Independent, Fee-Only Financial Advisor

Independent, Fee-Only Financial Advisor

Wednesday, June 27, 2012

market manipulation

Market manipulation is bad. Even the name sounds bad. Besides being an opportunity for one party (or, cabal?) to profit from a VERY unfair advantage of others, it erodes trust in the market. Trust in the market is essential to the working of the economy. Individuals and companies of all stripes come to the public capital markets for everything from buying a house or retiring to making payroll or financing expansion to lowering risk or buying groceries (ok, buying groceries is a little indirect, but i could explain it at a stretch). Lack of faith in those markets makes it hard and expensive to reach, slowing growth.

A particularly fascinating case of market manipulation involves Barclays Capital manipulating LIBOR. This email exchange is fascinating look at how traders fudged numbers on the LIBOR survey to benefit their own positions. As their position values were calculated on this rate, moving the rate up or down a basis point could be the difference between making profit or loss.

Alas, market manipulation can cut both ways. Barclays is a huge bank, as such it will invariably hold opposing positions as it attempts to hedge its risk. These emails show that at times, different traders needed the needle to move different directions. Not only was the manipulation wrong and illegal, it was stupid and unproductive.

The meaning of this manipulation is huge, and it is important that it was caught. There is a huge amount of data in the marketplace and it can be very difficult to detect the needling fraud in the haystack of transactions. HFTs and Hedge Funds often use very advanced computing techniques to detect arbitragable patterns in market data - it is time that regulators stepped up to that plate as well. Collecting data and keeping it transparent has been and will remain key to protecting the marketplace from fraud and manipulation.

For a great overview of LIBOR and how it comes to be, check this primer!

Wednesday, June 20, 2012

listening to shareholders

Shareholders have a few ways to express their thoughts or ask their questions to company boards. The most obvious expression is with their money, selling shares when they don't like the direction a company is taking, buying when they do. They can vote in annual meetings - and it is important that they have that right. Most directly shareholders can ask questions of the board in quarterly and special conference calls (or call or write letters any time, really, but you may not get answered).

Quarterly conference calls are often full of analysts asking questions to build their reports for clients (owners and potential owners). Companies solicit questions beforehand, screen callers or whatever they like to manage the questions and make sure the board makes it home for dinner. It is important that shareholders and thoughtful analysts can make themselves heard to the board - it helps remind the board that they are merely stewards of the company accountable the owners.

FedEx took a big step yesterday in their conference call and widened their audience to include StockTwits, a popular twitter aggregating social network for traders, investors and other market participants or observers. Attention to the crowd is incredibly important, and it is good to see a company taking the initiative to expand the field of people they are listening to.

It is important that investors pay attention to their companies - and it is important that the companies pay attention to their investors. Kudos to FedEx for this move.

Thursday, June 07, 2012

easy math with derivatives

Expanded version here:

Derivatives. Scary stuff, right? If you hear it in the financial news, you probably know a little bit about them: they are huge and unpredictable and scary, right? In fact, a recent report points out that 75% of derivatives are concentrated on (or off) the books of six US firms. Thats a high concentration to be sure, but what does it mean?

How big is this market? It is actually huge. The Fitch report puts the notional size at $300 Trillion dollars. Uh, ok, thats big right? Do you realize how big of a number that is? $300,000,000,000,000. Thats a lot of zeros. For comparison, JP Morgan has 130,452,000,000 in net tangible assets (what they have minus what they owe) at last check and I just bought a small cup of coffee for $1.65, so that is 181,818,181,818,181.8 cups of coffee or 2,300 JP Morgans.

If you want the maths details, I have tried to work them out on my personal blog. Basically, the notional amount is like the principal on a loan, and it goes both ways. Each party owes that to each other, so that will cancel out. It is the cash flows on top that matter. The cash flows depend on interest rates, which are miserably small right now, so even on that $300,000,000,000,000, there may be only a few billion in payments going back and forth. That is manageable for the banks.

Yes, derivatives are HUGE, but their size may be exacerbated by the low interest rates right now. The two main issues with derivatives that I see are the complexity to people working with them, and their nature as off balance sheet items. If people working with them cannot properly hedge their risk away (which is generally the goal) there is still risk in holding it. If investors can't see what directional exposure exists, they cannot properly analyze the company.

Counterparty risk is a big deal. This is why AIG was bailed out so urgently - they were tied to just about everybody pretty much with the losing end of the deal every time. Their contracts obligated them to pay a lot of people a lot of money. If the contracts were not honored, everyone else would suffer along with them (a lot more than they obviously did).

Notional size is not what is important here, unhedged liability and counter-party risk is what matters. Just remember that when before the size of this market starts to frighten you.