Showing posts with label Market uncertainties. Show all posts
Showing posts with label Market uncertainties. Show all posts

Wednesday 13 May 2020

When do you allow for the possibility that you’re wrong? When does reason-based confidence turn into hubris and obstinateness?

Holding and adding to declining positions is only a good idea if the underlying thesis turns out to be right and things eventually go as expected.

  • In other words, when do you allow for the possibility that you’re wrong?  
  • When does reason-based confidence turn into hubris and obstinateness? 


Investor faces uncertainty in investing.  An investor having a sense of uncertainty is not a bad thing.


Howard Mark shared his experiences:

“Investing scared” – a less glamorous term than “applying appropriate risk aversion” – will push you to
-   do thorough due diligence,
-   employ conservative assumptions,
-   insist on an ample margin of safety in case things go wrong, and
-   invest only when the potential return is at least commensurate with the risk.
In fact, I think worry sharpens your focus. Investing scared will result in making fewer mistakes (although perhaps at the price of failing to take maximum advantage of bull markets).


• When I started investing in high yield bonds in 1978, and when Bruce Karsh and I first targeted distressed debt in 1988, it seemed clear that the route to long-term success in such uncertain areas lay in limiting losses rather than targeting maximum gains. That approach has permitted us to still be here, while many one-time competitors no longer are.


• I can tell you that in the Global Financial Crisis, following the bankruptcy of Lehman Brothers, we felt enormous uncertainty. If you didn’t, there was something wrong with you, since there was a meaningful possibility the financial system would collapse. When we started buying, Bruce came to me often saying, “I think we’re going too slow,” and then the next day, “I think we’re going too fast.” But that didn’t keep him from investing an average of $450 million per week over the last 15 weeks of 2008. I think Bruce’s ability to grapple with his doubts helped him arrive at the right pace of investment.



The topic of dealing with what you don’t know brings me to a phrase I came across a few years ago and think is very important: intellectual humility.


Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”


Tuesday 12 May 2020

The challenge lies in trying to be above average in assessing the future. Why is that so hard?

First of all, forecasting is a competitive arena. The argument for the difficulty of out-forecasting
others is similar to the argument for market efficiency (and thus the limitations of active
management).

  • Thousands of others are trying, too, and they’re not “empty suits.” Many of them are educated, intelligent, numerate, hard-working, highly motivated and able to access vast amounts of data and computing power. 
  • So by definition it shouldn’t be easy to be better than the average.


In addition, since economics is imprecise, unscientific and inconsistent in its functioning,  there can’t be a method or process for forecasting that works consistently. 

  • To illustrate randomness, I say that if, when I graduated from business school, I was offered a huge budget, an army of PhDs and lavish financial incentives to predict the coin toss before each Sunday’s football games, I would have been a flop. 
  • No one can succeed in predicting things that are heavily influenced by randomness and otherwise inconsistent.

So forecasting is difficult for a large number of reasons, including

  • our limited understanding of the processes that will produce the future, 
  • their imprecise nature, 
  • the lack of historical precedent, 
  • the unpredictability of people’s behavior and 
  • the role of randomness, and 
these difficulties are exacerbated by today’s unusual circumstances.



Reference:

In investing, uncertainty is a given – how we deal with it will be critical. Read Howard Marks’s latest memo, in which he discusses the value of understanding the limitations of our foresight and “investing scared.”

Wednesday 11 April 2012

A Buffett Disciple Shares His Secrets (Morningstar)



Low risk, high uncertainty situations.

Wall Street punishes uncertainties. The rewards can be very high for such low risk situations.

Tuesday 9 August 2011

US recession: Avoid investing huge amounts as stock market seen nowhere near its bottom, advise experts

MUMBAI: Don't jump into the market with a suitcase full of cash as yet, experts warn retail investors, as many seem attracted at the prospect of entering the market after Monday's plunge.

"Suddenly, many investors have become extra brave and want to get into the market because they think every huge fall is a great buying opportunity. But they could be wrong because we are definitely not at the bottom of the market and there would be a lot of volatility in the near term, which the retail investors would find hard to stomach," say Devendra Nevgi, founder & principal Partner, Delta Global Partners.

"They should wait for at least six to eight weeks for a clear picture on the global scenario," he adds. But the advice is meant only for those who want to invest large sums at this point of time in stocks. Existing equity investors should continue with their regular investments like systematic investment plans ( SIPs) in mutual funds, as the long-term prospects of the Indian economy and the stock market is intact, albeit somewhat foggy, say experts.

"Long-term investors can continue to invest in stocks with a three to five-year time frame in mind," says Suresh Sadagopan, chief planner, Ladder7 Financial advisories. "Investors should use this opportunity to build and consolidate their equity portfolio. The current global problems could actually help the Indian markets as lower commodity prices, especially oil prices, could moderate inflation."

"We may also be near the peak interest rates as the Reserve Bank of India may hold rates against the current global backdrop," says A Balasubramanian, CEO, Birla Sun Life Mutual Fund. "With every fall, the valuations of stock are also getting attractive, making a strong case for allocation into equity."

Not surprisingly, investment advisors also want small investors to seriously consider diversifying their portfolio into precious metals, especially gold. Gold is already attracting a lot of investor attention, especially from HNIs, because many consider gold as the best hedge against upheavals in the global economy.

"We have been advocating gold for almost four years now. Investors should seriously consider parking 5-10% of their portfolio in gold, mainly as a hedge against uncertainties," says Nevgi. However, advisors warn investors against going overboard on gold as it could cause problems in the long term.

"I recently came across portfolios of individuals where the exposure to gold is as high as 30-40%. Sure, the prospects of gold look extremely promising, but still there is no reason for you to put all your eggs in one basket," says a wealth manager who declined to be named.

Monthly income plan is another option investors should consider at this point. "MIPs are meant for conservative investors as they invest mostly in debt and take a little exposure to equity. The debt part can unlock value in the near term when the interest rates start falling. Also, the equity valuations are attractive for long-term investment," says Balasubramanian.

"MIPs could prove a win-win situation as prospects for both debt and equity look bright at this point," says Nevgi.

http://economictimes.indiatimes.com/markets/analysis/us-recession-avoid-investing-huge-amounts-as-stock-market-seen-nowhere-near-its-bottom-advise-experts/articleshow/9534750.cms

Sunday 12 June 2011

The Risk is Not in The Car; It is the Driver Behind The Wheel.

It would be a risky situation if a person decides to drive a car without having undergone any form of training.  It is the person's lack of knowledge and skill that makes the situation risky and not the car.

Similarly, if someone wants to invest (or trade) in a particular instrument but has not undergone any form of training, this person would be assuming a higher risk, and it has nothing to do with the instrument.  It is often the lack of knowledge and skill that makes investing (and trading) risky and not the instrument itself.


What is risk in the context of investing?

Risk is a quantifiable entity.
People associate risk with uncertainty in outcome or expected return.  A fixed deposit gives an expected return that is certain but not stocks.
People associate risk with volatility.  Yes, this too can be risky for those who do not understand volatility and who fall folly to it, rather than taking advantage of it.


Risk in investing is thus generally defined as:  


"The quantifiable likelihood (probability) of loss or less-than-expected returns."  
The keyword here is uncertainty in outcome or expected returns.

How to be a good investor?

To be a good investor (and trader), one must first seek knowledge about the instrument that one is going to invest in (or to trade).  It is similar to taking on a new job.

  • First, you must learn what your new role is all about, what kind of tools are there to help you in your everyday routines, what are the skill sets needed to perform your new job properly, etc.  
  • After that, once you have acquired the knowledge and learnt the skills required, you still need a period of constant practice to apply your newly acquired knowledge and hone your new skills.  
  • It is only after having practised for a sustained period of time before one is able to get the "feel" of the job and perhaps do it with ease and confidence.

Risk comes from NOT knowing what you are doing.
Enter at your own risk.

Tuesday 11 May 2010

Risk and Uncertainty

Risk

What is risk?

In financial terms, risk is the probability of an investment's actual return being lower than expected.

Can we understand risk and take actions to lower it?

We now have the two elements necessary to start us on a path of business risk management.

How can we:

(1)  lower the potential downside of risk

and/or

(2)  lower the probability of occurrences?


Risk can be both
  • intrinsic (within ourselves) and 
  • extrinsic (from outside).  

If risk is the potential for a business loss, when may a business project be deemed a high risk?

A business project may be deemed a high risk because either:

(1)  there is a high likelihood of a loss of any size, 

or

(2)  there is even a very small likelihood of a large loss.  

Almost every business action carries some degree of risk.  High-risk actions require careful management because of their potential large negative consequences to the business.

Threat:  A threat is a potential event with a very low probability but a high negative impact.  

"Bet-your-company risk":  Avoid taking a "bet-your-company risk."  The potential negative consequences of such a risk are just too, too large.  For example, a bet-your-company risk would be spending all your available resources on developing a risky new product.  The company could fail if development were to be delayed or if sales were much lower than projected. 

However, entrepreneurial companies usually must face bet-your-company risks as they start up and grow.  Understanding and managing risk and uncertainty is especially important in these fledging enterprises.  Startups must be focused, innovative, responsive and also very lucky to survive.  Most often, they are not.


Uncertainty

"Uncertainty" is different from risk.  

Uncertainty is not knowing what the future will bring.  However, under the cloak of uncertainty, high risk can lurk.  Thus, lowering uncertainty can lower risks too.

Uncertainty can be more dangerous than risk.  Because we often know the elements of risks, we can plan for risk and take measures to mitigate the negative consequences of risk.  However, with uncertainty we are often flying blind.  It is hard to lower uncertainty if you do not know what it is and thus what to do to lower it.  


Quotes:  
"The consequences of our actions are so complicated, so diverse, that predicting the future is a very difficult business indeed."

"The best way to predict the future is to invent it."

"It's tough making predictions, especially about the future."

Related:
Risk and uncertainty in investing.  Investing is serious business.

Investing Money in Plain English (Video)

Wednesday 4 November 2009

Risk versus Uncertainty: Known knowns, known unknowns and unknown unknowns

Risk versus Uncertainty: Frank Knight’s “Brute” Facts of Economic Life
By William Janeway
Published on: Jun 07, 2006

Dr. William H. Janeway, Vice Chairman, Warburg Pincus, received his doctorate in economics from Cambridge University where he was a Marshall Scholar. He was Valedictorian of the Class of 1965 at Princeton University. Prior to joining Warburg Pincus in 1988, where he was responsible for building the Information Technology practice, he was Executive Vice President and Director at Eberstadt Fleming. Dr. Janeway is a director of BEA Systems, Manugistics, Scansoft and UGS. He is also a member of the board of directors of the Social Science Research Council and a member of the board of Trustees of Cambridge in America, University of Cambridge. He is a Founder Member of the Board of Managers of the Cambridge Endowment for Research in Finance (CERF).

“…there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.”—Donald Rumsfeld

“Ah, what a dusty answer gets the soul, When hot for certainties in this our life”—George Meredith

Donald Rumsfeld’s characteristically idiosyncratic gloss on George Meredith’s existential meditation attracted derision across many constituencies. But Rumsfeld summarized a way of structuring our understanding of the world that has profound and immediate relevance. Most particularly, over the past generation, the application of increasingly powerful and sophisticated computerized statistical analysis has interacted with the work of theoreticians of finance to transform the capital markets in the U.S. and around the world. Our mastery of “known unknowns”—i.e., well-defined probabilities—has increased enormously, transformationally. The measurement and management of “risk” has become a major concern of all financial institutions and their regulators, especially since the collapse of Long Term Capital Management (LTCM) in 1998. At the same time, proposals to privatize Social Security and, more generally, to rely on “risk-managed” financial markets for economic security find their theoretical rationalization in the teachings of “modern” finance. And yet, as Rumsfeld and Meredith assert in their very different ways, there is another category of the world’s possible outcomes that lies beyond the reach of modern, market-based, risk management techniques.

More than eighty years ago, Frank Knight set out to parse the difference between risk and uncertainty and the significance of that difference. In Risk, Uncertainty and Profit, Knight distinguished between three different types of probability, which he termed: “a priori probability”; “statistical probability” and “estimates”. The first type “is on the same logical plane as the propositions of mathematics”; the canonical example is the odds of rolling any number on a die. “Statistical probability” depends upon the “empirical evaluation of the frequency of association between predicates” and on “the empirical classification of instances”. When “there is no valid basis of any kind for classifying instances”, only “estimates” can be made.1 In contemporary Bayesian parlance, in the first case, the probability distribution of the prior and all its moments are known definitionally; in the second case they are specified by statistical analysis of well-defined empirical data; in the third case such data as exists do not lend themselves to statistical analysis.

This last case is what interested Knight the most, as an economist exploring the world of business and the nature of profit in that world. Knight identified the “confusion” between “the problem of intuitive estimation” with “the logic of probability”, whether a priori or statistical2:

The liability of opinion or estimate to error must be radically distinguished from probability or chance of either type, for there is no possibility of forming in any way groups of instances of sufficient homogeneity to make possible a quantitative determination of true probability. Business decisions, for example, deal with situations which are far too unique, generally speaking, for any sort of statistical tabulation to have any value for guidance. The conception of an objectively measurable probability or chance is simply inapplicable…3

“[A]t the bottom of the uncertainty problem in economics”, Knight noted, “is the forward-looking character of the economic process itself.” 4 The post-Keynesian economist Paul Davidson defined the problem as the inapplicability of the “ergodic axiom”:

The economic system is moving through calendar time from an irrevocable past to an uncertain and statistically unpredictable future. Past and present market data do not necessarily provide correct signals regarding future outcomes. This means, in the language of statisticians, that economic data are not necessarily generated by an ergodic stochastic process. Hicks has stated this condition [in language that prefigures Rumsfeld] as: “People know that they just don’t know”.5

When Knight turned to the role of profit as the reward to the entrepreneur for bearing inevitable uncertainty, he characterized these facts of economic life in the most stark of terms:

Profit arises out of the inherent, absolute unpredictability of things, out of the sheer, brute fact that the results of human activity cannot be anticipated and then only in so far as even a probability calculation in regard to them is impossible and meaningless.6

I have documented what Frank Knight meant by “uncertainty” to clarify what is at stake in applying the calculus of financial “risk” to issues of economic and, indeed, social security. More than fifty years ago, “mainstream” economics launched itself on the grand project to formalize the principles of economics in rigorous mathematics. Unsurprisingly, such a system was as incapable of incorporating Knight’s “uncertainty” as it was of addressing the “extreme precariousness” of expectations and confidence described so eloquently in Chapter 12 of Keynes’ General Theory.7 For a time, the “rational expectations hypothesis” (REH) served as a sort of placeholder for serious consideration of the fundamental issues that Knight addressed and the consequences of which Keynes explored. It is not, I believe, an excessive caricature of REH to say that it turns on the assumptions that (1) all market participants have equal access to the same data; (2) all market participants share one model of how the world works, application of which translates data into meaningful and actionable information; and (3) that model happens to be “the truth” (and is identified recursively with “mainstream” general equilibrium theory). In this world, bubbles and panics cannot exist. All risks can be priced and insured or effectively hedged through the construction of appropriate contingent, derivative securities markets which are assumed to exist.

Application of REH to the capital markets of real economies generates a problem. REH defines a market in which the only occasion for any participant to trade is an externally generated “shock”: price volatility, identified with market risk, should be very low and aligned with the incidence of such shocks. However, empirical studies of the capital markets have identified three “puzzles”: the volatility of stock prices is too great, the risk-free interest rate is too low, and the “equity risk premium” (the return from investing in stocks compared with owning risk-free debt) is far too high to be compatible with REH. And the cluster of capital market shocks around the turn of the millennium seems to have decisively challenged the usefulness of a theory that hardly appeared consistent with the Asian Flu, the Russian Default, the collapse of LTCM, and the great NASDAQ boom and bust. In consequence, a variety of imaginative approaches are being actively deployed to understand the empirical “puzzles” generated by the attempt to explain—or, rather, explain away—the functioning of the capital markets through the application of REH.8 In different ways, this work, which serves to confirm the common sense of the market, is implicitly (sometimes explicitly) re-engaging with Knight, as it variously incorporates such building blocks for theory as “heterogeneous beliefs”, “endogenous uncertainty” and “fat-tailed Bayesian priors”.

When the domain of interest is dominated by uncertain estimates, your (more or less well informed) guess is as good as mine. This is what makes horse races—and securities markets. But, in the case of the stock market, what do you and I each need to guess? In his classic deployment of the metaphor of the “beauty contest”, Keynes captured the challenge:

…[P]rofessional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.9

Keynes never reduced his intuition, informed by his years of successful investing, to a formal, empirically testable model; indeed, before the development of stochastic calculus and game theory, it may not have been possible for him to do so. But the disparity between financial reality and modern, mathematically formalized economic theory has long been observable to those who have cared to look. A short generation ago, Frank Hahn began a series of lectures on money and finance with an observation pertaining to the social construction of the asset we call “money”:

The most serious challenge that the existence of money poses to the theorist is this: the best developed model of the economy cannot account for it.10

The “precautionary” motive for holding cash is among those enumerated by Keynes in his analysis of liquidity preference and has a long history in the literature on money and banking. Hahn and Solow, in their collaborative Critical Essay on Modern Macroeconomic Theory, elaborate on this:

Uncertainty enters the demand for money in two ways. First, it affects the calculation of the relative advantage of different assets including money. It also enters through considerations of liquidity or flexibility. Transaction costs will make it costly to change a portfolio choice once made. Agents know that as the future unfolds…their probability calculations will change. There is thus a probability that a portfolio choice, once made, is not optimal in light of what will be learned. This consideration, when combined with transaction costs, leads to a premium on “liquid” or low-transaction-cost assets…It is not hard to see how all of this provides a motive for holding money.11

Hahn, alone and with Solow, was observing the disparity between the Arrow-Debreu model and its derivatives—wherein all markets can simultaneously clear because all contingencies can be efficiently and effectively hedged—with the institutionalized reality of cash holdings across all observable economic systems.

Of course, this appreciation of the fine calculations by rational agents as they assess their (changing) optimal portfolios need not conceal the relevance of such analysis to the circumstance of the “agents” who face utter financial loss from the collapse of an Enron or the impact of a Katrina. Holding cash is how people self-insure against the uninsurable uncertainties of economic life, as distinct from the insurable risks. The proliferation of social security systems across the developed world since Bismarck’s innovation in 1891 further confirms the inability of markets to generate adequate hedges, sufficient in scale and distributed fairly enough to pre-empt successful appeal to the political process by market participants threatened with ruin. The evident failure of the Bush administration’s efforts at social security “reform” suggests that, in the nation where market forces are most explicitly respected, popular recognition persists that effective insurance against life’s uncertainties ultimately depends upon the power of the state.

If social security is the explicit institutionalization of state insurance against economic and financial uncertainty, more deeply rooted still in the institutional history of capitalism is the central bank’s role as lender of last resort. In 1873, Walter Bagehot, editor of The Economist, laid out in Lombard Street an analytical description of the British financial system as it had evolved to date. His most controversial and lasting contribution was the detailed discussion of “the duties which the Bank of England is bound to discharge as to its banking reserve”. It was controversial because

…first…the Bank has never by any corporate act or authorized utterance acknowledged the duty, and some of its directors deny it; …second (what is even more remarkable) no resolution of Parliament, no report of any Committee of Parliament (as far as I know), no remembered speech of a responsible statesman, has assigned or enforced that duty on the Bank; third (what is more remarkable still), the distinct teaching of our highest authorities has often been that no public duty of any kind is imposed on the Banking Department of the Bank…12

Bagehot provided a succinct definition of and rationale for the Bank’s “duty”:

…the Bank of England is bound…not only to keep a good reserve against a time of panic, but to use that reserve effectively when that time of panic comes. The keepers of the Banking reserve…are obliged then to use that reserve for their own safety. If they permit all other forms of credit to perish, their own will perish immediately and in consequence.13

In the central bank-less United States, the story of how the Panic of 1907 initiated the process that led seven years later to the creation of the Federal Reserve is well known. Equally well known is the world-historical failure of the Federal Reserve to perform its Bagehotian duty in the cumulative crisis of 1931-33: perhaps if the Governors of the Federal Reserve in 1931 had been proprietors of a private banking institution, they would have appreciated that unchecked financial panic means economic ruin. What is not well-known is the story of the first successful exercise of Bagehot’s “duty” by the Federal Reserve some sixty years later. In June 1974, in the context of the first Oil Crisis and the loss of presidential authority due to Watergate, Chairman Arthur Burns—not the most highly regarded of American central bankers—responded to the failure of the German Herstatt Bank and the consequent foreign exchange settlement crisis by quietly but effectively invoking the provisions of the Federal Reserve Act that authorized the regional Reserve Banks to accept as collateral any assets (including , as I recall, desks and chairs) of their member banks. Since 1987, the evolution of the “Greenspan Put” has finally institutionalized the Fed’s role of lender of last resort in an uncertain world.

Access to liquidity, then, is how we seek to deal with Knight’s brute fact. But liquidity is a most perverse substance. First-generation purveyors of “modern portfolio theory” modeled liquidity as a stable attribute of particular securities, statistically derived from observation of price and volume data over time. But, as the partners, clients and counter-parties of LTCM all learned, liquidity—and such other statistical properties of securities as correlations—are, in fact, the variable attributes of markets. And the worst of it is this: liquidity declines more than proportionally with the intensity of the demand for it. The more you need cash, the higher the price you have to pay to get it. And when average opinion comes to believe that average opinion will decide to turn assets into cash, then liquidity may be confidently expected to go to zero. By definition, no market can hedge this risk; no individual participant is rich enough not to need the hedge.

Bagehot defined the need and the remedy that Greenspan has finally institutionalized in America and for the world. But, if the uncertainty that each market participant, each citizen, faces is underwritten by the one power that can create all the liquidity any may require on demand, then the balance between greed and fear has been shifted and shifted materially. The “moral hazard” that arises when the insured farmer no longer need apply himself assiduously to keep his barn from burning becomes a generalized influence on all calculating economic agents. Some 75 years ago, Andrew Mellon gave President Hoover the definitive rationale for refusing to respond to the financial crisis:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate…People will work harder, live more moral lives.” 14

Mellon’s construct is helpful, at least to the student looking back if not to the well-meaning but bewildered President he was confronting. For it poses the stark choice that both generates and informs political discussion in this domain. A social science that evades Knight’s brute facts and Mellon’s correspondingly brutal prescription will contribute little to those seeking to formulate pragmatic responses to Meredith’s dusty answer. A social science that builds on Knight’s deep intuitions can contribute much.


http://privatizationofrisk.ssrc.org/Janeway/

Investment under market and climate policy uncertainty

 
Investment under market and climate policy uncertainty

 
Sabine Fuss, a, , Jana Szolgayovaa, Michael Obersteinera and Mykola Gustia

 
aInternational Institute of Systems Analysis, Schlossplatz 1, A-2361 Laxenburg, Austria

 
Abstract

 
Climate change is considered as one of the major systematic risks for global society in the 21st century. Yet, serious efforts to slow the accumulation of emissions are still in their primordial stage and policy makers fail to give proper long-term signals to emitters. These days, investors do not only face uncertainty from volatile prices in the traditional markets, but also from the less conceivable uncertainty of stricter climate change policy.

This paper investigates the impact of learning about the commitment of government to a climate policy regime in a real options framework. Two types of uncertainty are distinguished:  
  • market-driven price volatility around a mean price and
  • bifurcating price trajectories mimicking uncertainty about changing policy regimes.  
One of the findings is that the producer facing market uncertainty about CO2 prices invests into carbon-saving technology earlier than if the actual price path had been known on beforehand. This is not a typical real options outcome, but the result of optimizing under imperfect information, which leads to decisions that are different from the optimal strategies under full information.

On the other hand, policy uncertainty induces the producer to wait and see whether the government will further commit to climate policy. This waiting is a real options effect.

In other words, if learning about government commitment is more valuable than investing into mitigation technologies immediately, the option value exceeds the value of the technology and investment will be postponed. This might lead to supply shortages and limited diffusion of less carbon-intensive technology.

 
Keywords: Policy uncertainty; Real options; Electricity planning

http://www.sciencedirect.com/science?_ob=ArticleURL&_udi=B6V1T-4S26RY3-1&_user=10&_rdoc=1&_fmt=&_orig=search&_sort=d&_docanchor=&view=c&_searchStrId=1076869927&_rerunOrigin=google&_acct=C000050221&_version=1&_urlVersion=0&_userid=10&md5=211ffe0641bd2bfe5faa9d97f7816e5b

Futures market uncertainties increase risks for wheat growers

Futures market uncertainties increase risks
Sep 3, 2008 2:06 PM, By Roy Roberson
Farm Press Editorial Staff

Many wheat growers in the Southeast who expected to reap big profits from high prices for the 2007-2008 crop ended up disappointed with the price they received and disillusioned with the Chicago Board of Trade.

Speaking at the recent 71st annual meeting of the North Carolina Feed Industry Association, Randy Gordon says the CME (Chicago Mercantile Exchange) which now owns the Chicago Board of Trade admits the wheat futures contract is broken.

Gordon, who is vice-president of communications and government affairs for the National Grain and Feed Association, says the same trends are beginning to be seen in corn and many wonder whether soybeans will be next. Gordon says elevator managers and feed mills have lost confidence in futures markets as a risk management tool.

“Down to the farmer level there is little confidence futures prices are a true barometer of what supply and demand conditions are for crop and commodity values,” Gordon says. “Losing the ability to forward contract crops significantly increases what is already a huge risk in farming.”

Gordon explains that investors who manage long-only index funds have invested billions of dollars in both agriculture and energy commodities. All these investors do is continually roll contracts from one delivery date to the next, never planning to take delivery of the commodity.

“At the close of trading in late July, in the soft wheat market in Chicago, there was more than a $2.50 difference in cash prices and futures prices — unprecedented levels. And, the prediction is that this difference or basis price, may go as high as $3 in the wheat market, which is an untenable situation for grain buyers,” Gordon says.

The futures market has created tremendous pressure on the industry to continue to fund margin calls that occur as buyers try to maintain hedge positions. This situation has severely limited forward contracting. Many, if not most lenders, are reluctant to extend contracts longer than 30-60 days, according to Gordon.

Elevator managers have begun asking, and in some cases insisting, that farmers share some of the margin cost, if they want to contract for longer periods of time. Elevators just can’t afford to continue to do business as usual.

“Lenders are trying to stick with grain buyers, but it’s a tough call on them as well. The risks involved in financing margin requirements, even inventory purchases, have caused some long-term lenders to pull back,” Gordon says.

“At the last meeting of the CME, they publicly admitted for the first time their wheat futures contract is broken. It’s been a long time coming, but they now admit the problem that grain buyers have warned was happening over the past couple of years. The CME is now reaching out to the grain industry to try and fix the problem,” Gordon adds.

Red winter wheat is the poster boy for futures market trading with differences in cash and futures prices consistently topping $2. In corn the price differential as of late July was 45 cents and less for soybeans. “The great fear is that corn and beans will go the way of wheat, which would be catastrophic for grain buyers, grain growers and ultimately consumers,” according to Gordon.

Possible solutions the National Grain and Feed Association and other grain industry associations are looking at include:

• Increasing storage rates at delivery warehouses to try and force price convergence to occur.

• Establish a side by side ag index fund.

• Encourage, or force takers of deliveries to load out the commodity as specified in the contract.

• Add more delivery locations, making delivery a more reasonable option.

• Establish a cash settlement contract.

There are a number of possible solutions, but no magic bullet right now, Gordon admits. One of the major stumbling blocks that needs to be fixed, he contends, is that long-term index funds, large retirement funds and other large financial investors in agricultural commodities have very limited reporting responsibilities to the Commodity Futures Trading Commission, which oversees the futures market.

“There are numerous ways for these large investment managers to report the value of their index funds — all perfectly legal. What this says is that we have a broken reporting system, too,” Gordon says.

One option is to get the USDA Commodity Credit Association to provide loan guarantees to lenders who extend credit to elevators and feed mills for hedging commodities. It’s a different wrinkle, but indicative of how critical the problem is for grain buyers.

Farmers would love to contract out into the 2009 crop season to capture some of these high commodity prices. The risk to elevator managers and feed mills is just too great to allow that to happen, unless some dramatic changes are made,” Gordon says.

The biggest fear lenders have in financing grain buying and marketing is that farmers will walk away from contracts and simply not deliver. It’s hard from a grower’s perspective to contract corn, for example, at $3 a bushel and see prices at over $7 a bushel.

“The best insurance policy against failure to deliver is always to include the National Grain and Feed Association’s arbitration rules in contracts with growers. It’s not an ironclad guarantee, but a good insurance policy against going to court. Even if cases go to court, most courts have ruled that arbitration agreements are valid and both the grower and buyer tend to come out better,” Gordon says.

The commodity market woes have attracted the attention of the U.S. Congress. An unprecedented bill recently was approved by the House Agriculture Committee. This legislation would require the Commodity Futures Trading Commission issue within 60 days rules on how to prevent excessive speculation on ag and energy futures markets.

With virtually every input cost to farmers tied directly to the price of their product, fixing the futures market is critical. Without a viable futures market for grain, the risks may be too high from some farmers to stay in business.

e-mail: rroberson@farmpress.com

http://southeastfarmpress.com/grains/commodity-markets-0904/

How to handle market uncertainty

Wednesday November 4, 2009
How to handle market uncertainty
Personal Investing - By Ooi Kok Hwa



AFTER the strong rally over the past seven months, the market is finally undertaking some corrections. Some investors may not fully comprehend why the stock market moved up when the companies reported bad financial results, but tumbled when the companies started to show better financial performance.  (Comment:  There were many periods in the past when market movements were down when the economy was doing well, and vice versa.)

We need to understand that the market had discounted the good news. Some of those good financial results were already reflected in the stock prices. The stock market cycle always moves ahead of the economic cycle.

During the Great Depression in 1929, the stock market recovered eight months ahead of the real economic recovery. Even though some investment experts say the worst is far from over, we notice that a lot of economic indicators are pointing to an economic recovery.

However, the economic growth may not move as fast as the stock market. As a result, while the economy continues to recover, stock prices need to come down to reflect the fundamentals of the companies.  (Comment:  Overcome this short term uncertainties by taking a long term horizon in your investments.)

This explains why once investors started to realise that the stock prices could not be supported by the fundamentals of some companies, especially blue-chip stocks, the stock prices had to come down to reflect the true value of companies.

Nevertheless, based on our analysis, most listed companies in Malaysia showed great recovery in their second quarter of 2009 financial results against the results in the first quarter as well as the fourth quarter of 2008.

We need to understand that there are many disturbing factors that affect the stock prices, but not reflect the fundamentals of companies. From the perspective of behavioural finance, investors’ expectations and emotions have great influence on stock prices. Two factors influence investors’ expectations – past experience and new information.

In the absence of new information, investors will use past trends to extrapolate into the future. As a result, the stock prices may persist in trend for a while before the next market reversal. This may cause the market to overreact to good financial results as shown by some companies.

According to Fischer Black, some investors tend to be affected by noise that makes it difficult for them to act rationally. (Comment:  This is to the benefit of those who are able to value the stocks and not act in folly with the market.)  He defines noise as what makes our observations imperfect as well as keeps us from knowing the expected return on a stock.

Some investors, due to lack of self control and proper financial training, may misinterpret economic information and sometimes be carried away by the stock market emotion. Investors may feel uneasy over the recent strong market performance. However, they will still choose to follow the market trend even though they feel their judgment may be wrong. In behavioural finance, we label this as conformity in which we are inclined to follow the example of others even though we do not believe in the action.

The above phenomenon of stock prices being valued beyond the fundamentals of the companies is applicable to some selected blue-chip stocks. Nevertheless, Bursa Malaysia does have plenty of second- and third-liner stocks which are still selling at cheap valuations. Investors may want to take the current market corrections to accumulate them for the long-term.

We need to relate the current stock prices to the intrinsic value of the companies. Some investment tools like price-to-earnings ratio, dividend yield and price-to-book ratio will assist us in filtering out some good companies for investment.

Even though there are a lot of uncertainties along the way to full financial recovery, we feel that investors may view the recent corrections as good opportunities to build their long-term investment portfolios. For those who have been looking for investment returns higher than fixed deposit rates, there are still a lot of stocks that are paying handsome dividend yield of more than 4% and yet selling at cheap prices.

One of the most important investing principles is to have the discipline to hold long term. We should not pay too much attention to the fluctuation of stock prices; instead, we need to focus on the earning power of the companies as it is one of the most important drivers in deriving the intrinsic value of a company.

As a result of the financial crisis, even though a lot of companies are showing great recovery, their performance and prices are still lower than their peak level during the year in 2007. If the overall economy and the companies’ performance recover to 2007 level, their current stock prices may be a good entry level.

● Ooi Kok Hwa is an investment adviser and managing partner of MRR Consulting.
http://biz.thestar.com.my/news/story.asp?file=/2009/11/4/business/5035143&sec=business