Investments and Risk Reward Ratio

It is always interesting that there are so many different types of investments around us, ranging from regulated investments such as bonds and stocks, all the way to unregulated investment vehicles such as collectibles, antiques and many others. In this post, I’m slightly more inclined to talk about some common investments, mainly money markets, bonds, stocks and derivatives as well as their risk-reward relationships. To illustrate this, let’s start with a picture.

I do hope that the picture is pretty clearcut. Basically, it says that the higher the return, the higher the risk. Note that in the picture, derivatives has lower return, but higher risk and I will explain why it is so in the picture. I am actually taking into account expected rewards, which is different from potential rewards. Potential rewards mean the high end spectrum of what is achievable, whereas expected rewards basically mean the aggregate returns of all investors who participate in the investing of the instrument.

Now, after having explained my definition, let’s look at the investments and their risk rewards ratio. It is seen from the diagram that for taking more risk, the expected rewards is greater, with the exception of derivatives. The explanation is that derivatives are theoretically zero sum games, which means that when someone makes money, another has to lose it. After commissions, spreads and other charges, they are practically negative sum games.

I have friends who said that stock markets are negative sum games too, because the same principle applies. However, they missed an important point, which is the fact that wealth is created through the stock market and the evidence is in the issuance of dividends. For example, I bought a stock at $10 and sell it for $9.50. I may seem to have lost money, but what if I got a dividend payout of $1.00 while holding the stock? From this example, we can see that the purchase of stocks is not a zero sum game and that the general direction of the stock market in the long run is an uptrend. Of course, I am assuming that there is no large scale war or natural disaster that will destroy a significant amount of wealth. Even if there is though, wealth will be recreated as long as humans survived.

Just like stocks, bonds and money markets are also both not zero sum games, since there is an effective yield that you can get. While some of them may default their payments, we are looking at the aggregate of all investments in the instrument, which makes it a positive sum game.

For derivatives though, it is a clear cut zero sum game, because there is absolutely no payouts linked to the instrument. You don’t get dividends for holding options or futures. However, I would like to argue from another standpoint that perhaps it is not really that much of a zero sum game. The reason I would like to input this perspective is the prevalence of people who like to hedge their investments. Therefore, they may have holdings of stocks and buying options to offset the downside. Hedging in such a way often gives them an effective yield almost equilvalent to the risk-free rate. Therefore, they may not care if their derivative products lose money, since their overall portfolio gives them the desired return that they want.

This seems to get quite complicated, but I am suggesting that if there are really quite a number of hedgers out there in the financial world, it is possible that they are all holding the derivatives that lose money. Consequently, this may mean that it may be slightly easier to profit from derivatives than a strict zero sum game, since some people participate in the game without the intention of winning. Of course, if we aggregate all the positions, we are still back to a strict zero sum game. 

However, my purpose in this post is only to bring about another perspective that perhaps not everybody wants to make money from every market. Some people may participate in some markets and lose constantly but still persist because they satisfy them in some other way. Therefore, it may mean that for those who are serious about making money in the markets, the chances are slightly higher. After all, it is easier to win in a race against leisure runners than national runners who are committed to getting that next medal.

Of course, with everything said, it’s just my hypothesis and it may or may not be right. 

http://www.firstmillionchallenge.com/investments-and-risk-reward-ratio/


This article was first posted on 24.11.2011.

Lessons from the junk bonds debacles of the 1980s and their collapse in 1990

Contrary to the promises of underwriters, junk bonds were a poor investment. They offered too little return for their substantial risk. To meet contractual interest and principal obligations, the number of things that needed to go right for issuers was high while the margin for error was low. Although the potential return was several hundred basis points annually in excess of U.S. Treasury securities, the risk involved the possible loss of one's entire investment.

Motivated by self-interest and greed, respectively, underwriters and buyers of junk bonds rationalized their actions. They accepted claims of a low default rate, and they used cash flow, as measured by EBITDA, as the principal determinant of underlying value. They even argued that a well-diversified portfolio of junk bonds was safe.

As this market collapsed in 1990, junk bonds were transformed into the financial equivalent of roach motels; investors could get in, but they couldn't get out. Bullish assumptions were replaced by bearish ones. Investor focus shifted from what might go right to what could go wrong, and prices plummeted.

Why should the history of the junk-bond market in the 1980s interest investors today? If you personally avoided investing in newly issued junk bonds, what difference should it make to you if other investors lost money? The answer is that junk bonds had a pernicious effect on other sectors of the financial markets and on the behavior of most financial-market participants. The overpricing of junk bonds allowed many takeovers to take place at inflated valuations. The excess profits enjoyed by the shareholders of the acquired companies were about equal to the losses eventually experienced by the buyers of this junk. Cash received by equity investors from junk-bond-financed acquisitions returned to the stock market, bidding up the prices of shares in still independent companies. The market prices of securities involved in arbitrage transactions, exchange offers, and corporate reorganizations were all influenced by the excessive valuations made possible by the junk-bond market. As a result, even those who avoided owning junk bonds found it difficult to escape their influence completely.  We may confidently expect that there will be new investment fads in the future. They too will expand beyond the rational limitations of the innovation. As surely as this will happen, it is equally certain that no bells will toll to announce the excess. Investors who study the junk-bond debacle may be able to identify these new fads for what they are and avoid them. And as we shall see in the chapters that follow, avoiding losses is the most important prerequisite to investment success.

Ref: Margin of Safety by Seth Klarman

Collateralized Bond Obligations - a pile of junk is still junk no matter how you stack it.

Collateralized Junk-Bond Obligations

One of the last junk-bond-market innovations was the collateralized bond obligation (CBO). CBOs are diversified investment pools of junk bonds that issue their own securities with the underlying junk bonds as collateral. Several tranches of securities with different seniorities are usually created, each with risk and return characteristics that differ from those of the underlying junk bonds themselves.

What attracted underwriters as well as investors to junkbond CBOs was that the rating agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating. This means that an issuer could assemble a portfolio of junk bonds yielding 14 percent and sell to investors a senior tranche of securities backed by those bonds at a yield of, say, 10 percent, with proceeds equal to perhaps 75 percent of the cost of the portfolio. The issuer could then sell riskier junior tranches by offering much higher yields to investors.

The existence of CBOs was predicated on the receipt of this investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment grade securities. As usual these yield pigs sacrificed credit quality for additional current return. The rating agencies performed studies showing that the investment-grade rating was warranted.  Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancings. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it.

Investments and Risk Reward Ratio

It is always interesting that there are so many different types of investments around us, ranging from regulated investments such as bonds and stocks, all the way to unregulated investment vehicles such as collectibles, antiques and many others. In this post, I’m slightly more inclined to talk about some common investments, mainly money markets, bonds, stocks and derivatives as well as their risk-reward relationships. To illustrate this, let’s start with a picture.

I do hope that the picture is pretty clearcut. Basically, it says that the higher the return, the higher the risk. Note that in the picture, derivatives has lower return, but higher risk and I will explain why it is so in the picture. I am actually taking into account expected rewards, which is different from potential rewards. Potential rewards mean the high end spectrum of what is achievable, whereas expected rewards basically mean the aggregate returns of all investors who participate in the investing of the instrument.

Now, after having explained my definition, let’s look at the investments and their risk rewards ratio. It is seen from the diagram that for taking more risk, the expected rewards is greater, with the exception of derivatives. The explanation is that derivatives are theoretically zero sum games, which means that when someone makes money, another has to lose it. After commissions, spreads and other charges, they are practically negative sum games.

I have friends who said that stock markets are negative sum games too, because the same principle applies. 

However, they missed an important point, which is the fact that wealth is created through the stock market and the evidence is in the issuance of dividends. For example, I bought a stock at $10 and sell it for $9.50. I may seem to have lost money, but what if I got a dividend payout of $1.00 while holding the stock? From this example, we can see that the purchase of stocks is not a zero sum game and that the general direction of the stock market in the long run is an uptrend. Of course, I am assuming that there is no large scale war or natural disaster that will destroy a significant amount of wealth. Even if there is though, wealth will be recreated as long as humans survived.

Just like stocks, bonds and money markets are also both not zero sum games, since there is an effective yield that you can get. While some of them may default their payments, we are looking at the aggregate of all investments in the instrument, which makes it a positive sum game.

For derivatives though, it is a clear cut zero sum game, because there is absolutely no payouts linked to the instrument. You don’t get dividends for holding options or futures. However, I would like to argue from another standpoint that perhaps it is not really that much of a zero sum game. The reason I would like to input this perspective is the prevalence of people who like to hedge their investments. Therefore, they may have holdings of stocks and buying options to offset the downside. Hedging in such a way often gives them an effective yield almost equilvalent to the risk-free rate. Therefore, they may not care if their derivative products lose money, since their overall portfolio gives them the desired return that they want.

This seems to get quite complicated, but I am suggesting that if there are really quite a number of hedgers out there in the financial world, it is possible that they are all holding the derivatives that lose money. Consequently, this may mean that it may be slightly easier to profit from derivatives than a strict zero sum game, since some people participate in the game without the intention of winning. Of course, if we aggregate all the positions, we are still back to a strict zero sum game. 

However, my purpose in this post is only to bring about another perspective that perhaps not everybody wants to make money from every market. Some people may participate in some markets and lose constantly but still persist because they satisfy them in some other way. Therefore, it may mean that for those who are serious about making money in the markets, the chances are slightly higher. After all, it is easier to win in a race against leisure runners than national runners who are committed to getting that next medal.

Of course, with everything said, it’s just my hypothesis and it may or may not be right. 

http://www.firstmillionchallenge.com/investments-and-risk-reward-ratio/

Bill Passed in Senate Broadly Expands Oversight of Wall St.

May 20, 2010
Bill Passed in Senate Broadly Expands Oversight of Wall St.

By DAVID M. HERSZENHORN

WASHINGTON — The Senate on Thursday approved a far-reaching financial regulatory bill, putting Congress on the brink of approving a broad expansion of government oversight of the increasingly complex banking system and financial markets.

The legislation is intended to prevent a repeat of the 2008 crisis, but also reshapes the role of numerous federal agencies and vastly empowers the Federal Reserve in an attempt to predict and contain future debacles.

The vote was 59 to 39, with four Republicans joining the Democratic majority in favor of the bill. Two Democrats opposed the measure, saying it was still not tough enough.

Democratic Congressional leaders and the Obama administration must now work to combine the Senate measure with a version approved by the House in December, a process that is expected to take several weeks.

While there are important differences — notably a Senate provision that would force big banks to spin off some of their most lucrative derivatives business into separate subsidiaries — the bills are broadly similar, and it is virtually certain that Congress will adopt the most sweeping regulatory overhaul since the aftermath of the Great Depression.

“It’s a choice between learning from the mistakes of the past or letting it happen again,” the majority leader, Harry Reid of Nevada, said after the vote. “For those who wanted to protect Wall Street, it didn’t work.”

The bill seeks to curb abusive lending, particularly in the mortgage industry, and to ensure that troubled companies, no matter how big or complex, can be liquidated at no cost to taxpayers. And it would create a “financial stability oversight council” to coordinate efforts to identify risks to the financial system. It would also establish new rules on the trading of derivatives and require hedge funds and most other private equity companies to register for regulation with the Securities and Exchange Commission.

Passage of the bill would be a signature achievement for the White House, nearly on par with the recently enacted health care law. President Obama, speaking in the Rose Garden on Thursday afternoon, declared victory over the financial industry and “hordes of lobbyists” that he said had tried to kill the legislation.

“The recession we’re emerging from was primarily caused by a lack of responsibility and accountability from Wall Street to Washington,” Mr. Obama said, adding, “That’s why I made passage of Wall Street reform one of my top priorities as president, so that a crisis like this does not happen again.”

The president also signaled that he would take a strong hand in developing the final bill, which could mean changes to the restrictive derivatives provisions the Senate measure includes and Wall Street opposes. It is also likely that the administration will try to remove an exemption in the House bill that would shield auto dealers from oversight by a new consumer protection agency. Earlier, Mr. Obama had criticized the provision as a “special loophole” that would hurt car buyers.

As the Senate neared a final vote, Senator Sam Brownback, Republican of Kansas, withdrew an amendment to put a similar exemption for auto dealers into the Senate bill.

Mr. Brownback’s move had the effect of killing an amendment by Senators Jeff Merkley, Democrat of Oregon, and Carl Levin, Democrat of Michigan, to tighten language barring banks from proprietary trading, or playing the markets with their own money — a restriction generally known as the Volcker rule for the former Fed chairman Paul A. Volcker, who proposed the idea. Congressional Republican leaders, adopting an election-year strategy of opposing initiatives supported by the Obama administration, voiced loud criticism of the legislation while trying to insist that they still wanted tougher policing of Wall Street.

But while Republicans criticized the bill in mostly political terms, arguing that it was an example of Democrats’ trying to expand the scope of government, some experts have warned that the bill, by focusing too much on the causes of a past crisis, still leaves the financial system vulnerable to a major collapse.

The Senate bill, sponsored primarily by Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the banking committee, would seek to curb abusive lending by creating a powerful Bureau of Consumer Protection within the Federal Reserve to oversee nearly all consumer financial products.

In response to the huge bailouts in 2008, the bill seeks to ensure that troubled companies, no matter how big or complex, can be liquidated at no cost to taxpayers. It would empower regulators to seize failing companies, break them apart and sell off the assets, potentially wiping out shareholders and creditors.

To coordinate efforts to identify risks to the financial system, the bill would create a “financial stability oversight council” composed of the Treasury secretary, the chairman of the Federal Reserve, the comptroller of the currency, the director of the new consumer financial protection bureau, the heads of the Securities and Exchange Commission and the Federal Deposit Insurance Corporation, the director of the Federal Housing Finance Agency and an independent appointee of the president.

The bill would touch virtually every aspect of the financial industry, imposing, for instance, a thicket of rules for the trading of derivatives, the complex instruments at the center of the 2008 crisis.

With limited exceptions, derivatives would have to be traded on a public exchange and cleared through a third party.

And, under a provision written by Senator Blanche L. Lincoln, Democrat of Arkansas, some of the biggest banks would be forced to spin off their trading in swaps, the most lucrative part of the derivatives business, into separate subsidiaries, or be denied access to the Fed’s emergency lending window.

The banks oppose that provision, and the administration has also said that it sees no benefit.

Concern about the derivatives provisions also led Senator Maria Cantwell, Democrat of Washington, to vote against the bill, saying it still included a dangerous loophole that would undermine efforts to regulate derivative trades. Senator Russ Feingold of Wisconsin was the other Democrat to oppose the measure.

The four Republicans to support the bill were Senators Susan Collins and Olympia J. Snowe of Maine; Scott Brown, the freshman from Massachusetts; and Charles E. Grassley of Iowa, who is up for re-election this year.

Among the differences between the House and Senate bills is the inclusion in the House measure of a $150 billion fund, to be financed by a fee on big banks, to help pay for liquidation of failing financial companies.

The administration opposes the fund, which it says it believes could hamper its ability to deal with a more costly collapse of a financial company. Republicans demanded that a similar $50 billion fund be removed from the Senate bill because they said it would encourage future bailouts of failed financial companies.

There are numerous other differences. For instance, the House bill addresses the consumer protection goals by establishing a stand-alone agency that would be subject to annual budget appropriations by Congress. The Senate bill establishes its consumer protection bureau within the Federal Reserve, limiting future Congressional oversight.

Lawmakers said that the bills would be reconciled in a formal conference proceeding, possibly televised.

Edward Wyatt contributed reporting.

http://www.nytimes.com/2010/05/21/business/21regulate.html?src=me&ref=business

Buffett (2000): Derivatives - Weapons of Mass Destruction

Buffett's letter for the year 2000 discussed his views on tendencies of certain CEOs to make lofty projections of their companies' future earnings potential and the risks associated with such projections. Let us now move on to accumulating wisdom from the letter for the year 2002*.

In his 2002 letter, the master has devoted a fair deal of time and space to the topic of derivatives. Infact, the master's prognosis on the risks associated with derivatives come so perilously close to describing the current US sub-prime crisis that one would be forgiven for assuming that Mr. Buffett has access to a crystal ball.

Derivatives: Devious or delightful?

Much like most of the other inventions, derivatives too, were created for the benefit of mankind in general and commerce and trade in particular. It was especially helpful to smaller firms that did not have the capacity to bear big risks. Derivatives enabled such firms to transfer some of these risks to stronger, more mature hands. But again, like most of the other inventions, derivatives can also be put to misuse. Abuse of the same, as has become more frequent these days, could lead to dire consequences. Furthermore, the very nature of a derivatives contract makes it risky to the users. This is because unless accompanied by collaterals or guarantees, the final value in a contract depends on the payment ability of the parties involved.

The master is also of the opinion that since a lot of derivatives contract don't expire for years and since they have to be provided for in a company's accounts, manipulation could become a serious threat. For e.g., incorporating overly optimistic projections into a contract that does not expire until say 2018 could lead to inflated earnings currently. However, if the projections fail to materialize, they could lead to potential losses in the future. In an era of short-term profit targets and incentives, such measures result in higher CEO salaries. But they hurt long-term shareholder value creation.

This is what the master has to say on the issue:

"Errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid (in whole or part) on "earnings" calculated by mark-to-market accounting. But often there is no real market (think about our contract involving twins) and "mark-to-model" is utilized. This substitution can bring on large-scale mischief. As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counterparties to use fanciful assumptions."

He further goes on to add "The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth."

Highlighting other dangers of derivatives, the master finally goes on to say something that if central banks around the world, importantly the US Fed, would have paid proper heed to, it could have been probably able to avert or maybe minimize the enormous damage that is being caused by the US sub-prime crisis.

We conclude the article with the reproduction of that comment.

Weapons of mass destruction

The master says, "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts."

Buffet's view on Derivative contracts

Derivative contracts

Finally, you should expect large swings in the carrying value of these contracts, items that can affect our reported quarterly earnings in a huge way but that do not affect our cash or investment holdings. That thought certainly fit 2009’s circumstances. Here are the pre-tax quarterly gains and losses from derivatives valuations that were part of our reported earnings last year:

Quarter    $ Gain (Loss) in Billions
1    (1.517)
2    2.357
3    1.732
4    1.052

As we’ve explained, these wild swings neither cheer nor bother Charlie and me. When we report to
you, we will continue to separate out these figures (as we do realized investment gains and losses) so that you can more clearly view the earnings of our operating businesses. We are delighted that we hold the derivatives contracts that we do. To date we have significantly profited from the float they provide. We expect also to earn further investment income over the life of our contracts.

We have long invested in derivatives contracts that Charlie and I think are mispriced, just as we try to
invest in mispriced stocks and bonds. Indeed, we first reported to you that we held such contracts in early 1998.

The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead

• to leverage and/or 
• counterparty risk that is extreme. 

At Berkshire nothing like that has occurred – nor will it.

It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. At Berkshire, I both initiate and monitor every derivatives contract on our books, with the exception of operations-related contracts at a few of our subsidiaries, such as MidAmerican, and the minor runoff contracts at General Re. If Berkshire ever gets in trouble, it will be my fault.  It will not be because of misjudgments made by a Risk Committee or Chief Risk Officer.


http://www.berkshirehathaway.com/letters/2009ltr.pdf



Comment:

For those tracking their portfolio, the large swings in their portfolio values should be expected and should not excite them unduly.  For the long term investor, focusing on the operations of the businesses of the stocks in the portfolio is more important.  As was mentioned, the large swings do not affect his cash position or his investment holdings.

Derivatives - options and futures

Stocks and bonds are financial assets.

A derivative is also a financial asset but it differs from stocks in one fundamental way: the value of the derivative is based on the performance of an underlying financial asset that you do not own.

------------

Options

Options are one of the most common types of derivative.

There are 2 main types of options - calls and puts.

A call option gives the buyer the right but not the obligation, to purchase a specified number of shares of a particular stock at a particular price (called the exercise price) within a specified time frame.

A put option does the reverse - it gives the buyer the right but not the obligation, to sell a specified number of shares of a particular stock at a specified price within a specified time frame.

A definite advantage for the buyer of an option - whether a call or a put option - is that there is no obligation to exercise the option.

A simple example of a call option.

Suppose that you want to own 1,000 Microsoft shares at $30 each.

If you are fortunate enough to have this large amount of money ($30,000) at hand, you can pay up right away and own the shares.

But suppose you do not have this sum of money to invest directly, and your roommate is willing to sell you the right to buy the 1,000 shares at $30,000 each. For this right, he will charge you a fee of $1,500 and this right lasts three months. In effect, your roommate has sold you a call option.

If you buy the call option, the value of your investment now depends on the underlying asset - the share price of Microsoft.

If the price of Microsoft goes up, so does the value your call option.

If the price of Microsoft goes down, your derivative falls in value.

When you buy a call option, you pay the seller $1,500 for the right, but not the obligation, to buy the shares at $30,000.

If you change your mind because you found a better deal elsewhere, you can just walk away. You will only lose $1,500, which is called the option premium.

--------------

Futures

Suppose a coffeeshop owner wants to buy 5 metric tons (mt) of Robusta coffee in six months, and he worries that the price of coffee might increase threefold by that time.

One thing he can do now is to strike a deal today with a farmer whereby he promises to pay, say, $1,000 per mt in 6 months' time for 5 mt of coffee. In other words, the coffeeshop owner and the farmer agree that 6 months from now, the coffeeshop owner will exchange $5,000 for 5 mt of coffee.

The agreement that they have created is a futures contract.

With the futures contract, both the coffeeshop owner and the farmer have locked in the price of coffee six months from now.

Suppose that coffee is selling for $1,500 per mt in 6 months' time. If this happens, then the coffeeshop owner would have benefited from having entered into the futures contract.

However, if the coffee sells for only $700 per mt then, he would have made a loss of $1,500, because he is forced by contract to pay $1,000 per mt.

A futures contract is therefore a bet on the future price of whatever is being bought or sold.

An important feature of traded futures contracts is that they are standardised, meaning each contract calls for the purchase of a specific quantity of a particular underlying asset.

The contract specifies in detail what the underlying asset is and where it is to be delivered.

For example, with a Robusta coffee contract, the contrct would specify that a specified quantity of a particular type of coffee will be delivered at one of a few approved locations on a particular date in exchange for the agreed-upon futures price.