December 9, 2008
Joshua-Michéle Ross at O’Reilly Radar writes about the money the American taxpayer (government) is giving Genera Motors, Chrysler and Ford to save them from bankruptcy:
This is the privatization of profit and the socialization of loss.
The very concept of “Too Big To Fail” points to a deeper truth: the U.S.’s auto industry does not operate within the “free market” at all. Far from it. As their moniker suggests, the “Big Three” are an oligopoly with a long record of eschewing innovation ( electric cars, hybrids etc.), killing off alternatives like mass transit and bullying public policy (lobbying against CAFÉ standards, environmental and tax policies [Hummer owners get a $34K tax credit!], the threat of relocating factories etc.) all in an effort to conform the not so “free market” to its lumbering non-strategies of pursuing short-term profit.
Full article: Catch 22: Too Big To Fail, Too Big To Suceed
The consensus in the comments to that article is that if the government is saving a company that is too big too fail, it should be split up into several smaller companies, so that we only ever have to save it once.
October 23, 2005
Commodities are anything that you can take physical delivery of, such as sugar, coffee, wheat, etc. Many have heard the story of the trader who bought a pork belly future, intending to sell the contract at a profit. He forgot about it and when the contract expired a lorry full of pigs arrived at the bank to deliver the pork bellies he had agreed to buy !
Financial commodities are bullion (gold) and energy.
London Interbank Offered Rate. The rate at which banks lend / borrow from each other. The rate depends on how long the loan is for, so it is usually quoted as 3m LIBOR (if borrowing for 3 months), 6m LIBOR, etc. If the currency is not sterling then it is quoted as well – for example 3m $ LIBOR or 6m EUR LIBOR. Investments typically have to pay more than LIBOR because otherwise we could simply lend the money to another bank at LIBOR. Hence LIBOR is a reference rate.
How easy it is to convert an asset into cash. Government bonds and equity in large companies are very liquid because there are many buyers and sellers constantly active in the market. An option on the currency of a small country or a very exotic, highly structured, bond would be illiquid because it would be hard to find someone to buy them from you.
Banks make money from:
- The bid / offer spread: The difference between what they buy something at and what they sell it for. This is the same as the buy / sell on high street foreign exchange boards.
- Fees: Most investments made through a bank incur a fee – the bank makes money whether the investment does or not.
- Time value of money
Over The Counter (OTC) / Exchange traded
An instrument traded OTC is negotiated directly between buyer and seller. An exchange traded instrument is bought and sold in a specific physical location where buyers and sellers meet. Most financial business used to be conducted in exchanges by open outcry (buyers and sellers stand in a circle and shout out what they are selling and buying). The traditional image of a trader in a colorful jacket shouting and waving his arms is open outcry. Nowadays computer networks mean buyers and sellers do not have to be in the same physical location, and most business is OTC.
The most popular and ‘ordinary’ flavor of ice-cream. Used to mean the simplest most common type of a financial instrument. The opposite of ‘exotic’.
A derivative is a financial contract that is based on (derived from) something else, either another financial instrument (a bond, shares, currency, etc) or a commodity (sugar, coffee, energy, etc). What the derivative is based on is called the underlying.
The three main types of derivatives are Swaps, Futures and Options.
Interest Rate Swaps
The exchange of cash flows representing interest receipts or payments on an agreed notional principal amount for an agreed period of time. Swaps are tools which allow for management of the interest basis of funds.
If you owned a property you were renting out and I had a savings account paying a fixed rate, you might want to swap your rent receipts for my interest receipts. You exchange the higher riskier rate (the rent payments which the tenants might not pay) for a lower less risky rate (the interest which the bank most probably will pay).
A company having borrowed money from a bank at a floating rate (6m LIBOR) might want to swap that for a fixed rate (6%) so that they are no longer at risk if interest rates go up. On one side they pay 6% (of the agreed notional principal) and receive 6m LIBOR, and on the other side they pay the 6m LIBOR straight out to repay their loan. They have converted a floating rate loan into a fixed rate loan.
The bank involved in the swap above would typically back it out with another swap, say paying 5.95% for 6m LIBOR. They make a profit from the .05% difference and are taking no risk with regards to interest rate changes.
The types of interest rate swap:
- Fixed / Floating: As in our example. This is the most popular type of swap. Also called a coupon or asset / liability swap.
- Basis swap: For example swapping 3m LIBOR for 6m LIBOR. Basis swaps are used a lot by mortgage companies that swap 1m for 3m (because they get mortgage repayments monthly).
- Currency swap (both fixed): Say fixed $ for fixed £.
- Currency basis swap (both floating): 3m $ LIBOR for 6m Yen LIBOR.
- Cross currency swap: Fixed £ for 3m CHF LIBOR.
A futures contract is a firm obligation to make or take delivery (or implied delivery through cash settlement) at a future date of a specific commodity at a specific price.
Futures are usually traded on an exchange (in England this is LIFFE). They are very standard. 3 month sterling interest rate futures are contracts to lend or borrow sterling for 3 months. They will have a delivery date (when the loan starts). So a June 3m £ future starts next June when one party borrows sterling from the other at the agreed rate for 3 months.
A future agreed directly with a bank is a Forward Rate Agreement (FRA). It can be tailored where there are no futures on the exchange that match our needs, or for currencies there are no futures in.
A contract in which the holder buys (at a premium) the right but not the obligation to buy or sell an agreed amount of a commodity at a predetermined price over a specified time period.
An option granting the right to buy the underlying is a call option. An option granting the right to sell the underlying is a put option.
European options can only be exercised when the option expires. American options can be exercised at any time during the life of a contract.
The underlying (what we are buying the option on) can itself be a derivative. Exchange traded options often have a futures contract as the underlying.
A warrant is a share option that is usually traded over the counter (OTC). Share options are usually traded on an exchange. The warrants are usually ‘given’ away as sweeteners on new deals but have a secondary market of their own. This asset class is nowhere near as popular as it used to be. Barings built, and probably lost, a huge fortune from Japanese warrant trading.
The derivatives market is mostly made up of derivatives based on:
- Interest rates: ( ~65% of the market). LIBOR, Bond rates, treasury bill rates, etc. The biggest derivative is the $ swap – swapping fixed rate dollars for floating rate dollars.
- Currencies: (~25%). Options and swaps on foreign exchange.
- Equity: (~5-10%). FTSE futures, Index swaps, etc.
- Commodities: (~0-5%).
(data correct as of the year 2000)
On the use of derivatives
Derivatives are used for speculation or hedging.
For speculation, derivatives give you leverage.
For example instead of buying a $10Million bond in the hope its price will go up, we can buy an option on that bond, which might only cost us $2000. The profit opportunity is almost the same (the price of the option slightly reduces our profit) but the risk is much less as the most we can lose is the option price ($2000).
For hedging, derivatives allow you to fix the price now for a trade in the future, or at least limit the rise / fall of that price.
For example an oil producer can arrange a futures contract for the sale of his oil in 1 years time. That way he knows exactly how much money he will make and can use that to invest. A UK company holding a US bond which is about to mature could buy an interest rate option to ensure the Dollar / Sterling rate did not reduce the value of its bond.
A loose collection of definitions and information concerning the financial world. Accuracy not guaranteed.
A security is anything that guarantees a loan. Your house is the security in your mortgage agreement. It offers security to the lender because if you don’t pay back the money they can take the house. In agreements between large financial institutions long term securities are bonds, shares (also called equity), floating rate notes, medium term notes, etc.
A bond is a way in which governments and companies raise money. The issuer of the bond borrows money from the entity that buys the bond. A bond has a value ($10 000), a coupon (5%), and a maturity date (in 10 years). The person lending the money buys the bond (pays $10 000 to the issuer), receives the value of the coupon each year (5% of $10 000) and the value of the bond back at maturity (after 10 years).
The entity that bought the bond can sell it on to anyone at any time before it matures. There is an active market in bonds.
Government issued bonds are often used as a reference bond, and bonds issued by companies are priced in terms of these. Government bonds are very low risk (the government can always print more money), easily traded, but offer the lowest interest rates. Corporate issued bonds are issued at the rate of government bonds plus a bit, as they are more risky (the company might go bankrupt and not pay back the bond when it matures). Government bonds in the U.K. are called Gilts.
Convertible Bonds are bonds which allow the owner to convert the bond into a fixed amount of shares in the company that issued it. If the value of the shares goes above the value of the bond, the owner can convert and make a profit. If the values of the shares goes down the owner holds on to the bond and has not lost any money, and still receives the coupon.
Re-purchase Agreements (repos) are contracts for the sale and future re-purchase or a security. The securities are almost always government issued bills or bonds (‘bills’ covers a range of other ways money can be borrowed by large institutions, usually for a period of time shorter than a bond).
Repo’s are almost always between banks, so they are an inter-bank loan backed by a security. If the security is shares it is called a sell and buy back.
Time value of money
Money has a time value because:
- Inflation means prices go up: £10 a hundred years ago was a lot of money !
- Lenders need an incentive to take the risk of lending (the risk being that the borrower won’t pay back the money).
Compounding: To calculate the future value of money by working forward from the present value.
FV = PV * (1 + InterestRate / 100) ^ N
where N is the number of periods, i.e. years if the interest rate is yearly.
Discounting: To calculate the present value by working back from a future value.
PV = FV / (1 + InterestRate / 100)^N
Ratings agencies give opinions on the ability of companies to pay back their debt. The two main ratings agencies are Moodys and Standard and Poors.
The ratings vary by agency, but typically they are letters and go, from lowest to highest risk, AAA, AA, A, BBB, BB, B, CCC, CC, C, D. Debt between AAA and BBB is considered investment grade – beyond BBB is speculative or ‘junk’ debt. A D rating implies the company has already defaulted on that debt.
Foreign Exchange (FX) is the selling of one currency and buying of another. Dollar, Sterling, Euro and Yen are the currencies traded the most.
Many international transactions (a UK company buying a US bond) involve an FX deal (the UK company has to turn its pounds into dollars). For this reason the money markets are amongst the most active of any financial market, and large companies (that otherwise have no banking interests) maintain a money market trading desk.