link from step four, navigate to the top of the website and change the "Type" to "Pricer" and "Expiration" to "May 08" and click the "View Chain" button to get the Greeks for AEF. Change the various values on the website and click on the "Calculate" button. For example, in the “Current Imp Vol”, you should change to 36.9%. In the “Days Until Exp”, you should change to 62. Lastly, in the “Int Rate”, you should change the value to 4.05%. Click on the "Calculate" button and you should get the Greeks value for all the May 08 call option updated. Leave this page as it is as we will be comparing the remaining values later. Note that the delta is 0.517 and the “Theo Value” (which is the theoretical value for the call option price) is 1.729.
Let’s move on to do the computation for the remaining Greeks. In cell B16, type in “Gamma”. Copy and paste the following formula =EXP(-((LOG(C7/C12)+C11/365*(C9+0.5*C8^2))/(C8*SQRT(C11/365)))^2/2)/SQRT(2*PI())/C7/C8/SQRT(C11/365) in cell C16. You should get a value of 0.089. The Gamma value on the website from step 13 is 0.091.
In cell B17, type in “Vega”. Copy and paste the following formula =C7*EXP(-((LOG(C7/C12)+C11/365*(C9+0.5*C8^2))/(C8*SQRT(C11/365)))^2/2)/SQRT(2*PI())*SQRT(C11/365)/100 in cell C17. You should get a value of 0.049. Again the Vega value on the website from step 13 is 0.049.
In cell B18, type in “Theta”. Copy and paste the following formula =(-C7*EXP(-((LOG(C7/C12)+C11/365*(C9+0.5*C8^2))/(C8*SQRT(C11/365)))^2/2)/SQRT(2*PI())*C8/2/SQRT(C11/365)-C9*C12*EXP(-C9*C11/365)*NORMSDIST(((LOG(C7/C12)+C11/365*(C9+0.5*C8^2))/(C8*SQRT(C11/365)))-C8*SQRT(C11/365)))/365 in cell C18. You should get a value of -0.016. The Theta value on the website from step 13 is -0.016.
Lastly, let compute the “Rho”. In cell B19, type in “Rho”. Copy and paste the following formula =C11/365*C12*EXP(-C9*C11/365)*NORMSDIST(((LOG(C7/C12)+C11/365*(C9+0.5*C8^2))/(C8*SQRT(C11/365)))-C8*SQRT(C11/365))/100 in cell C19. You should get a value of 0.024. The Rho value on the website from step 13 is 0.023.

I hope you all enjoy this as much as I do. Please do not delete away the spreadsheet as I will use the same one to illustrate the computation for the put option in my later post. For those who understand and trade options and warrants, you will appreciate more and how this modeling exercise can help you better in choosing your option.

Analysis of Warrant Data (Part 8)

2008-02-29T11:53:00.003+08:00

Today is the 29th of February 2008. I suppose you know this day only comes once every four years. This year is a leap year. I am not too sure if you know there is also something known as the leap century which occurs once every four hundred years. Something interesting about the leap century is that the 1st of January of a leap century always falls on a Saturday. You can easily verify this with a perpetual calendar if you are interested. The last leap year was 2004 and the last leap century was 2000. We have to wait for another four years till 2012 for another leap year and 2400 for another leap century. I do not think I will see that year coming.

Theta

In warrant, there is the effect of time as well and you do not have the luxury of another four years. The Greek used to measure time is known as theta. Theta, also called time decay, measures the rate of change in the price of a warrant as its maturity is running short while all other things being equal. It can be expressed as an absolute value or a percentage relative to the warrant price (theta / warrant price). Unless in some special circumstances, the value of theta is usually negative, reflecting the declining value of a warrant as time passes. The time decay has its greatest effect when the warrant is near to its maturity. Time decay accelerates as time passes.

In percentage terms, time value has the biggest impact on out-of-the-money (OTM) warrants. The value of a warrant consists of intrinsic value and time value. They vary in absolute and relative terms for warrants with different strike prices and maturity dates. In the case of OTM warrants, their intrinsic values are negligible or zero. In other words, time value makes up most of their values. Hence, they are more sensitive to the passage of time. As for the in-the-money (ITM) warrants, given that a large part of their value is made up of intrinsic value, they are less sensitive to the passage of time, and such sensitivity decreases as the maturity date gets nearer.

Investors should find out more about the theta of a warrant as a percentage relative to its price, that is, relative theta. The latter is a better indicator to the sensitivity of a warrant to the passage of time, and will give you a better idea about the effect of time value on the gain or loss on warrants you are holding.

Vega

Vega measures the rate of change in the warrant price for each point of movement of its implied volatility. No matter it is a call warrant or a put warrant, Vega is always positive, indicating that the warrant price and its implied volatility always move in the same direction. Vega can be an absolute value or a percentage relative to the warrant price.

In terms of the percentage change in price, changes in implied volatility have the biggest impact on OTM warrants. Besides, the closer they get to the maturity, the bigger the impact. Next come at-the-money (ATM) warrants, and then ITM warrants. For the latter, the closer they get to maturity, the smaller the impact. Hence, in picking warrant, investors should check out its Vega as a percentage relative to change in warrant price, in order to assess the impact of implied volatility on the warrant.

Gamma

Gamma measures the sensitivity of the delta of a warrant to the price movements of its underlying. The higher the gamma, the bigger the change in delta will be in reaction to a movement in the underlying price.

Gamma = rate of change of delta / rate of change of underlying price

No matter it is a call warrant or put warrant, gamma is always positive. When the underlying goes up, in the case of a call warrant, its delta will go up as it is more likely to be ITM; in the case of a put warrant, the same will happen too as it is more likely to be OTM and its delta will get closer to zero.

ATM warrants (for those with maturity of less than a year) have the highest gamma. This means that they have the highest rate of change of delta.

Rho

Rho measures the sensitivity of warrant price to changes in the market interest rate. Call warrants have a positive rho, meaning that the price of a call warrant moves in the same direction as the market interest rate. In contrast, put warrants have a negative rho, and this shows that the price of a put warrant moves in the opposite direction to the market interest rate. Given that changes in interest rates tend to be limited in the short term, their effect on warrant prices is minimal.

This is my last post on analysis of warrant data. What I have discussed above is known as the Greeks of warrant. They look quite similar to those of option. The Greeks are important in trading both warrants and options. Unfortunately, the information for the Greeks for warrants are not easily available as compared with options.

Analysis of Warrant Data (Part 7)

2008-02-28T12:00:00.003+08:00

I went for a MSDN Tech-Talk held by Microsoft yesterday at One Marina Boulevard in the NTUC Auditorium. I was particularly impressed by the SQL Server 2008 that is going to be release soon in March. There is this Data analysis feature available since SQL Server 2005 and this is really a very powerful feature I would say. You can download a plug-in for Microsoft Excel 2007 and made used of this data analysis feature that comes with the developer, standard and enterprise version of the SQL Server 2005 and 2008 to perform time series regression to forecast short term and long term trend of data available in either the SQL Server or Microsoft Excel 2007. The plug-in also allows you to generate a report formatted with visual cue that made interpreting the data much easier.

I will be testing out the feature once I can get the SQL Server analysis service to setup on my computer. Meanwhile in today’s posting, I am going to continue on the Analysis of warrant data. I have been busy preparing my CFA level II examination and hence have not been updating my blog as regularly. This is the second last post on Analysis of warrant data which I will talk about Delta.

Put simply, delta measures how much, in theory, the warrant price will move for a $1.00 change in the underlying price (For me, I treat this as the first derivative of warrant price, typical engineer thought). For investors, delta is meaningful in the following aspects:

Relationship between delta and ITM/ATM/OTM

Call warrants have a positive delta, which means that the underlying price and the warrant price move in the same direction. On contrary, put warrants have a negative delta, which means that the underlying price and the warrant price move in opposite direction.

The value of delta lies between 0 and 1 for a call warrant, and between 0 and -1 for a put warrant. When a call warrant is at-the-money (ATM), its delta should be around 0.5. This value will move closer to 1 in the case the warrant becomes deeper in-the-money (ITM), or closer to 0 in the case the warrant moves further out-of-the-money (OTM). For a put warrant, when it is ATM, its delta should be around -0.5. Likewise, this value will move closer to -1 in case the warrant becomes deeper ITM or closer to 0 in case the warrant moves further OTM.

Delta reflects the degree of probability that a warrant will be ITM at maturity. A far OTM warrant has a delta close to 0, indicating almost zero chance that it will become ITM at maturity. An ATM warrant has a delta of around 0.5 and there is about 50% chance that the warrant will become ITM at maturity. A deep ITM warrant has a delta close to 100%, and this means there is nearly 100% chance that the warrant will stay ITM at maturity.

Prediction of changes in the warrant price

In general, investors can use delta to predict how much the warrant is likely to move for a $1.00 change in the underlying price. Say, for example, UOB BNP ECW100319 has a delta of 0.7468 after market closed yesterday. The conversion ratio is 14.993. The closing price for UOB was $18.42 yesterday. If the underlying price goes up by $1.00, the warrant price should, in theory, rise by $1.00 * 0.7468 / 14.993 = $0.05.

In reality, when the underlying price goes up or down by $1.00, the warrant is unlikely to move by the exact amount suggested by its delta, which is not a constant, but a variable. It will vary along with the underlying price, implied volatility and days to maturity. For example, assuming that the underlying price remains constant, with its time value or implied volatility falling, an OTM warrant will see a decline in its delta while an ITM warrant will see a rise. Usually, investors focus only on the relationship between delta and changes in the underlying price, and neglect the effect of changes in the implied volatility and time value.

Besides, the price of a warrant is determined by the market, and will be affected by market sentiments, market making activities, and the outstanding quantity of warrant. Hence, warrant usually trade at a level different from the theoretical price suggested by its delta.

Finding out the number of units of the warrant to be bought

Investors can also use delta to roughly estimate how many units of a warrant should be bought to reap a potential return close to that from a given units of the underlying. For example, a certain investor is optimistic about the UOB counter and wants to invest with a smaller amount of capital. If the investor wants to get an exposure to 1000 shares of UOB stock, using the previous warrant as an example, the delta is 0.7468, the number of units of warrant the investor should buy is equal to 1000 (the number of shares) divided by 0.7468 (the delta of the warrant), that is, 1340 units.

Finding out the number of units of new warrant to be bought for switching

Besides, investors can also use delta to roughly estimate how many units of a warrant need to be bought for switching to maintain the potential return. If the warrant on hand is about to expire or is going further OTM, one should consider switching. To find out how to use delta to calculate the number of units of the new warrant that need to be bought to replace the old warrant in order to maintain potential return at the original level, we can simply divide the delta of the warrant we intend to switch with that of the warrant we are switching to.

For example, CAPITALAND DB ECW080616 and CAPITALAND DB ECW080616 A have a strike of $7.30 and $6.30 respectively. Both have a conversion ratio of 5:1 and same maturity date. At point of writing, CapitaLand has a price of $6.62. Hence CAPITALAND DB ECW080616 A is ITM and CAPITALAND DB ECW080616 is OTM. CAPITALAND DB ECW080616 A has a delta of 63.27% and an effective gearing of 5.08x while CAPITALAND DB ECW080616 has a delta of 43.11% and an effective gearing of 5.44x. We noticed that CapitaLand share price has been going up for at least the past two weeks and says we remain positive that CapitaLand will move further up in price for next two weeks. Hence we want to switch from CAPITALAND DB ECW080616 A to CAPITALAND DB ECW080616 since it has a higher effective gearing even though CAPITALAND DB ECW080616 A has a higher delta. Therefore, we need to buy 63.27/43.11 = 1.46 units of CAPITALAND DB ECW080616 for each unit of CAPITALAND DB ECW080616 A to maintain the potential return.

You may ask, since the potential profit remains more or less the same, why should be bothered with switching at all? Why should we pay the additional transaction costs for selling CAPITALAND DB ECW080616 A and buying CAPITALAND DB ECW080616?

The purpose of switching is to allow us to sell a warrant with a higher price for another warrant with a higher effective gearing so as to invest with less capital for better utilization of funds. We do not have to be bound by the switching ratio, but it will give us an idea about how many units of new warrant we should buy to maintain potential profit as the same level.

The examples given are for illustration purpose and not my recommendation. I have tried to use real examples to illustrate my points. I will be positing my last post on analysis of warrant data soon.

A New Way to Value the Market

2008-02-21T00:09:00.003+08:00

I came across this article by Geoff Colvin, senior editor from Fortune magazine, and I thought it is an interesting article to share with my readers. The article discussed about the valuation of company using the economic value added (EVA). I have reposted the article in my blog here for your reading.

Are stocks cheap yet? That slippery, eternal question is worth a look right now because a remarkable new set of data has just become available, allowing us to analyze the market in ways we never could before. I wish I could tell you that this new trove of numbers reveals that stocks are a screaming buy. It doesn't. But it does suggest that, amid all the recent tumult, just maybe the market is being rational.

The new data are derived from the most fundamental, capital-based way of analyzing a company's finances and value. How much capital is a company using? What is its return on capital? How much does the capital cost? Those questions hold the key to corporate performance, but finding the answers in most financial statements isn't easy, and many executives don't know the answers themselves. The Stern Stewart consulting firm began popularizing these concepts more than 15 years ago with the term EVA (economic value added), and the new data come from EVA Dimensions, a firm that is now the source of Stern Stewart's EVA data.

EVA-based analysis has proven extremely valuable in analyzing individual companies. I almost never make calls on specific stocks, but in late 1999 the EVA analysis of AOL was so compelling that I wrote a column declaring flatly that the stock price could not possibly be justified. That column was published on Jan. 10, 2000, right near the overall market peak (and the very day that AOL announced it was using its insanely overvalued stock to buy my employer, Time Warner (TWX, Fortune 500) - but that's another story). I also used EVA analysis to write last summer that Google (GOOGLE) was overpriced at $540; that call looked wrong for a while, though as I write this the stock is at $501.

One thing you couldn't do with EVA analysis was use it to value the whole market. Compiling the data for a significant number of companies used to take months. But now, through the miracles of our networked world, EVA Dimensions can compile it every day for 2,669 companies in the Russell 3000 (those for which at least two years of data are available). This is essentially the U.S. stock market. So: Is it worth what it costs?

Look first at how well the companies are doing at their most basic task, which is earning a return on their capital that's greater than the total cost of that capital. Turns out they've been doing very well. The dollar difference between their return on capital and cost of capital (their EVA) was $375 billion over the past four quarters. It was only half that much in 2005, and in 2004 it was negative, which isn't surprising. Over time, for the broader market, EVA should be more or less zero since competition is always forcing high returns down toward the cost of capital, while companies that can't meet their capital cost will eventually go under. So America's publicly traded companies did great last year; in fact, with economic growth strong through the third quarter, it's safe to say that they were at or near the top of the business cycle.

Next question: How are they being valued? On a recent day when the Dow closed at 12,265, the 2,669 Russell 3000 companies had a total enterprise value of $29.8 trillion (equity plus debt). To judge whether that's a lot or a little, consider that over the past four quarters these companies produced after-tax operating profits of about $1.8 trillion. Even if we assume that earnings will only match, not exceed, that level in future years, then the companies' aggregate market value today would still be $22.5 trillion (note to finance wonks: that's their profits capitalized at their capital cost of about 8.1%), which is about 75% of their actual market value.

So now we reach the central question. About 25% of the current market value of these companies is based on expectations of future profits above and beyond the profits they earned last year, at the top of the business cycle. Does that seem reasonable? Actually, it just might. The math gets a bit tedious, but you can assume no profit growth for the next several years and very modest growth thereafter, and the valuation still looks okay. Buying at today's prices may not make you rich. But - for the first time in a long time, in my view - it isn't crazy.

Analysis of Warrant Data (Part 6)

2008-02-13T15:21:00.011+08:00

Time really flies. Today is the 7th day of Chinese Lunar New Year also known as 人日, which means it is the birthday of human beings. Therefore, I would like to wish everyone a happy birthday. This is part 6 of my posting on Analysis of Warrant Data. In this post I will talk about effective gearing and gearing.

The biggest appeal of warrant trading lies in the leverage effect. Investors only need to invest a small sum to earn a potential return or even higher than that from directly investing in the underlying. However, in picking warrant, investors often get confused with gearing and effective gearing. So, what are the differences between them? Which of them is more indicative?

Gearing

Gearing only reflects how many times the underlying costs versus the warrant. Its calculation formula is:

Gearing = Underlying Price / (Warrant Price * Conversion Ratio)

For example, the SPC call warrant, SPC RB ECW080526, has a gearing of 7.12 times at point of writing. Then an investment of S$1000 for the warrant will be equivalent to an investment of S$1000 * 7.12 = S$7120 in the underlying. However, gearing do not reflect the relationship between changes in the warrant price and in the underlying price. For example, both CAPITALAND MBL ECW080606 and CAPITALAND BNP ECW080606 have the same maturity on 6th Jun 2008, same entitlement ratio of 3:1 and approximately same implied volatility 44.65% and 46.17% respectively (I know the implied volatility is not really very close but this pair of warrant is one of the closest I can find to illustrate the effect of gearing).The strike price for the warrants are S$5.80 and S$5.98 respectively. The underlying price at point of writing is S$5.85. We can see that the warrant which is further out-of-the-money has a higher gearing of 10.54x compared with 9.51x. If an investor uses the gearing of these two warrants to work out their potential returns, they may be disappointed. The rate of increase/decrease in the warrant price relative to the underlying price is not the same as gearing. When the underlying price increases by 1%, CAPITALAND MBL ECW080606 with a gearing of 9.51x should ideally increase by 9.51% and CAPITALAND BNP ECW080606 with a gearing of 10.54x should ideally increase by 10.54% too. However, in reality, based on the data I have collected for the two warrants, CAPITALAND MBL ECW080606 increases by 20.59% while CAPITALAND BNP ECW080606 does not move a bid with the same price change movement in the underlying. We should look at the effective gearing.

Effective Gearing

Effective gearing reflects the relationship between changes in the warrant price and in the underlying price. Its calculation formula is:

Effective Gearing = Gearing * Delta

In the example I have chosen above, CAPITALAND MBL ECW080606 has an effective gearing of 5.42x while CAPITALAND BNP ECW080606 has an effective gearing of 5.52x. Then, other things being equal, for every 1% change in the underlying price, the warrant price will in theory move by 5.42% and 5.52% respectively. In my not so perfect example here, because the implied volatility for both warrants are difference which causes the warrant prices to be difference and hence the difference in Effective Gearing. In conclusion, when you invest in warrants, you should look to their effective gearing, not gearing, as a reference for their risk/return performance. Just remember that a high effective gearing can give you a higher leverage but it also means it will fall faster too when the market is in not in favor of your direction of your warrant.

Relationship between maturity and effective gearing

Maturity is negatively related to effective gearing. If we have two warrants with the same strike price but different maturity dates, the one with a longer maturity has a lower effective gearing than the other. This is because that the one with a shorter maturity has a lower time value, and thus a higher effective gearing.

ITM/OTM and effective gearing

Further OTM warrants have a higher effective gearing, because their gearing levels are higher. So, if we have two call warrants with the same maturity but different strike prices, the further OTM one will have a higher effective gearing.

One point that must be stressed here is that although the leverage effect is the biggest appeal of warrants as an investment instrument, one should never blindly go after high returns. While it is true that, generally, a higher effective gearing means a higher potential return, if you are too eager to chase after those OTM warrants which are about to expire, the risk involved can be unaffordable.

These warrants are usually less than one month away from maturity, with an over 10% gap between the strike price and the underlying price, which is extremely out of the money.

By now, most readers must have understood that one should look to the effective gearing to predict the size of change in the warrant price for every 1% change in the underlying price.

Yet, one should note that effective gearing can only reflect the theoretical change in the warrant price in response to a given amount of change in the underlying price in the near term. In fact, when the underlying price changes, the delta and gearing levels will change to, which in turn affect the effective gearing. Besides, the formula for effective gearing is based on the assumption that all other things being equal (such as implied volatility, interest rate and market supply and demand). Hence, in case these factors vary, the warrant price may fail to rise in the way suggested by the effective gearing even in the short term.

In general, premium and effective gearing go up and down together. So, a low-premium warrant has a low effective gearing, and the same goes for the opposite. In the case of a short term ITM warrant, although it carries a high delta, its effective gearing is low due to the high price tag and thus, a low gearing. Mind you, warrant trading is mainly about the leverage effect. When the effective gearing is too low, it does not mean much to invest in the warrant, which only gives you a slightly enlarged return when the underlying price moves. Yet, you are not facing less risk associated with the shortening maturity and changes in implied volatility. The risk and return are out of proportion. Besides, although such warrants have a low premium, they are not suitable for investors with a short term perspective. For a more appropriate strategy, you should first identify your target underlying and short list the relevant warrants with a comfortable effective gearing. Then, simply compare the candidates based on their implied volatility to select your right warrant.

I have been very busy this Chinese Lunar New Year and is unable to blog that regularly. I will be posting more regularly on my upcoming posts. :)

Analysis of Warrant Data (Part 5)

2008-02-06T09:47:00.000+08:00

Hi my readers, I am sorry for not posting for awhile. I have been busy doing spring cleaning :) Now my room has once again regained its cleanliness. I am going to continue my posting on analysis of warrant.

There was an article on My Paper on the 1st of Feb 2008, which was last week, regarding option trading. I am not too sure if anyone had read about the article? In the article, there was a short mentioned about the yield curve, a methodology to peek where our economy is heading towards to in year 2008 and perhaps the next one to two years to come. In fact, last year November, I had a similar post to explain the shapes of the yield curves and its implication on the economy. That was one of the reasons I started to monitor the STI put warrants since beginning this year, but I did not trade any of them, at least not using real money. :(

Anyway, I am a novice and risk adverse investor and I do not want to jump straight into the market before I understand how warrants work for me. It is like learning how to drive. We all started on circuit then we moved on to the roads and once we are familiar with it, we can drive safely on roads. Thought that does not guarantee you will not meet up with any accidents (touch wood) but at least you are more cautious and know what to look out for. Hence I do encourage novice investors and traders who wish to trade warrants or stocks to start doing virtual trade and make it as real as possible. Once you are able to reap consistent profit from your virtual trading, then perhaps it is time for you to test out your concepts and skills in the real market. Just remember to minimize your losses and let your profits run.

I would like to continue to share what I have learnt so far in warrant trading. This post is about premium. Premium is a measure of how much the underlying price has to move for the warrant to break even if it is held to maturity.

The premium for a call warrant =

([Strike Price + Warrant Price * Conversion Ratio] – Underlying Price) / Underlying Price * 100%

Whereas, Warrant Price * Conversion Ratio is the cost of buying a warrant, and Strike Price + Cost component is the breakeven point of the warrant. In this formula, we first calculate the difference between the breakeven point and the underlying price and then divide it by the underlying price to find out the premium as a percentage.

Likewise, the premium for a put warrant =

(Underlying Price - [Strike Price - Warrant Price * Conversion Ratio]) / Underlying Price * 100%

For example, the recently listed UOB call warrant UOB BNP ECW100319 is trading at SGD$0.315 at point of writing, with strike of SGD$15.38 and a conversion ratio of 14.993:1. The underlying price is SGD$17.36 at point of writing, then the premium is

Premium = (S$15.38 + S$0.315 * 14.993 - S$17.36) / S$17.36 * 100% = 15.80%
Breakeven = S$15.38 + S$0.315 * 14.993 - S$17.36 = S$20.10

In other words, if the investor intends to hold the warrant until maturity, its takes 15.8% increase in the underlying price from its current level of S$17.36 to S$20.10 to breakeven. In this example, what we have is an in-the-money (ITM) warrant, and the underlying needs a modest increase in the underlying price to breakeven. In the case of an out-of-the-money (OTM) warrant, the underlying must make a bigger climb to reach the breakeven point.

To sum up, the premium only measures the percentage increase in the underlying price that will allow the warrant investor to breakeven upon maturity. It does not tell us whether the price of a warrant is too high or too low. Hence, unless you are prepared to hold the warrant until maturity, premium is not a relevant indicator for you.

Today is Lunar New Year eve, I hereby wish everyone 恭喜发财,万事如意.

Analysis of Warrant Data (Part 4)

2008-01-30T15:46:00.000+08:00

The Federal Reserve began a two-day meeting on Tuesday that was expected to end with the second interest rate cut in just over a week, but market confidence in an aggressive half-percentage point drop was waning.

The Fed is mulling its next step to bolster the economy after stunning markets on January 22 with its biggest rate reduction in more than 23 years - an emergency move that brought the benchmark federal funds rate down three-quarters of a point to 3.5 percent.

Since then, investors have widely bet the Fed would keep slashing to head off a recession given worsening financial market conditions.

But after stronger-than-expected data on consumer confidence and durable goods orders on Tuesday, investors scaled back bets on a half-point move significantly.

Short-term interest rate futures showed the implied chances for a half-point cut had dipped as low as 60 percent by midday on Tuesday from 86 percent on Monday. A quarter-point cut was still fully priced in.

The Fed has been trying to minimize the impact from the subprime by cutting rate. The decision was to stabilize the market but then the market is still in a rollercoaster state. This is a good time for us to learn more about warrant and save up your cash then to jump into the market. In this post, I am going to mention two other important aspects of warrant – turnover and outstanding quantity.

Turnover is the total units of a warrant bought and sold on a day, while outstanding quantity refers to the accumulated units, or the accumulated overnight positions, held by investors (other than the issuer) at the close of trading. Outstanding percentage is the portion held by investors of the total units of the warrant in issue. I noticed this information may not be easily gathered. ShareInvestor site does have the outstanding warrant which is updated every Friday of the week and SGX also provides such information.

On a trading day when the market is dominated by day trade investors rather than overnight traders, the turnover can be way above the increase in outstanding quantity. In contrast, if all the new positions of the day are held overnight, the increase in outstanding quantity will be equal to the turnover.

Normally, when a high turnover meets a flat outstanding quantity, what we have is a day trade market. This may be a sign of a lack of confidence in the outlook for the warrant. When a high turnover meets a fall in outstanding quantity, then the market is dominated by sell orders. This may mean that the holders of a call warrant are selling on expectation that the underlying is topping out (or bottoming up in the case of a put warrant). When a high turnover meets an increase in outstanding quantity, the investors here are probably long-term players who are rather upbeat about the market outlook.

Outstanding quantity is more indicative than turnover

In comparison, outstanding quantity is a more significant indicator than turnover. Warrants that make it to the top ten in turnover may lose their followers in just a week. However, outstanding quantity tells you how many people are in the same boat as you. If we look at the price performance, together with the outstanding quantity, of a warrant, we can get a rough idea about whether it is good time to buy or whether selling pressure is building up.

Moreover, the outstanding percentage may reflect the market making the capability of an issuer. Where the outstanding percentage is too high, it shows that the issuer does not have enough holdings on hand for the purpose of price stabilization. In such a case, the warrant price may fluctuate too widely. It may even fall out of step with the underlying price. Hence, such warrants are more risky than others. For example, for a warrant with an outstanding percentage reaching 90%, the issuer will be left with only around 10% of the total units on hand. With the dwindling inventory, the issuer will find it hard to increase the supply in case the strong market demand shows no sign of ebbing. The warrant price may then shoot up to an unreasonable level due to the imbalance between the demand and supply.

In selecting warrants, investors usually focus on the strike price, maturity, effective gearing and implied volatility. Seldom do they pay attention to the outstanding quantity and percentage, which do not bear a direct relation to the value, but at times do affect the price of a warrant. Hence, investors should also know more about the outstanding quantity and percentage of their target warrants.

Reflection of market demand

Changes in the outstanding quantity of a warrant reflect the market demand, rather than the decision of the issuer. When there is an increase in demand and more investors are buying the warrant, the issuer is obliged to provide the liquidity by selling certain units in its holding to the market. Hence, the outstanding quantity will increase. In contrast, when there is a decrease in demand and more investors are selling the warrant, the issuer must buy the excess units in the market. So, the outstanding quantity will decrease.

For some warrants, their outstanding quantities grow as their trading history gets longer. Given that they have a large crowd of investors, these warrants are normally more actively traded. Investors have to be more cautious. Given the high level of outstanding quantity and the large number of participants, the prices of these warrants are subject to a stronger impact of changes in demand and supply and in market sentiment. They are therefore likely to fall out of pace with their underlying. This is particularly at times of heavy buying or selling, when huge trading volume makes it difficult for the issuer to get the market back in order quickly. While these warrants may generate a higher than expected return when they are driven to excesses, investors may also suffer a bigger loss when there is an abrupt market downturn.

How to define a high outstanding level?

Some investors may find the outstanding quantity of a warrant at a high level when it reaches a certain percentage of offer size. Actually, this is not totally correct, as the offer size of a warrant is not limited. Sometimes, a warrant may be reissued again and again, and its total offer size will be relatively large. Some investors may apply for a bigger offer size. With an expanded offer size, the outstanding quantity will of course become lower in proportion. However, this may not necessarily mean that the outstanding level is not high. Investors should refer to actual number of outstanding units as a clue. One should also be aware of the outstanding percentage. If a warrant has a very high outstanding percentage (over 80%), the issuer, with an insufficient inventory on hand, may have difficulty in maintaining the stability of its implied volatility. Hence, whenever there is an imbalance between demand and supply, the implied volatility of the warrant will overshoot, making it hard to predict its price movement.

To find out whether the outstanding level of a warrant is high or low, investors should also take note of the conversion ratio. For examples, both STI 3100 BNP ECW080328 and STI 3100 BNP EPW080328 have the same underlying, strike price and maturity. Yet for STI 3100 BNP ECW080328, the conversion ratio is 1000:1 while STI 3100 BNP EPW080328 is 770:1. Both warrants have an outstanding quantity of 40 million at point of writing. Although one of the warrants is a call and the other is a put, this does not really matter. What I wish to show here is does both of them have the same outstanding level? The answer to the question is no. In fact, the outstanding level for the put is about 1.2987 times (1000 / 770) more than the call. The reason is that each unit of the put warrant represents the right of conversion for 1/770 unit of the underlying, while each unit of the call warrant represents that right of conversion for only 1/1000 unit of the underlying. Hence, for hedging purpose, the issuer has to buy, in theory, 1.2987 times more for put warrant than that of the call warrant of the underlying or over-the-counter options.

Assuming both warrants currently have a delta of 50%. Then for every 20 million units of the call warrant sold or repurchased, the issuer has to buy/sell only 10000 units of the underlying for the hedging purpose. However, for the same quantity of the put warrant sold or repurchased, the issuer has to buy/sell 12987 units of the underlying. Although the difference between the two numbers is not very significant in this example, because I have chosen an index warrant, you will see how great the impact will be for stock warrant. Hence, when the put warrant in our example here is in heavy trading, especially around this period of time, the issuer may face a bigger problem in keeping the order and the warrant price may face a wider fluctuation.

Studying the outstanding quantity is not only helpful for warrants selection, but also indicative of the fund flows in the market. No matter what, before buying a warrant, it would be a nice idea to check out its outstanding quantity. If the level is too high, then you should be careful. In the best case scenario, the implied volatility of a warrant should hold steady after it is bought. In case the warrant’s performance turns funny (for example, the warrant price goes up although the underlying price is unchanged), it may be a sign that the market maker is losing out in maintaining the order of the market. In this case, you should sell the warrant as soon as possible to swap for another with a lower implied volatility. When it’s implied volatility finally goes down to a reasonable level, the price of the warrant will finally goes down to a reasonable level, the price of the warrant will drop even though the underlying price remains intact. This happens when the issuer has restored its holdings on hand or when other investors are selling for fear that the issuer will soon issue additional units of the warrant.

I shall continue my post on analysis of warrant data again. Chinese New Year is round the corner and I hereby take the opportunity to wish everyone a prosperous CNY.

What are Treasury Bills And How You Can Use It?

2008-01-24T10:16:00.000+08:00

I got this email from Philips Capital and I just re-post it here. I believe some of you might have received this email as well. Before you are in a hurry to delete it, let’s spend some times to see how it can benefit us? Well, at this period of time where we are unsure which way the market is heading to, though it seems we are most likely to head towards a soft economy; this might be a good alternative fixed income investment for risk adverse investors.

Singapore Government Securities (SGS) Treasury bills (T-bills) are short-term debt securities that are issued by the Singapore Government. The tenors for Treasury bills range from as short as 7 days up to 1 year.

Treasury bills are a very useful and low risk investment tool that everyone should take advantage of.

How you can make use of Treasury bills?

Given the current yield of 1.52% p.a. (Rate is based on a 3 month T-bill and is accurate as of 23 Jan 2008.) for a 3 month T-bill, it is definitely much better than the interest given by normal saving deposits (Based on rates of UOB Passbook Saving Account, OCBC Passbook Saving Account, and DBS Auto-save (Personal) Account. Rates are taken from respective websites and accurate as of 16 Jan 2008.).

Given the flexibility of selling away your T-bills at any time, you will be able to liquidate your investment when you need the money. You can even choose to liquidate just part of it (in multiples of 1000 units).

While some fixed deposits might be offering a higher interest as a promotion, they usually require you to lock up your deposit for the entire tenure, and require a minimum investment of quite a significant sum. Unlike them, T-bills only require a minimum investment of less than $1000. If you are unwilling to lock-up a huge chunk of your funds in fixed deposits, T-bills will be suitable for you.

For equities investors, you can make use of T-bills as well. During occasions where you are staying at the sidelines, waiting for the next opportunity to make a killing, you can park your spare cash in T-bills to earn some interest. Make your money work harder for you.

How Treasury bills work?

Treasury bills have a fixed maturity date and have zero coupons. This simply means that during the tenor, the owner of the Treasury bill will not be receiving any interest payments. Instead the Treasury bills are sold at a discount and redeemed at par value upon maturity. That is why Treasury bills are also known as pure discount investment instrument.

Suppose you purchase 1000 units of a 1-year T-bill at a yield of 2%.
You will only need to pay $980 and you will receive $1000 upon maturity a year later.

Similarly for 1000 units of a 3-month T-bill at a yield of 2%, you will only need to pay $995 and you will receive $1000 upon maturity 3 months later.

To find out more on how you can start investing in Treasury bills, please visit here, email dcm@phillip.com.sg or call 6531 1555.

By the way, I do not get any benefits from Philips Capital for helping them to post this here in my blog. I just find this could be an alternative means of fixed income investment to grow your money, at least at this period of time when market is going up and down like a rollercoaster.

Analysis of Warrant Data (Part 3)

2008-01-23T20:15:00.000+08:00

The Fed's surprise rate cut on Tuesday calmed investors a little but many were struggling to decide whether the move was a sign of salvation or of worse to come in troubled markets. Apple's disappointing results will also keep shares subdued. In fact at this point of time I am blogging, the futures of S&P 500, Nasdaq and Dow are down by approximately -20.25, -41.75 and -131 respectively. We seem to be experiencing a rollercoaster market and a good strategy to use in such a situation is to buy a call and a put to form a straddle. In that way, you reap profits when market goes either ways. What is the catch? Well, the catch is, the market must move significant enough for you to reap a profit. I will cover how we can form a straddle in one of my upcoming posts.

I would like to continue my posting on analysis of warrant data. If you have trade warrant before or you have read up on warrants trading or attended some warrants trading seminar, then I suppose you may have come across these terms such as conversion ratio, although it is also called the subscription ratio, the exercise ratio, the cover ratio, the entitlement ratio, the parity ratio, the multiplier, the set, or just the plain ratio. Whatever it is known as, this simply means the number of warrants required exercising into one share, or its cash equivalent and it could be any value.

In my post here, I will just use the term conversion ratio as a reference. The conversion ratio determines the number of warrants required for conversion into one share of the underlying stock or one point of the underlying index at maturity. For example, where the conversion ratio is 10:1 or 10 or 0.1 (1/10), depending how the issuers present their data, it means 10 units of warrants will be required to be exchanged for each share of the underlying stock.

The price of a warrant is determined by a set of terms. Even though some warrants may have the similar terms, their prices may vary. For example, two warrants may have largely the same strike price, maturity and implied volatility, but the price of one may be a few cents while the other a few dollars. Why so? Well, indeed, even for warrants with identical terms, their prices may vary hugely. This is due to their conversion ratios.

For example, STI 3300 SGA EPW080328 and STI 3300 BNP EPW080328 both have a strike price of 3300, same maturity at 28th March 2008 and approximately similar implied volatilities of 38.35% and 40% respectively at point of writing. Their conversion ratios are 590 and 1250 respectively and their last traded price are S$0.655 and S$0.315 respectively at point of writing.

From the example above, one should notice that the bigger the conversion ratio, the lower the warrant price. Although the last traded value of one warrant is approximately twice of that of the other, they are actually worth the same. If we look at STI 3300 SGA EPW080328 which has a conversion ratio of 590, one has to buy 590 units to get one share of its underlying stock upon conversion. In other words, the cost of getting one share of the stock is S$386.50 (590 x S$0.655) which is approximately S$390. In the case of STI 3300 BNP EPW080328, it has a conversion ratio of 1250 and the cost of getting one share of the stock here is S$393.80 (1250 x S$0.315) which is approximately S$390 too. Thus these two warrants are worth approximately the same. Their prices vary only in proportion to the difference in their conversion ratios and of course, in my not so perfect example here, the cost is a bit difference because of their different in implied volatility. Recall from my previous post on “Implied Volatility, Historical Volatility and Volatility Smile”, the lower the implied volatility, the lower the price of the warrant.

The point I am trying to get across above is that conversion ratio is insignificant as a performance indicator and should not be used as a reference for the price of the warrants. Instead one should look out for implied volatility as a guideline.

Psychologically, investors tend to prefer warrants with a lower price. After all, warrants of different price ranges do differ in tick movement. Accordingly, issuers have to make a choice on the conversion ratio. Yet, in theory, the difference in conversion ratio will not affect the price performance of warrants. If you understand the reason behind this, it may help enhance your chances of success.

In calculating the value at maturity and the effective gearing of a warrant at any time, the conversion ratio is always taken into account. When you are picking a warrant, do not be bothered with insignificant data such as the conversion ratio or premium. Unless you want to hold the warrant until maturity, these data should not be a matter of concern. Rather, to make sure that you are picking the right choice, you should check out carefully the other terms of the warrant, such as implied volatility and effective gearing.

I shall continue to post on warrant analysis soon.

ETF Tricks From Forbes Asia

2008-01-20T12:56:00.000+08:00

I read this in the recent Forbes magazine and I found it is quite interesting. This is an article written by Michael Maiello on Exchange Traded Funds (ETF) in the US. An ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange, thus experiencing price changes throughout the day as it is bought and sold.

Since it trades like a stock whose price fluctuates daily, an ETF normally does not have its net asset value (NAV) calculated every day like a mutual fund does.

By owning an ETF, you get the diversification of an index fund as well as the ability to sell short, buy on margin and purchase as little as one share. Another advantage is that the expense ratios for most ETFs are lower than those of the average mutual fund. When buying and selling ETFs, you have to pay the same commission to your broker that you'd pay on any regular order. One of the most widely known ETFs is called the SPDR (Spider), which tracks the S&P 500 index and trades under the symbol SPY in the US market and the STI ETF 100 which had recently undergone a stock split to become STI ETF, which tracks the STI index in Singapore.

The article discussed about some new opportunities and new hazards in this fast-changing arena. Like dandelions after a spring rain, ETFs are cropping up everywhere. Last year alone, there are some 253 launches. There are now 612 ETFs in the US, sponsored by 19 money managers, according to State Street, which manages the Spider ETF among others.

How do you choose among this vast welter? One place to start is the recommended Best Buys list extracted from the magazine as shown below.

The Best Buy formula for actively traded funds puts equal weight on costs and performance. But since ETFs are passive (usually tracking a stock index), past performance does not tell you anything useful. So the ETF Best Buys are the ones with the lowest costs in each of seven different categories of portfolios. Here the costs are defined as the sum of annual expenses and one-fifth the average bid/ask spread observed on a recent trading day.

An ETF is a cross between a closed-end fund (with a fixed number of shares outstanding) and an open end (whose sponsor continually sells shares to newcomers while cashing out departing customers).

An ETF has a fairly rigid portfolio mix. It trades, like a closed end, with a bid-and-ask spread on a stock exchange, and when you buy or sell it you run up a brokerage commission. Shares are created and extinguished in response to demand. They are created when a brokerage firm assembles a basket of constituent stocks and hands that in, getting ETF shares in return. Shares are extinguished in a reverse process that ends with the broker selling constituent stocks.

Beyond The Index

Trust manufacturers of financial products to make simple things complicated. The original ETFs tracked broad indexes like the S&P 500, however the newest aim at narrow sectors, such as banks (with a bad showing in 2007) and oil (windfalls gains of late). International ETFs are popular and enjoying since price gains; 31 overseas ETFs started in 2007.

Lately, ETF managers have hired companies like S&P and Zacks to create custom indexes for them. One such batch of ETFs was launched by Power-Shares and based on something called “Intellidexes”. These ETFs screen for stocks using 25 factors ranging from valuations to growth rates.

The PowerShares Dynamic Market ETF, the first one, has outstripped the S&P 500 since 2003 debut, scoring an annual return 14.3% return versus the S&P’s 12%. Its portfolio of 100 stocks is rebalanced quarterly, turning over the portfolio once a year, on average. The rules for picking stocks are cryptic, but this fund is an open book compared with an open-end fund. An open-end does not have to reveal its portfolio until its next semiannual report; the ETF discloses the stocks in the basket daily on the PowerShares Web site.

Some of these creatures are rather clever and so far have not slipped up. Take the Claymore/Sabrient Insider ETF, a basket of 100 stocks (adjusted quarterly) that corporate insiders are buying heavily. Since the ETF’s September 2006 debut, it is up 17% versus 13% for the S&P 500.

The newest iteration is the actively managed ETF, although it is unclear whether the US Securities & Exchange Commission (SEC) will approve the notion. The agency up to now has preferred that ETFs follow some kind of index. Bruce Bond, chief executive at PowerShares, says regulators have warned him about comparing his ETFs too closely with an actively managed portfolio.

Pending SEC approval, the proposed PowerShares Active Mega-Cap will behave just like a quant mutual fund, where various formulas kick out stock picks so the company claims that a large part of it is passively managed. Human managers will have some role, supposedly secondary.

Exchanged Traded Commodities

ETF does not necessarily have to own shares. It can own commodities or commodities contracts – the StreetTracks Gold Shares is sitting on $16.8 billion worth of gold bars in bank vaults. In the case of a curious pair of oil-related ETFs, MacroShares Oil Up and MacroShares Oil Down, the funds own, essentially, contracts with one another. They were invented by Robert J. Shiller, a Yale University economist.

The MacroShares, which first appeared in November 2006, together hold a $60 million portfolio of short-term US Treasury bonds. When the price of oil goes up, MacroShares Up gets a larger claim on the portfolio; as the price declines, it cedes value to its partner fund. Buying either half of the fund is like going long or short an oil contract on a commodities exchange.

Unlike most ETFs, which tend to trade at prices very close to their net asset values, these two years veer off. In response to popular demand, the oil-up shares were recently trading at a 9% discount to their $33.11 NAV, while the oil-downs were at 46% premium to their $10.10 NAV. (The combined $40.01 share price, however, was very close to the combined $40.45 NAV)

An advantage to the ETF as a way of speculating on commodities: it is available in small doses. An oil future on the Nymex has a contract size of 1,000 barrels, worth $99,000. Another advantage is that the ETFs do not get expire, so you can make one trade and sit on the position indefinitely. The disadvantage of these ETFs is their rapacious 1.6% expense ratio.

Dollar Cost Averaging

A popular if somewhat overrated way of investing is to buy a fixed dollar amount of an asset at regular intervals over a long period of time. You buy, say, $500 of an index fund every month for ten years. No-load funds are ideal for this style of investing, ETFs less so, because of the brokerage commissions make the ETF option at least plausible these days. Scottrade charges only $7 a trade. Bank of America offers 30 free trades per month to any customer with $25,000 in a BofA account.

If you are interested in trading ETF, you can start with the Singapore STI ETF. You can find more information here. You can also read about Gold as Investment from Wikipedia.

Analysis of Warrant Data (Part 2)

2008-01-19T11:05:00.000+08:00

I believed by now, most of you have noticed the Singapore market had tanked more than 10% (based on the STI index) since beginning of this year. If you have read my blog earlier on regarding the “Yield Curve for Bonds” and if you have understood what the inverted yield curves really mean, and if you have read up more on warrants, I believe you may have earn quite a lot from buying the STI put warrants. One of the put warrants I was monitoring has risen more than 50% in price since beginning of this year and another is most likely going to expired in-the-money (ITM) in another 10days time. Well I am not encouraging anyone to go jump in the market and buy the STI put warrants now. The STI index has shown some signs of reversal for the last two days and some put warrants have drop in price. Give yourself some times and learn more about warrants before you embark your journey to warrant trading.

This post is a continuation of my previous post on Analysis of warrant data. Some of you might have known this already but to make it more complete, I will try not to miss out anything about warrants. What do we mean when we say a warrant or option is in-the-money? A warrant is described as in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM), depending on the relationship between its strike price and its underlying price. A call warrant is OTM when its strike price is higher than its underlying price. In contrast, when its strike price is lower than its underlying price, the call warrant is ITM. The situation is just opposite for put warrants. When its strike price is higher than its underlying price, a put warrant is ITM; and when its strike price is lower than its underlying price, it is OTM. No matter it is call or put, if the strike is equal to the underlying price, the warrant is said to be ATM. The above is summarized below:

In-the-money : Call warrant – Strike price less than Underlying price
At-the-money: Call warrant – Strike price equals Underlying price
Out-of-the-money: Call Warrant – Strike price greater than Underlying price
In-the-money : Put warrant – Strike price greater than Underlying price
At-the-money: Put warrant – Strike price equals Underlying price
Out-of-the-money: Put Warrant – Strike price less than Underlying price

If we take into account the extent of the difference between the strike price and the underlying price, warrants can be further classified into ITM, deep ITM, OTM and far OTM. Generally, where there is a 15% or above difference between the strike price and the underlying price, a warrant will be considered far OTM or deep ITM. However, this 15% mark is merely a rough idea, not an absolute threshold. One must also look to the volatility of the underlying. Some warrants may be considered deep ITM or far OTM even if the difference between strike price and the underlying price is only 10% or more.

Besides classifying warrants in term of moneyness i.e. ITM, OTM or ATM, warrants can be classified accordingly to the length of their remaining days to maturity. Normally, we will describe a warrant with less than 3 months to maturity as a short-term warrant; one with 3 to 6 months left to maturity a medium-term warrant; and one with more than six months running to maturity as a long term warrant.

If we also take into account whether a warrant is ITM, ATM or OTM, a general investor may consider a medium-term warrant with around 3 months running to maturity and a strike price around 5% above or below the underlying price. More aggressive investors may go for OTM warrants with a shorter maturity. For conservative investors, they may choose ITM warrants with longer maturity.

Whether it is long-term or short term, ITM or OTM, a warrant is after all a leveraged investment instrument. Be cautious in funds allocation and stop-loss arrangements. Do not get carried away by the potential return without considering your risk tolerance.

Personally, if I am willing to invest say, SGD$400 to buy warrants, then SGD$400 is the amount I am willing to lose if I hold onto maturity and the warrant expire OTM. Hence, be very careful with your money management. If you do not intent to hold the warrant till maturity, then as a general guideline, sell off your warrants 30 days before they get expire. Another personal advice from me, although we can trade warrants like stock meaning we are able to short sell warrants, please DO NOT ever do it, unless you really know what you are doing? I will keep up with my posting on warrants soon. Have a nice day. Oh, please kindly vote in my blog too. :)

Analysis of Warrant Data (Part 1)

2008-01-14T22:25:00.000+08:00

It’s been thirteen days since I first blog in this New Year. I must apologize for those who visit my blog and yet found nothing new to read. I have been on a holiday to Hong Kong and have been busy with work since I returned. Nevertheless, no matter how busy I can be, I would still find some times to share what I have learnt. In fact, prior to my trip, I finally found out how to model warrant pricing. I would like to share that with my readers. But before that, I would like to share more information about warrants.

Let’s first talk about decoding a warrant name. In Singapore, the two major types of warrants being traded are index and stock warrants. In particular, I’m going to discuss about covered warrants or more commonly known as structured warrants.

A warrant name is formed by a series of English letters and Arabic numbers. But, what do they actually mean? Let’s find out the answer by looking at STI3500SGAEPW080328 as an example.

Warrant name: STI3500SGAEPW080328
Underlying: STI (for Straits Times Index)
Strike Price: 3500
Issuer: SGA
Warrant Type: e (for European type)
Warrant Class: PW (for put warrant)
Expiry Date: 080328 (for 28th March 2008)

This is an example of an index warrant. Basically, all warrant names contain the above components. Some may have one extra English letter at the end, e.g. CAPITALANDDBECW080616A, what does it mean? The latter is an example of a stock warrant which can be decoded as follow:

Warrant name: CAPITALANDDBECW080616A
Underlying: CAPITALAND
Strike Price: SGD6.30
Issuer: DB
Warrant Type: e (for European type)
Warrant Class: CW (for call warrant)
Expiry Date: 080616 (for 16th June 2008)

Noticed the in the latter warrant name, we cannot find the strike price as part of the warrant naming convention. This is normally the case for stock warrant. Hence you need to find out from the issuer what the strike is or you can simply do a search at SG Warrants. In our example, CAPITALANDDBECW080616A ends with the English letter A. Others may end with B, C or D. These letters actually mean that the same issuer has issued more than one warrant, with different strike, on the same underlying with the same maturity. If you check up on the SG Warrant for CapitaLand, you will realize there is one with warrant name CAPITALANDDBECW080616 with strike price SGD7.30. In short, the letter is there to avoid any confusion that may be caused to investors. So, there is no need to be concerned too much about this extra letter. Just do not mistake a letter “C” at the end for call warrant!

After knowing how to decode the warrant name, we need to understand some of the warrant terms. The terms of a warrant include its code, name, underlying, call/put, strike price, expiry date, conversion ratio and issue price. Basically the price is determined by the terms of the warrant. The pricing of a warrant is not totally up to the issuer nor is it simply a matter of demand and supply.

Two major factors affecting warrant prices are the strike price and expiry date, which are set by the issuer before a warrant is issued. For call warrant, the lower strike price and longer the maturity, the higher the issue price of a warrant will be. A warrant gives its buyer the right to exercise it at maturity. A longer maturity means that there is a higher possibility that the holder can exercise the right. Hence, one has to pay a higher price for it. In contrast, the shorter the maturity, the less chance the right can be exercised. So, the issue price of such a warrant should be lower.

Turning to the strike price, the more in-the-money (ITM), the higher the chance for the warrant to be exercised, and the higher the warrant price will be. The same logic works on the opposite case. Hence, short-term out-the-money (OTM) warrants are normally issued at lower price, while long-term ITM warrants are issued at a higher price, provided other factors remain the same.

Apart from the strike price and expiry date, the issuer also needs to take into account any expected dividend payout of the underlying and the interest rate direction during the life of the warrant. Let us look at a call warrant again. If a high dividend payout is expected from the underlying, the warrant may be issued at a lower price. This is because the dividend received can partially offset the cost of issuance by the issuer. Accordingly, the issue price of the warrant may be set at a lower level.

In addition to these relatively more transparent data, the issuer has to consider one more factor in fixing the warrant price: the implied volatility. The issuer has to hedge against the issued units of the warrant and implied volatility is the most critical cost factor. The higher the implied volatility, the higher the hedging cost and, thus, the higher the issue price of the warrant will be. Different issuers may have different expectations on implied volatility. This is particularly so for warrants on newly-listed stocks, since there is less reference data on their volatility. As a result, such warrants may differ widely in their implied volatility. This also explains why warrants with exactly the same strike price or maturity may be issued at different prices. However, as market expectations come closer on future volatility of the underlying, the differences in the implied volatility of similar warrant will narrow, so will their price differences.

I’ll continue on my blog on warrants. I noticed prior to US market open tonight, the futures are up. Hence high chance is, the market may rally a bit tonight and hopefully the Singapore market will go up tomorrow too. Cheers!

Different Types of Warrants

2008-01-01T14:45:00.000+08:00

Time passes really fast. 2007 is gone and now is 2008. Have you ask yourself what have you learnt this year? Have you fulfilled your resolutions for 2007? If you have, that is good for you. If you have not, try not to put what you need to do today to tomorrow again. This is my first post of 2008. I’m going to continue on my blog about warrants. I’ll discuss more about the different types of warrants.

Company warrants vs. Covered (Structured) warrants

The basic concept of warrants is to give investors the right to buy or sell the underlying at the pre-determined strike price on the pre-determined date. Company warrants and covered warrants share the same concept. Yet, there are some major differences: why they are issued? And how they are settled at maturity?

Company warrants are issued by companies to raise funds or to reward employees or shareholders. Upon maturity of a company warrant, provided the stock price is higher than the strike price at the time, the holder is entitled to buy certain number of shares of the company at the strike price. When the holder does exercise the warrant, the company must issue new shares to meet the promise. So, when company warrants are exercised, the shareholding of the company will be diluted.

Covered warrants are mainly issued by investment banks. They are issued to offer a leveraged investment tool for investors. Let’s take call warrants as an example. Upon maturity, if the underlying settlement price is higher than the strike price, the difference will be paid by the issuer to the investor. Given that cash settlement, rather than physical delivery, is the norm for covered warrants, companies will not face any changes in their shareholding structures as a result. In other words, covered warrants will not dilute a company shareholding.

Both company warrants and covered warrants are tradable on the market. However, company warrants normally have a lower liquidity, and there is no way to compare their prices. This is because the price of a company warrant is mainly determined by the board of directors. Therefore, the warrant price is very likely to deviate from the underlying price. Put another way, company warrants are less transparent and, sometimes, more speculative. In contrast, covered warrants have a good liquidity due to the market making system. Besides, their pricing mechanism is more transparent (statistics such as effective gearing is readily available). Hence, it is possible to track changes in the theoretical prices of covered warrants.

Although the concepts behind company warrants and covered warrants are similar, the two are subject to different levels of risks. Investors should study the relevant information carefully and bear in mind their own risk tolerance in making the decision whether to invest in company warrants or covered warrants.

American warrants vs. European warrants

Warrants can be divided into American or European types, based on the way they are exercised.

American warrant – Holder can exercise the right to buy (or sell) the underlying at anytime between the listing date and the expiry date.
European warrant – Holder can exercise the same right only at maturity.

American warrants can be exercised at any time between the listing date and the expiry date. So, they seem to be more flexible. However, in practice, few investors choose to exercise their warrants. Hence, this feature does not matter much. When we look into the issue of “time decay”, you will understand that it is often more beneficial to sell the warrant back to the market before expiry rather than holding it until the date to exercise.

In Singapore, all warrants are European type and are settled by cash rather than physical delivery. This means that if the warrants are in-the-money, the issuer will calculate and pay the difference between the settlement price of the underlying and the strike price of the warrant. Cash settled warrants are automatically exercised. So, there is no need for issuer to serve any notice of exercise.

Index warrants vs. Stock warrants

To compare index warrants and stock warrants, we can look at their difference in risk/return performance and the investment attitude.

Let’s start with the risk/return issue. The two types of warrants have basically the same structure. Their major difference is their underlying assets, and as such, the difference in their risk/return performance.

In general, an index comprises a number of stocks of different sectors and industries. Hence, its risk exposure is diversified. Its volatility reflects the weighted average volatility of its constituent stocks.

Based on conventional wisdom, when the market is bullish, investors tend to buy stock warrants. On the other hand, when the market is bearish or in a range-trade, investors tend to buy index warrants. This can be deduced by the higher trading volume of index warrants as a percentage of the total turnover when the market is on the downturn.

There are two reasons for the above. Firstly, in terms of number and variety, there are far more stock call warrants in the market. Yet, only a few, or none at all, put warrants are issued on individual stocks. In contrast, index call warrants and index put warrants are more in proportion. Secondly, when the market is climbing, investors normally expect that different stocks will take turns in leading the run. Therefore, they will focus only on the related stock warrants as they take the domino effect. Trading in index put warrants is simpler and direct investment strategy.

Of course, where investors have strong views on a particular stock, it would be better to invest in the related stock warrants. Yet, trading in index warrants might be a good idea if you want to ride on a general trend, if you are satisfied with a modest risk/return, or if you want to hedge or insure against the risks of your stock holdings on hand.

There are many difference types of warrants around, including currency warrants and exotic warrants such as dividend warrants, locked return warrants, average return warrants, spread warrants, digital warrants, knock-in warrants, window barrier warrants and straddle warrants. Given the complex settlement method of exotic warrants, one should read the terms carefully before investing. You can buy this book “School of Warrants” by Edmond Lee sponsored by Societe Generale, if you wish to learn more about exotic warrants. I’ll be away for a short trip and will be back on the 9th Jan 2008. As such, I may not be able to blog for awhile. I hereby wish everyone a happy new year 2008. May all your dreams come true this wonderful year.

Life Cycle of a Trade (Part 3)

2007-12-29T13:56:00.000+08:00

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.

Warrants - Basic Knowledge & Concepts

2007-12-25T12:22:00.000+08:00

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.

Warrants give you a right but not obligation
A warrant’s value is mainly affected by the underlying price
The longer the maturity, the higher the value of a warrant
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.

Life Cycle of a Trade (Part 2)

2007-12-22T11:38:00.000+08:00

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:

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).
The broker validates that the order is coming from a correct and reliable source.
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.
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.

Once the risk management check passes, the client’s order is forwarded to the exchange.
On receipt of the order, the exchange immediately sends an order confirmation to the broker’s trading system.
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.

Put-Call Parity

2007-12-21T09:52:00.000+08:00

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;

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.
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.
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.
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.
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.
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.
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.
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?

Life Cycle of a Trade (Part 1)

2007-12-20T16:04:00.000+08:00

Have you ever wonder what happens after you submit your order for your trade? If you have flipped through the papers and come across terms like Front office, Middle office and Back office, what are they and their roles?

In this post, I shall show how an order flows from an investor to an exchange, how it gets converted into a trade, and how it gets settled. Each order that is initiated by an investor follows a defined life cycle from initiation to settlement. The image below illustrates this life cycle. This life cycle is defined worldwide by the existing operational practices of most institutions, and the processes are more or less similar. The emphasis is on getting the orders transacted at the best possible price and on getting trades settled with the least possible risk and at manageable costs. Designated employees in the member’s office ensure that each trade that takes place through them or in their house account gets settled properly. Unsettled trades lead to liability, risk, and unnecessary costs.

The following steps are involved in a trade’s life cycle:

Order initiation and delivery
Risk management and order routing
Order matching and conversion into trade
Affirmation and confirmation (this step is relevant for institutional trades only)
Clearing and settlement

Steps 1 and 3 are generally called front-office functions, and steps 4–5 are called back-office functions. The risk management part in step 2 is a middle-office function, and the routing part is again a front-office function. In the trading and settlement value chain, steps that take place before the order gets executed are called pre-trade. These include order initiation, order delivery, order management and routing, order-level risk management, and so on. Similarly, steps that take place after the order is matched and converted into a trade are called post-trade. The entire gamut of clearing and settlement is known as post-trade activity.

Though the underlying philosophies of executing orders at the lowest costs and performing risk-free settlements remain the same, the operational steps differ from member to member and also from country to country.

Also, given an institution, the steps followed differ from client to client. This is actually more linked to the client type rather than to the client. An individual person trading is classified as a retail customer and is hence considered risky. Corporate customers, funds, banks, and financial institutions are called institutional investors. For example, risk management before order routing may be a step that takes place compulsorily for a retail client but could be waived for an institutional client, especially if the institution has a sound financial standing in the market. Additional steps are involved in settling an institutional trade in comparison to a retail trade. This difference is because institutions normally outsource their settlement function, and members have to talk to this additional agency. Institutions also have a number of checks and balances that each member has to follow.

Order Initiation and Delivery

This is the first step, and it involves accepting orders from a client and forwarding them to the exchange after doing risk management checks.

Clients keep a close eye on the markets and keep scouting for investment opportunities. They form a view about the market. View alone, however, is not enough to produce profits. Profits come from maintaining a position in the market. Positions are the results of trades that investors execute in the markets. Clients place orders with their brokers through multiple delivery channels. Some popular channels for placing orders include phones, faxes, the Internet, and interactive voice response systems (IVRSs). The majority of brokers have built-in capabilities to allow clients to submit their orders through personal digital assistants (PDAs) and other handheld devices. Institutions usually place a large number of orders. Most institutions submit their orders in soft-copy format through a floppy disk or any other bulk-upload medium.

Those who trade a lot in a particular market may even demand that the broker gives them a dedicated trading terminal. They may also set up their own trading terminal that connects to the broker’s trading terminal/server through a proprietary protocol or industry-standard protocol such as Financial Information Exchange (FIX), which is a technical specification prepared in collaboration with brokers, exchanges, banks, and institutional investors to enable the seamless exchange of trading information between their systems. Systems with broker and trading institutions generate orders automatically depending upon the market conditions. Trading on such automatically generated orders is called program trading and is not allowed in some markets because it is perceived to cause volatility. Regardless of the methodology used for order delivery, the broker carefully records the orders so that there is no ambiguity or mistakes in processing. Almost all brokers record the conversation between clients and brokers, which can be used later for dispute resolution in case any ambiguity exists over what was communicated and what was interpreted and executed.

Institutions normally speak to a sales desk of the broker and get a feel for the market. An institution or the fund manager who places the order may be managing multiple funds. At the time of placing the order, however, the fund manager may not know to which fund he will allocate the securities bought/sold. At the point of placing the order, the fund manager just instructs the sales desk of the broker to execute the order.

An individual order received from a client is tagged with some special conditions such as good till cancelled (GTC), good till date (GTD), limit order, market order, and so on. These conditions dictate the rate and condition at which the customer expects the orders to be executed. The member on a best-effort basis accepts the order. Unless an institution specifically demands it, there is no standard practice of giving back-order confirmation details. This essentially means that the clients work with brokers on good faith that the broker has understood their order terms clearly and will get it executed at the best possible price. It is important that brokers preserve the sanctity of the conditions specified and get the orders executed within the boundaries of specification. Failure to do so will result in the client moving to a different brokerage house.

I’ll discuss the remaining steps in my next few posts.

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

2007-12-16T19:32:00.000+08:00

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:

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.
Higher CPF returns and
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.

Implied Volatility, Historical Volatility and Volatility Smile

2007-12-15T20:03:00.000+08:00

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. :)

Option Ticker Symbol

2007-12-13T21:19:00.000+08:00

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.

The Black-Scholes formula

2007-12-12T20:08:00.000+08:00

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:

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.
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.
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.
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.
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.
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.
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.
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.

In the "Set cell:", select the cell B9.
In the "To value:", type in 2.
In the "By changing cell:", select cell B2.
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

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

2007-12-10T10:11:00.000+08:00

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.

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

2007-12-09T12:44:00.000+08:00

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.

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

2007-12-07T13:42:00.000+08:00

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.

What are Treasury securities?

2007-12-04T10:34:00.000+08:00

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.

Commodities Investment

2007-12-03T15:22:00.000+08:00

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.

What is FRAs?

2007-11-25T21:09:00.000+08:00

If you have flipped through the newspapers, you may have come across this acronym known as the FRAs. What is FRAs then? A forward rate agreement (FRA) can be viewed as a forward contract to borrow/lend money at a certain rate at some future date. In practice, these contracts settle in cash, but no actual loan is made at the settlement date.

This means that the credit worthiness of the parties to the contract need not be considered in the forward interest rate, so an essentially riskless rate, such as LIBOR, can be specified in the contract. The long position in an FRA is the party that would borrow the money (long the loan with the contract price being the interest rate on the loan). If the floating rate at contract expiration (LIBOR or Euribor) is above the rate specified in the forward agreement, the long position in the contract can be viewed as the right to borrow at below market rates and the long will receive a payment. If the reference rate at the expiration date is below the contract rate, the short will receive a cash payment from the long.

To calculate the cash payment at settlement for a forward rate agreement, we need to calculate the value as of the settlement date of making a loan at a rate that is either above or below the market rate. Since the interest savings would come at the end of the "loan" period, the cash payment at settlement of the forward is the present value of the interest "savings". We need to calculate the discounted value at the settlement date of the interest savings or excess interest at the end of the loan period.

For those who are not sure what is LIBOR? It is the lending rate on dollar-denominated loans between banks and is actually known as London Interbank Offered Rate or simply LIBOR.

LIBOR is published daily by the British Banker's Association and is compiled from quotes from a number of large banks; some are large multinational banks based in other countries that have London offices. There is also an equivalent Euro lending rate called Euribor, or Europe Interbank Offered Rate. Euribor, established in Frankfurt, is published by the European Central Bank.

The floating rates are for various periods and are quoted as such. For example, the terminology is 30-day LIBOR (or Euribor), 90-day LIBOR, and l80-day LIBOR, depending on the term of the loan. For longer-term floating rate loans, the interest rate is reset periodically based on the then-current LIBOR for the relevant period.

Dividends and Dividend Policy

2007-11-22T18:53:00.000+08:00

If you have bought shares before, chances are, you may have received dividends. There is however companies which do not pay out dividends but simply reinvest their earning back to the companies. There are also companies which go to the market to repurchase back their own shares and there are companies which decided to perform stock splits. The question here is what will happen to the share price with each different decision made and each action taken? Let's try to understand the various ways a company can choose to exercise their decisions.

Cash dividends, as the name implies, are payments made to shareholders in cash. They come in three forms:

Regular dividends occur when a company pays out a portion of profits on a consistent schedule (e.g., quarterly). A long-term record of stable or increasing dividends is widely viewed by investors as a sign of a company's financial stability.
Special dividends are used when the company does not have a regular dividend schedule or if favorable circumstances allow the firm to make a one-time cash payment to shareholders. Many cyclical firms (e.g., automakers) will use a special dividend to share profits with shareholders when times are good, but maintain the flexibility to conserve cash when profits are down. Other names for special dividends include "extra dividends" and "irregular dividends."
Liquidating dividends occur when a company goes out of business and distributes the proceeds to shareholders. For tax purposes, a liquidating dividend is treated as a return of capital and amounts over the investor's tax basis are taxed as capital gains.

No matter which form cash dividends take, their net effect is to transfer cash from the company to its shareholders. The payment of a cash dividend reduces a company's assets and the market value of its equity. This means that immediately after a dividend is paid, the price of the stock should drop by the amount of the dividend (theoretically).

Stock dividends are dividends paid out in new shares of stock rather than cash. In this case, there will be more shares outstanding, but each one will be worth less. Stock dividends are commonly expressed as a percentage. A 10% stock dividend means every shareholder gets 10% more stock.

Stock splits divide each existing share into multiple shares, thus creating more shares. There are now more shares, but the price of each share will drop correspondingly to the number of shares created, so there is no change in the owner's wealth. Splits are expressed as a ratio. In a 2-for-1 (US convention, Singapore convention would be 1-for-2) stock split, each old share is split into two new shares. Stock splits are more common today than stock dividends.

The bottom line for stock splits and stock dividends is that they increase the total number of shares outstanding, but because the stock price and earnings per share are adjusted proportionally, a shareholder's total wealth is unchanged.

Reverse stock splits are the opposite of stock splits. After a reverse split there are fewer shares outstanding but higher stock prices. Since these factors offset one another, shareholder wealth is unchanged. The logic behind a reverse stock split is that the perceived optimal stock price range is $20 to $80 per share in the US, and most investors consider a stock with a price less than $5 per share less than investment grade. A company in financial distress whose stock has fallen dramatically may declare a reverse stock split to increase the stock price.

There are a few dates which we need to take note of. They are,

Declaration date - The date the board of directors approves payment of the dividend.
Ex-dividend date - The first day a share of stock trades without the dividend. The ex-dividend date is also the cut-off date for receiving the dividend and occurs two business days before the holder-of-record date. If you buy the share on or after the ex-dividend date, you will not receive the dividend.
Holder-of-record date - The date on which the shareholders of record are designated to receive the dividend.
Payment date - The date the dividend checks are mailed out, or when the payment is electronically transferred to shareholder accounts.

Stocks are traded ex-dividend on and after the ex-dividend date, so stock prices should fall by the amount of the dividend on the ex-dividend date. Because of taxes, however, the drop in price may be closer to the after-tax value of dividends.

A share repurchase is a transaction in which a company buys back shares of its own common stock. Since shares are bought using a company's own cash, a share repurchase can be considered an alternative to a cash dividend. If the tax treatment for both cash dividend and share repurchase is the same, then a share repurchase has the same impact on shareholder wealth as a cash dividend payment of an equal amount.

A share repurchase using borrowed funds will increase EPS if the after-tax cost of debt used to buy back shares is less than the earnings yield of the shares before the repurchase. It will decrease EPS if the cost of debt is greater than the earnings yield, and it will not change EPS if the two are equal.

There are three ways a company can perform share repurchase. They are,

Buy in the open market
Buy a fixed number of shares at a fixed price
Repurchase by direct negotiation

A company's dividend payout policy is the approach a company follows in determining the amount and timing of dividend payments to shareholders. Six primary factors affect a company's dividend payout policy:

Signaling effect - Unexpected changes in a company's dividend policy is often viewed by investors as a signal from management about projections of the firm's future performance. In other words, stockholders perceive changes in dividend policy as conveying important information about the firm.
Taxation of dividends - Investors are concerned about after-tax returns. Investment income is taxed by most countries; however, the ways that dividends are taxed vary widely from country to country. The method and amount of tax applied to a dividend payment can have a significant impact on a firm's dividend policy.
Clientele effect - This refers to the varying preferences for dividends of different groups of investors, such as individuals, institutions, and corporations.
Restrictions on dividend payments - Companies may be restricted from paying dividends either by legal requirements or by implicit restrictions caused by cash needs of the business.
Flotation costs on new issues versus cost of retained earnings
Shareholder preference for current income versus capital gains

The information conveyed by dividend initiation is ambiguous. On one hand, a dividend initiation could mean that a company is sharing its wealth with shareholders - a positive signal. On the other hand, initiating a dividend could mean that a company has a lack of profitable reinvestment opportunities -a negative signal.

An unexpected dividend increase can signal to investors that a company's future business prospects are strong and that managers will share the success with shareholders.

Unexpected dividend decreases or omissions are typically negative signals that the business is in trouble and that management does not think the current dividend payment can be maintained. In rare instances, however, management can attempt to send a positive signal by cutting the dividend. Management may believe profitable investment opportunities are available and that shareholders would ultimately receive a greater benefit by having earnings reinvested in the company rather than being paid out as dividends.

The information content in dividend policy changes is viewed differently across countries. In the US, investors infer that even small changes in a dividend send a major signal about a company's prospects. However, in Japan and other Asian countries, investors are less likely to assume that even a large change in dividend policy signals anything about a company's future. As a result, Asian companies are freer to raise and lower their dividends as circumstances change without being concerned about how investor reactions may affect the stock price.

Hope this post has provided better insight to the dividends and dividend policy used by companies. Take note that whatever discussed here is theoretical. What happen in real life when a company announced its earning and dividend payment or share repurchase can bring very different impacts to its share price based on investor sentiment. Cheers.

Forex Trading

2007-11-21T10:09:00.000+08:00

I have always heard of Forex Trading but I do not really understand how it works? The booster session last night by Conrad is another intriguing lesson. Before I forgot everything I learnt about Forex trading, I would like to share with the readers of this blog. I actually did more research once I reached home last night at around 1 am. I was too excited to go and sleep even though I am very tired. Here is what I found and learnt.

What is Forex Trading?

Forex or Foreign Exchange is the simultaneous buying of one currency and the selling of another. Currencies are traded in pairs.

The Forex market has more buyers and sellers and daily volume than any other market in the world and takes place in major financial institutions across the globe. The forex market is open 24 hours a day and five days a week.

In the Forex Market, currencies are always priced in pairs and all trades result in the simultaneous buying of one currency and the selling of another. The objective of currency trading is to buy the currency that increases in value relative to the one you sold. If you have bought a currency and the price appreciates in value, then you must sell the currency back to lock in the profit.

Currencies are quoted in pairs. The front or first currency is known as the base currency and the second is called the counter or quote currency. You always trade based on the front currency. For example, EUR/USD quote, you can only trade on the EUR currency by buying or selling. It is a norm to quote the stronger currency as the base currency. Currencies are quoted using five significant numbers, with the last placeholder called a point or a pip (percentage in price). For example, a EUR/USD quotes 1.1345/1.1350.

If you have studied Global Economic before, you may have come across quotes like American terms, European terms, Direct quote or Indirect quote. What do all these mean?

American terms means the quote is in the form of USD$ per unit of the foreign currency. There are generally four currencies that are quoted in American terms. They are Euro, Kiwi, Aussie and Sterling.
European terms means the quote is in the form of foreign currency per USD$. This is normally the case.
Direct quote means the quote is in the form of domestic currency per unit of foreign currency.
Indirect quote means the quote is in the form of foreign currency per unit of domestic currency. This is generally used in UK, Canada and US only.

Like all financial products, forex quotes include a "bid" and "ask" or a "sell" and a "buy" price. By quoting both the bid and ask in real time, brokers ensure that traders always receive a fair price on all transactions. As in any traded instrument, there is an immediate cost in establishing a position. This cost will vary between the different brokers and is sometimes called "spread". For example, USD/JPY may bid at 132.20 and ask at 131.25, this five-pip spread defines the trader's cost, which can be recovered with a favourable currency move in the market.

The Forex Market is a seamless 24 hours market and is open 5 days a week. At 5pm Sunday, New York time, trading begins as markets open in Sydney and Singapore. At 7pm the Tokyo market opens, followed by London at 2am, and finally New York at 8 am. (Time is based on New York time).

As a trader, this allows you to react to favourable and unfavourable news by trading immediately.

The trading of Forex takes place all over the world and is not located in any one central location. Deals are done between a variety of traders, from banks to managed funds to individual traders.

Forex trades approximately around US$1.85 trillion a day and is by far the most liquid market in the world. It takes the NYSE 3 months to trade the same USD value as the Forex trades each and every day making it the largest and most liquid market in the world. The Forex Market is always liquid, meaning positions can be liquidated and stop orders executed without slippage.

Traders can trade a variety of currency pairs, limited only by which pairs each broker provides. Major currency pairs are typically the USD pairs. For example,

EURUSD
GBPUSD
AUDUSD
USDJPY
USDCHF

Cross currency pairs are pairs which do not involve the USD for example

EURGBP
EURJPY
GBPJPY
EURCHF

Point/Pip values is the USD$ value for each point or Point/Pip. These are typical values and can vary between the different brokers and market makers.

You can sign up for a Forex account with InterbankFx. You can find more information at Forex Factory, Forex Capital Market, Daily Forex and also a good Forex Trading guide here. Trading is approximately 20% technical and fundamental and 80% psychological. With the psychological side of trading, it is important that you understand the sentiment of the market and have good money management skills.

Types of Order in the Market and Time Limits with Trade Orders

2007-11-19T11:34:00.000+08:00

If you have trade in the US market before, you will realise that the US market has so many features that you cannot find in Singapore market. Take for example, the types of order in the market. What is type of order in the market? In the US, we have orders such as Market Order, Limit Order and Stop Loss/Sell Stop etc. What do they mean?

Market Order
This is where you authorise your broker to buy or sell stock or options at the best price in the market.

Limit Order
This is where you:

only buy if share falls to a certain price or lower; or
only sell if share rises to certain price or higher.

Limits are recommended with options trading, particularly for spreads and combination trades. The reason for this is that the bid/ask spread prices can fluctuate dramatically and often not in your favour, so it is better to specify your prices.

Stop Loss/Sell Stop (Defensive)
This is where you:

Sell if stock falls below a certain price (sell stop is placed below the current price).

You can increase the stop loss if the share rises.

Buy Stops
This is where you will only buy once the stock has reached or exceeded a certain price. This is like the opposite of a limit order where you look to buy a stock when it has fallen to a certain price. A Buy Stop is appropriate where you expect a stock to rise beyond a resistance level or bounce up from a support level.

Buy Stop with limit - Only buy when stock is between two prices.
Buy Stop with limit and Stop Loss - Buy between two prices and sell if below another price.

There are however some time limits with different type of trade orders such as GTC, Day only, Week only etc. What do these mean then?

Good Till Cancelled (GTC)
This is where the order is valid unless and until you cancel it or until it is filled. For example, a limit order GTC means you authorise your broker to sell the stock at a particular price, today or any time in the future where the stock is selling at that particular amount, until you have sold the requisite number of shares. Smith Barney Benefit Access uses this. Be careful with GTC orders because these orders generally do not go to the top of the list of floor traders’ priorities.

Day Only
The order will be cancelled if it is not filled by the end of the day. This is a good ploy because it encourages the floor traders to deal. If they don’t by the end of the day, then they won’t get their commission, so there is an incentive for floor traders to put this type of trade nearer to the top of their list.

Week Only
The order will be cancelled if it is not filled by the end of the week.

Fill or Kill
The order of maximum priority. If it is not filled immediately, the order is cancelled. A fill or kill order is bound to capture the attention of the floor trader, but if it is a limit order, then you need to make it realistic.

All or None
Either the entire order is filled or none of it. This is not generally a good idea given that many trades are not filled all at once anyway because there has to be a buyer or seller on the other side, and most of the time they won’t be specifically dealing in the same lot sizes as your order. So if you want to be sure to get filled, do not go for all or none!

Weighted Average Cost of Capital

2007-11-16T10:00:00.000+08:00

Students who graduated from the WA08 class, if you can still recall, Conrad showed us this site where you can key in the stock symbol and the site will automatically compute the intrinsic value of the stock for you. For those who cannot remember, you can click on this link Online Intrinsic Value Calculator. I have also added the link to heading under Investment Related Sites.

If you have used the calculator for your stock valuation, you will notice there is this entry known as the Company WACC (%). So what is this company's WACC? WACC is actually an acronym for Weighted Average Cost of Capital for that company. If you understand about the capital budgeting process of a company that involved the discounted cash flow analysis, this is actually the discount rate that company used to discount its future cash flow. This rate is also known as the marginal cost of capital.

On the right (liability) side of a firm's balance sheet, we have debt, preferred stock, and common equity. These are normally referred to as the capital components of the firm. Any increase in a firm's total assets will have to be financed through an increase in at least one of these capital accounts. The cost of each of these components is called the component cost of capital.

The WACC is given by:

WACC = (wd)(kd)(1 – t) + (wps)(kps) + (wce)(kce)

where:

wd = The percentage of debt in the capital structure
wps = The percentage of preferred stock in the capital structure
wce = The percentage of common stock in the capital structure
kd = The rate at which the firm can issue new debt. This is the yield to maturity on existing debt. This is also called the before-tax component cost of debt.
kd(l - t) = The after-tax cost of debt. Here , t is the firm's marginal tax rate. The after-tax component cost of debt, kd(l - t), is used to calculate the WACC.
kps = The cost of preferred stock.
kce = The cost of common equity. It is the required rate of return on common stock and is generally difficult to estimate.

How a company raises capital and how they budget or invest it is considered independently. Most companies have separate departments for the two tasks. The financing department is responsible for keeping costs low and using a balance of funding sources: common equity, preferred stock, and debt. Generally, it is necessary to raise each type of capital in large sums. The large sums may temporarily overweight the most recently issued capital, but in the long run, the firm will adhere to target weights. Because of these and other financing considerations, each investment decision must be made assuming a WACC which includes each of the different sources of capital and is based on the long-run target weights. A company creates value by producing a return on assets that is higher than the required rate return on the capital needed to fund those assets.

The WACC as we have described it is the cost of financing firm assets. We can view this cost as an opportunity cost. Consider how a company could reduce its costs if it found a way to produce its output using fewer assets, say less working capital. If we need less working capital, we can use the funds freed up to buy back our debt and equity securities in a mix that just matches our target capital structure. Our after-tax savings would be the WACC based on our target capital structure, times the total value of the securities that are no longer outstanding.

For these reasons , any time we are considering a project that requires expenditures, comparing the return on those expenditures to the WACC is the appropriate way to determine whether undertaking that project will increase the value of the firm. This is the essence of the capital budgeting decision. Since a firm's WACC reflects the average risk of the projects that make up the firm , it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than average risk.

The weights in the calculation of WACC should be based on the firm’s target capital structure. In the absence of any explicit information about a firm’s target capital structure from the firm itself, an analyst may simply use the firm’s current capital structure as the best indication of its target capital structure. If there has been a noticeable trend in the firm’s capital structure, the analyst may want to incorporate this trend into his estimate of the firm’s target capital structure.

Alternatively, an analyst may wish to use the industry average capital structure as the target capital structure for a firm under analysis.

What Kind of Trader or Investor are you?

2007-11-14T11:49:00.000+08:00

Conrad mentioned this in the WA08 workshop and I thought it was kind of cute to classify traders and investors to the characteristics of the animals and hence I did a search on Investopedia to see what they really mean?

Turtle - A nickname given to a group of traders who were a part of an 1983 experiment run by two famous commodity traders, Richard Dennis and Bill Eckhardt. The goal of the study was to prove whether being a great trader was a genetic predisposition or whether it could be taught. Dennis believed that a person could be trained while Eckhardt thought it was an innate skill.

Pig - An investor who is often seen as greedy, having forgotten his or her original investment strategy to focus on securing unrealistic future gains. After experiencing a gain, these investors often have very high expectations about the future prospects of the investment and, therefore, do not sell their position to realize the gain.

Ostrich - A slang term given to investors or other market participants who ignore important pieces of information or situations, which have the ability to impact them or the market in which they operate. The reasons behind type of action can include risk aversion and bias.

Lemming - The act of following the crowd into an investment that will inevitably head for disaster.

Sheep - An investor who lacks a focused trading strategy and trades on emotion and the suggestions of others, including friends, family and financial gurus. This type of investor often makes rash investments without reviewing their financial viability. The behavior of sheep contrasts with that of bulls and bears, who have focused views about the market.

Barefoot Pilgrim - Slang for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market.

Which kind are you?

Yield Curve for Bonds

2007-11-14T10:44:00.000+08:00

For those students who graduated from WA07 class, if you still remember Conrad mentioned about the Inverted Yield Curves for year 2006 and 2007 and their implication to the economy, you may be wondering what Conrad is trying to get across to us. I'll try to explain what causes the shape of the yield curve in this post.

There are three theories to describe the term structure of interest rates that affect the shape of the yield curve. They are

So what does each theory say? The pure expectations theory states that the yield for a particular maturity is an average (not a simple average) of the short term rates that are expected in the future. If short term rates are expected to rise in the future, interest rate yields on longer maturities will be higher than those on shorter maturities, and the yield curve will be upward sloping. If short term rates are expected to fall over time, longer maturity bonds will be offered at lower yields.

Proponents of the liquidity preference theory believe that, in addition to expectations about future short term rates, investors require a risk premium for holding longer term bonds. This is consistent with the fact that interest rate risk is greater for longer maturity bonds.

Under this theory, the size of the liquidity premium will depend on how much additional compensation investors require to induce them to take on the greater risk of longer maturity bonds or, alternatively, how strong their preference for the greater liquidity of shorter term debt is.

The market segmentation theory is based on the idea that investors and borrowers have preferences for different maturity ranges. Under this theory, the supply of bonds (desire to borrow) and the demand for bonds (desire to lend) determine equilibrium yields for the various maturity ranges. Institutional investors may have strong preferences for maturity ranges that closely match their liabilities. Life insurers and pension funds may prefer long maturities due to the long-term nature of the liabilities they must fund. A commercial bank that has liabilities of a relatively short maturity may prefer to invest in shorter-term debt securities. Another argument for the market segmentation theory is that there are legal or institutional policy restrictions that prevent investors from purchasing securities with maturities outside a particular maturity range.

A somewhat weaker version of the market segmentation theory is the preferred habitat theory. Under this theory, yields also depend on supply and demand for various maturity ranges, but investors can be induced to move from their preferred maturity ranges when yields are sufficiently higher in other (non-preferred) maturity ranges.

The pure expectations theory by itself has no implications for the shape of the yield curve. The various expectations and the shapes that are consistent with them are:

Short-term rates expected to rise in the future -> upward sloping yield curve
Short-term rates are expected fall in the future -> downward sloping yield curve
Short-term rates expected to rise then fall -> humped yield curve
Short-term rates expected to remain constant -> flat yield curve

The shape of the yield curve, under the pure expectations theory, provides us with information about investor expectations about future short-term rates.

Under the liquidity preference theory, the yield curve may take on any of the shapes we have identified. If rates are expected to fall a great deal in the future, even adding a liquidity premium to the resulting negatively sloped yield curve can result in a downward sloping yield curve. A humped yield curve could still be humped even with a liquidity premium added to all the yields. Also note that , under the liquidity preference theory, an upward sloping yield curve can be consistent with expectations of declining short term rates in the future.

The market segmentation theory of the term structure is consistent with any yield curve shape. Under this theory, it is supply and demand for debt securities at each maturity range that determines the yield for that maturity range. There is no specific linkage among the yields at different maturities, although, under the preferred habitat theory, higher rates at an adjacent maturity range can induce investors to purchase bonds with maturities outside their preferred range of maturities.

Conrad showed us to this site where you can learn more about bonds. You can click on the link here.

Sam Stovall

2007-11-12T14:10:00.000+08:00

I first heard about Sam Stovall, who is the Chief Investment Strategist at Standard & Poor's, from Conrad Alvin Lim when I attended the Wealth Academy workshop. Sam Stovall wrote a book on Sector Investing. Conrad had used his model and showed us a demonstration on how this model works till today even though Sam Stovall wrote the book back in 1996. What Conrad had shown really impressed me a lot. I have always been a stock centric person and never really take the times to understand how the money flows from the one sector to the other. Hence after learning what Conrad had taught me, I decided to find more information regarding sector rotation, sector investing etc.

I found this very good article in Investopedia which you may be interested to take a look. I also found a research written by Sam Stovall. I have provided the links of the article and the research here. You can simply click on the links.

Nineteen Common Mistakes Most Investors Make

2007-11-06T08:35:00.000+08:00

This is a continuation of my yesterday post on the CAN SLIM acronym by William J. O’Neil book, "How to Make Money in Stocks A Winning System in Good Times or Bad - Third Edition". One of the chapters in the book mentioned about the nineteen common mistakes most investors make. I have consolidated and posted them here.

Even the most experienced investors often make the same classic mistakes that limit their profits or cause steep losses. Here are the 19 mistakes you must avoid:

Stubbornly holding on to losses when they are very small and reasonable. Instead of getting out cheaply, many investors hold on until the loss gets so large it costs them dearly. Without exception, cut every loss at 7 to 8 percent.
Buying on the way down in price, thereby ensuring miserable results. A declining stock seems to be a real bargain. But remember: With few exceptions a stock’s price is high or low for good reasons.
Averaging down in price rather than up when buying. If you buy a stock at $40 and then buy more at $30, and average your cost at $35, you are following your losers and putting good money after bad.
Buying large amounts of low-priced stocks rather than smaller amounts of higher priced stocks. When you invest, buy the best merchandise available, not the cheapest. Low-priced stocks cost more in commissions and are more volatile, usually to the downside.
Wanting to make a quick and easy buck. Wanting too much, too fast, without the proper preparation, can lead to big losses.
Buying on tips, rumors, split announcements, and other news events, stories, advisory service recommendations, or opinions you hear from supposed market experts on TV. Trust what you have learned through hard work, not rumors and tips, which usually aren’t true.
Selecting second-rate stocks because of dividends or low price earnings ratios. Dividends and P/E ratios aren’t as important as earnings per share growth. In many cases, the more a company pays in dividends, the weaker it may be.
Never getting out of the starting gate properly due to poor selection criteria. Many people buy highly speculative, risky stocks that have questionable earnings and sales growth; inevitably, they get what they deserve.
Buying old names you are familiar with. Many of the best investments will be newer companies that, with a little research, you could discover and profit from before they become household names.
Not being able to recognize and follow good information and advice. Friends and relatives can give bad advice. So can some stockbrokers and advisory services, because every profession includes a small minority who are top performers, many who are mediocre, and some who are truly awful.
Being afraid to buy stocks that are going into new high ground in price. A stock that reaches a new high may be on its way to much greater highs.
Cashing in small easy to-take profits, while holding the losers. You should do the opposite: Cut your losses short, and let your profits grow.
Worrying too much about taxes and commissions. The money to be made by selecting the right stocks is enormous in comparison to the cost of taxes and commissions.
Focusing on what to buy, and not understanding when the stock must be sold. Timing your exit is as important as planning your entrance.
Failing to understand the importance of buying quality companies with good institutional sponsorship.
Speculating too heavily in options and futures because they’re thought to be a way to get rich quick.
Rarely transacting "at the market" and preferring to put price limits on buy and sell orders. By quibbling on an eighth of a point, they miss the stock's larger and more important movement.
Not being able to make up your mind when a decision needs to be made. This invariably points to lack of a plan.
Not looking at stocks objectively. Relying on your emotions or only on your opinion is a recipe for failure.

I'll share more information of the book again. Cheers.

How to Make Money in Stocks - A Winning System in Good Times or Bad

2007-11-05T10:54:00.000+08:00

I guess some of you may have come across this book, "How to Make Money in Stocks - A Winning System in Good Times or Bad". This book is written by William J. O’Neil. For those who have heard of the acronym CAN SLIM, it actually came from this book. I have briefly summarise what does the acronym CAN SLIM means? Remember the simple acronym CAN SLIM. Each letter stands for one of the seven basic fundamentals of selecting outstanding stocks.

Most successful stocks share these seven common characteristics at emerging growth stages, so they are worth committing to memory.

C equals Current Quarterly Earnings per Share: They must be up at least 18 or 20 percent. The higher, the better. Also, quarterly sales must be accelerating or up 25 percent.

A equals Annual Earnings Increases: Require significant growth for each of the last three years and a return on equity of 17 percent or more.

N equals New Products, New Management, New Highs: Look for new products or services, a new senior management team, or significant changes in industry conditions. Buy stocks as they begin to make new highs in price.

S equals Supply and Demand: It doesn't matter whether a company has a large capitalization or a small cap, as long as it fits all of the other CAN SLIM rules. Look for big volume increases.

L equals Leader or Laggard: Buy market leaders and avoid laggards. Buy the No. 1 company in its field. Most leaders' Relative Price Strength Rating will be 80 or 90 or higher.

I equals Institutional Sponsorship: Buy stocks with increasing institutional ownership and at least a few sponsors with top-notch recent performance records.

M equals Market Direction: Learn to determine overall market direction by accurately interpreting daily market indices' price and volume movements, and the action of individual market leaders. This can determine whether you will win or lose. By using this simple, proven, and extremely powerful method, you can make money in stocks in any type of economy.

The reason that CAN SLIM continues to work, cycle after cycle, is because it is based solely on the reality of how the stock market actually works, rather than personal opinions, including those of the experts on Wall Street. Further, human nature at work in the market simply doesn't change. So CAN SLIM does not get outmoded as fads, fashions, and economic cycles come and go.

I would seriously recommend investors to borrow or buy the book if you wish to know more about how CAN SLIM can work for you. The 3rd edition also includes a chapter on "Nineteen Common Mistakes Most Investors Make".

What are futures?

2007-11-01T14:20:00.000+08:00

I guess many of us might have come across this term, "Futures". You may have heard of "Forwards" before as well. Simply put it, futures are simply forwards but they are regulated and are backed by clearing house.

A futures contract is a legally binding agreement between a buyer and seller to receive (in the case of a "long" position) or deliver (in the case of a "short" position) a commodity or financial instrument sometime in the future, but at a price that's agreed upon today. These contracts mature at a particular point in the future and are identified by reference to that date - for instance, a Nov 2007 Wheat futures contract or a December 2005 S&P 500 stock index futures contract. The ability to make or take delivery of the underlying commodity at expiration creates a strong tendency for cash and futures prices to move in the same direction by roughly equal amounts. It will take two options to replicate a future contract.

For those who wish to know more, Wikipedia provides very good information about futures and its difference between forwards. Click here for more information.

Company and Stock?

2007-10-26T11:23:00.000+08:00

Have you thought of these questions of what are the differences between a growth company and a growth stock? How about a defensive company and a defensive stock? Do they equate one another? What are their differences? Below is a summary of what do they actually meant.

Growth companies are ones that consistently earn higher returns than required by their risk. A growth stock is one that earns higher returns than other stocks of equivalent risk. Typically growth stocks have P/E ratios higher than that of the market average P/E as well.

A defensive company is a company that has earnings that are relatively insensitive to downturns in the economy. A utility company is a good example. These types of firms typically have low business risk and moderate financial risk. A defensive stock is a stock that will not decline as much as the market when the overall market declines. The returns of defensive stocks have a low correlation with the returns of the market. Defensive stocks are characterized by having low beta values.

A cyclical company is a company with earnings that tend to follow the business cycle. An automobile company is a good example. Cyclical companies often have high levels of fixed costs (business risk) and/or leverage (financial risk). A cyclical stock is a stock with rates of return that will change more than changes in the return on the overall market. These are stocks with betas greater than one, indicating more than a one-to-one reaction to changes in the return on the market.

A speculative company is a company that has assets that are very risky, but have the potential to generate very large earnings. An oil exploration company is a good example. A speculative stock is a stock that is highly likely to have very low or negative returns, because they are almost always overpriced. These stocks have a low probability of a return near that of the market, but a slight probability of an enormous return.

Individual Income Tax (Salaried Employee)

2007-10-24T10:36:00.000+08:00

This is the most dreaded thing by most people I guess where every year you have to pay a certain amount of your hard-earned money to the government. This is one aspect most people seldom take into consideration as their monthly expenses simply because it only occurs once a year. For Singaporean, you can easily compute your taxable income by using the spreadsheet provided by Inland Revenue Authority of Singapore (IRAS) to estimate your annual taxable income so you can set aside a sum of money for that month to your income tax. You can find more information for income tax for individual salaried employee and download the spreadsheet here.

Plain-vanilla interest rate swap

2007-10-24T09:51:00.000+08:00

Have you ever flip through the newspapers and see this term known as the "Plain-vanilla interest rate swap"? When I first heard of this, I thought it was kind of cute and interesting. I was asking myself, why plain vanilla? Why not chocolate or strawberry? Hmm.., anyone know why?

Anyway, what is a plain-vanilla interest rate swap then? A plain-vanilla interest rate swap is an exchange of a series of fixed interest payments for a series of floating interest payments, fluctuating with LIBOR (London interbank offer rate). The fixed rate of interest is often quoted as a spread over the current US Treasury security of the desired maturity and is called the swap rate. Normally, the floating rate paid at the end of each period is based on LIBOR at the beginning of the period. The times at which the floating rates are established are called the “reset dates.” The two sides of the swap are called the “fixed leg” and “floating leg”; and the life of a swap is called its tenor. In this case, only the cash flows, not the principals, of the two types of debt are exchanged. So the size of the swap is measured by its notional principal.

For example, for five years, one counterparty (“the buyer”) agrees to pay a fixed rate of interest, say the coupons that would be received on $1,000,000 of principal of the current five-year Treasury note plus 65 basis points (.65%) in exchange (from “the seller”) for five years of semiannual floating rate payments equal to $1,000,000 paying LIBOR with six-month resets. Here, the notional principal is $1,000,000 and the tenor of the swap is five years. The spread over treasuries allows the swap to be quoted “flat”, similar to a forward contract, so that no money need change hands at inception.

Swap financing is normally adopted by companies which operate globally and can be used as a hedge against foreign rate exchange risk.

Rates & Bonds

2007-10-20T15:07:00.000+08:00

For those who wish to know the different rates in the market now, for e.g. the 3-Month LIBOR rate, US Treasuries bill rate etc., you can find good information by clicking this link here: http://www.bloomberg.com/markets/rates

The difference between options and warrants

2007-10-20T11:39:00.000+08:00

Have you ever wonder what is the difference between options and warrants? They seem to be almost identical in some aspects. However, they are not truely similar.

Warrants are options to buy or sell shares that are listed on a stock exchange. The warrants themselves are listed on that stock exchange, rather than on the futures market.

The underlying asset of a warrant is always a share or a basket of shares, while the underlying product of an option could be anything from wheat to gold to shares.

Warrants are usually more accessible to the small investor, because the size of the contract, called the cover ratio, is smaller.

The cover ratio of an option or warrant is the number of options or warrants you need to buy one unit of the underlying asset. Warrants may, for example, only entitle you to buy a quarter or a half of a share, rather than one share or even 100 shares.

Warrants have no set time to maturity as this depends on the warrant issuer, but typically they are issued with an expiry date of four to 18 months. Options on the futures exchange usually have expiry terms – generally three months – that are set by the futures exchange.

How is STI index being computed?

2007-10-17T16:53:00.000+08:00

For those who observe closely on the indexes such as the S&P500, the DJIA, the STI etc., have you ever wonder how these indexes are constructed? There are 3 basic ways to compute these indexes. They are

Price-weighted
Market value-weighted
Unweighted

The returns on a price-weighted index could be matched by purchasing an equal number of shares of each stock represented in the index. Since the index is price-weighted, a
percentage change in a high-priced stock will have a relatively greater effect on the index than the same percentage change in a low priced stock.

A value-weighted index assumes you make a proportionate market value investment in each company in the index. The major problem with a value-weighted index is that firms with greater market capitalization have a greater impact on the index than do firms with lower market capitalization.

An unweighted index places an equal weight on the returns of all index stocks, regardless of their prices or market values. The procedure used to compute an unweighted index value assumes that the index portfolio makes and maintains an equal dollar investment in each stock in the index.

So how is the STI index computed? The STI index like most of the major US index are computed using the value-weighted approach and covers all sectors. As it is value-weighted, the influence of the large capitalisation constituent stocks on the index is moderated by weighting them by their free float percentages.

You can find more information on the STI index by clicking here and other information about other indexes such as the Nikkei 225 Index, MSCI Taiwan Index etc., by clicking here.

How to calculate Earning Per Share?

2007-10-17T10:44:00.000+08:00

If you are investor and you have read the analyst report, have you ever wonder how did the analyst compute the Earnings per share (EPS)?

EPS is one of the most commonly used corporate profitability performance measures for publicly traded firms. A company may have either a simple or complex capital structure. A simple capital structure is one that contains no potentially dilutive securities. A simple capital structure contains only common stock, nonconvertible debt, and preferred stock. On the other hand, a complex capital structure contains potentially dilutive securities such as options, warrants, or convertible securities.

All firms with complex capital structures must report both basic and diluted EPS. Firms with simple capital structures report only basic EPS.

The basic EPS calculation does not consider the effects of any dilutive securities in the computation of EPS.

Basic EPS = (Net Income - Preferred Dividends) / weighted average number of common shares outstanding.

The current year's preferred dividends are subtracted from net income because EPS refers to the per-share earnings available to common shareholders. Net income minus preferred dividends is the income available to common stockholders. Common stock dividends are not subtracted from net income because they are a part of the net income available to common shareholders.

Before computing the dilutive EPS, you need to understand the following terms:

Dilutive securities are stock options, warrants, convertible debt, or convertible preferred stock that would decrease EPS if exercised or converted to common stock.
Antidilutive securities are securities that would increase EPS if exercised or converted to common stock.

The numerator of the basic EPS equation contains income available to common shareholders (net income less preferred dividends). In the case of dilutive EPS , if there are dilutive securities (e.g., convertible preferred stock, convertible bonds, or warrants) that will cause the weighted average common shares to change, then the numerator must be adjusted for the following:

If convertible preferred stock is dilutive (meaning EPS will fall if stock is converted), the convertible preferred dividends must be added back to the previously calculated income from continuing operations less preferred dividends.
If convertible bonds are dilutive, then the bonds' after-tax interest expense would not be considered as an interest expense for diluted EPS. Hence, interest expense multiplied by (1-tax rate) must be added back to the numerator.

The diluted EPS equation (assuming convertible securities are dilutive) is:

diluted EPS = adjusted income available for common shares/weighted-average common and potential common shares outstanding

where adjusted income available for common shares is:

Net income - preferred dividends + Dividends on convertible preferred stock + After-tax interest on convertible debt

Remember, each potentially dilutive security must be examined separately to determine if it is actually dilutive (would reduce EPS if converted to common stock). The effect of conversion to common is only included in the calculation of diluted EPS for a given security if it is in fact dilutive.

At the end of the day, we just used these figures taken for granted. With the understanding of how the computation is done, it will give you more insight into a company capital structure. Hence for a complex capital structure company, the dilutive EPS will give a better estimation of the earning per share. Cheers.

Rationales for the usage of price multiples in equity valuation

2007-10-16T15:34:00.000+08:00

If you are investor and you read the analyst report, you may wonder why they used price multiples such as P/E, P/BV, P/S and P/CF ratios in equity valuation. Well, I have consolidated the rationales and their drawbacks here. Hope you find them useful.

Rationales for using price-to-earnings (P/E) ratios in valuation:

Earnings power, as measured by earnings per share (EPS), is the primary determinant of investment value.
The P/E ratio is popular in the investment community.
Empirical research shows that P/E differences are significantly related to long-run average stock returns.

The drawbacks of using the P/E ratio are:

Earnings can be negative, which produces a useless P/E ratio.
The volatile, transitory portion of earnings makes the interpretation of P/E difficult for analysts.
Management discretion within allowed accounting practices can distort reported earnings and thereby lessen the comparability of P/E ratios across firms.

Advantages of using the price-to-book value ratio (P/BV) include:

Book value is a cumulative amount that is usually positive, even when the firm reports a loss and EPS is negative. Thus, P/BV can typically be used when P/E cannot.
Book value is more stable than EPS, so it may be more useful than P/E when EPS is particularly high, low, or volatile.
Book value is an appropriate measure of net asset value for firms that primarily hold liquid assets. Examples include finance, investment , insurance, and banking firms.
P/BV can be useful in valuing companies that are expected to go out of business.
Empirical research shows that P/BV ratios help explain differences in long-run average returns.

Disadvantages of using P/BV include:

P/BV ratios do not recognize the value of nonphysical assets such as human capital.
P/BV ratios can be misleading when there are significant differences in the asset intensity of production methods among the firms under consideration.
Different accounting conventions can obscure the true investment in the firm made by shareholders, which reduces the comparability of P/BV ratios across firms and countries. For example, research and development costs (R&D) are expensed in the U.S., which can understate investment and overstate income over time.
Inflation and technological change can cause the book and market value of assets to differ significantly, so book value is not an accurate measure of the value of the shareholders' investment. This makes it more difficult to compare P/BV ratios across firms.

The rationales for using the price to sales (P/S) ratio include:

P/S is meaningful even for distressed firms, since sales revenue is always positive. This is not the case for P/E and P/BV ratios, which can be negative.
Sales revenue is not as easy to manipulate or distort as EPS and book value, which are significantly affected by accounting conventions.
P/S ratios are not as volatile as P/E multiples. This may make P/S ratios more reliable in valuation analysis.
P/S ratios are particularly appropriate for valuing stocks in mature or cyclical industries and for start-up companies with no record of earnings.
Like P/E and P/BV ratios, empirical research finds that differences in P/S are significantly related to differences in long-term average stock returns.

The disadvantages of using P/S ratios are:

High growth in sales does not necessarily indicate operating profits as measured by earnings and cashflow.
P/S ratios do not capture differences in cost structures across companies.
While less subject to distortion than earnings or cashflows, revenue recognition practices can still distort sales forecasts. For example , analysts should look for company practices that speed up revenue recognition. An example is sales on a bill-and-hold basis, which involves selling products and delivering them at a later date. This practice accelerates sales into an earlier reporting period and distorts the P/S ratio.

Rationales for using the price to cashflow (P/CF) ratio include:

Cash flow is harder for managers to manipulate than earnings.
Price to cashflow is more stable than price to earnings.
Reliance on cashflow rather than earnings addresses the problem of differences in the quality of reported earnings, (a problem when using P/Es).
Empirical evidence indicates that differences in P/CF ratios are significantly related to differences in longrun average stock returns.

Drawbacks to the P/CF ratio:

Some items affecting actual cashflow from operations are ignored when the EPS plus noncash charges estimate is used. For example, noncash revenue and net changes in working capital are ignored.
From a theoretical perspective, free cash flow to equity (FCFE) is probably preferable to cash flow. However, FCFE is more volatile than straight cashflow.

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2007-10-14T11:17:00.000+08:00

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