The LSE Analyst: Michaelmas Term 2010

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Contents| the analyst 03

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Microfranchising: Distributing Successful Businesses at the Base of the Pyramid The Rising Path of Islamic Finance Structural Incoherence in Financial Markets Technological Finance

SPECIAL REPORTS Microfranchising: Distributing Successful Businesses at the Base of the Pyramid

By Vladimir Shamanov

F

ranchising is what transformed Subway from a little sandwich

Microfranchising is the use of franchising in a developing setting as a market-based approach to poverty alleviation. shop to world’s second largest restaurant operator. The idea is simple: the franchisor sells or licenses a successful business model. For a fee, the franchisee receives complete guidance through the establishment and operation of a new enterprise. Microfranchising is the use of franchising in a developing country as a marketbased approach to poverty alleviation.

The idea behind microfranchising is to replicate the success of franchising at the base of the pyramid. Microfranchises promises to take microfinance to the next level by creating business opportunities for the global poor.

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In developed countries, franchising has proven to be a powerful economic force. In the US alone it accounts for $2.3 trillion sales annually. The advantages of a franchise over an independent enterprise include - among many others - centralized marketing and operations support, initial training, and quicker dispersion of innovations.

Microfranchising aims to replicate this success at the base of the pyramid.

The concept, first mentioned in 2004, is still relatively new. Like its franchising, it is concerned with the distribution of successful replicable business models. However, microfranchising is more along the lines of microfinance, as it aims to make these business models appropriate for poor entrepreneurs.

One successful example of a microfranchise is KickStart. Founded as a social enterprise in 1991 in Kenya, KickStart researches enterprise opportunities, develops appropriate technologies and business models, and then distributes them to micro entrepreneurs. Simple technologies such as a manual cooking oil press are mass-produced in Africa and designed to cost under $1000, thereby reaping profit. KickStart’s impact to date is impressive: 64 thousand new businesses created (growing 800 per month) that account to 0.6% of Kenya’s GDP and 0.25% of Tanzania’s GDP. A more recent example, Village Laundry Services (VLS), which is funded by Innosight Ventures, closely follows the fundamentals of mainstream franchis-

ing but operates on a much smaller scale. VLS introduced a new service in India: a small movable one-stop laundry kiosk offering 24-hour delivered laundry. Each kiosk has a washer, a dryer, an iron, and a self-contained water supply, which means that a kiosk can be placed anywhere that has access to the grid. Currently, the company owns 20 kiosks, but it plans to increase the number to 110 by the end of this year and start selling them to entrepreneurs. To succeed VLS will have to standardise its procedures, develop a training program for future owners, and foster partnerships with microfinance organisations. Despite its humble start, it is obvious that it has a large potential for growth in India and beyond.

These two cases seem to parallel the well-known Grameen’s Village Phone (VP). However, there is a big difference between Grameen’s approach and microfranchising. In VP program, “phone ladies” used Grameen loans to buy handsets to sell minutes to their neighbours, thus bringing GSM into rural Bangladesh—an area completely ignored by other networks. Grameen VP has been very successful and has changed many lives. Since its launch in 1997, 240 thousand phone operators generated an income for themselves and brought phone services to remote villages. Yet, the new business opportunities that VP created for rural phone operators were limited to selfemployment—they did not create any additional jobs. True microfranchising, on the other hand, is characterised by a more complex enterprise. Instead

of using MF loans to buy products (or services) in bulk for “door-to-door” distribution, a microfranchisee uses a loan to invest in capital that could employ waged workers. KickStart’s oil press owner, for example, employs two workers and contracts twenty farmers on average. As a result, microfranchising has larger impact per loan.

Unlike microfinance, microfranchising specifically focuses on creating opportunities with high potential for expansion. By contrast, few traditional MF borrowers use loans efficiently—most use them for copycat enterprises with very low or no capital. As most borrowers do not have capital, it is often impossible to expand businesses: expanding would mean simply hiring workers to do what workers can do independently.

Furthermore, most borrowers are neither willing nor able to expand. To most borrowers, who are usually women, their business is part-time and often comes second to other obligations.

Furthermore, a potential business expansion would require a whole set of entrepreneurial and managerial skills that most borrowers do not possess.

Nevertheless, microfinance is crucial in introducing microfranchising.

Combining the two is challenging but necessary. It would involve the separation of tasks: microfranchisors would develop and distribute new business opportunities, while microfinance institutions would provide funding and manage risks. The main challenge comes from the fact that microfranchising is not for everybody. It is more demanding than microfinance. Microfranchising requires a willingness to learn, a deeper commitment, and involves higher risks than microfinance.

Microfranchising is also demanding from an organisation’s perspective. A microfranchisor needs to constantly monitor diverse markets, and actively search for new business opportunities. Developing new business models takes time and resources and does not provide quick returns.

Furthermore, it will prove difficult for microfranchisors to raise funds. Mi-

crofranchising would be too unstructured and unpredictable for institutional donors, and not profitable enough for traditional finance. Overall, the shift from microfinance to microfranchising requires a change of paradigm: from lender to business partner.

The Rising Path of Islamic Finance

By Edward Kien Poon Chai

F

rom the first sukuk (plural of sakk) issued in Malaysia by Shell MDS Pvt. Ltd., to the first sukuk issued by a Japan Multinational Corporation and to the first sukuk issuance in the United Kingdom (UK) by International Innovative Technologies (IIT), sukuk is gradually gaining worldwide popularity as an alternative to conventional bonds by governments and corporations in fulfilling their financing requirements.

Riding on the momentum of its tremendous growth since 2001, the sukuk market is forecasted to exceed $30 billion by 2010 (The sukuk market would have been larger if not for the US subprime crisis and the series of notable sukuk defaults in the Gulf Cooperation Council (GCC) region).

Nevertheless, despite the vast potential of sukuk, the various structures of this financial instrument, its benefits and current limitations are not widely understood by conventional investors.

Since the middle ages, sukuk had been widely used by Muslims as a medium in trading and other commercial activities to represent financial obligations. However, in the current context of the capital markets, the structure of sukuk differs from that originally used.

Instead, in present day, it is related to the process of securitisation and is generally referred to as an Islamic bond. Securitisation is the financial engineering process for the creation and issuance of fixed or floating income securities, where payments of principal and profits come from the cashflow generated by the indebtedness that it represents, or from the receiva-

bles or revenue derived from the pool of assets that underline the transaction in the issuance of the securities.

To summarise, sukuk, better described as ‘trust certificates’ or ‘participation securities’ grants investors a share of an asset along with the cashflows and risk commensurate with such ownership.

In contemporary interpretation, sukuk is widely viewed as an Islamic alternative to conventional bonds. Sukuk is a financial instrument that helps the issuer to meets its capital requirements and is an important liquidity tool for Islamic financial institutions. Conventional bonds are not acceptable under the tenets of Shariah, principally because of its interest payments which are tantamount to usury or riba. Sukuk seeks to comply with prohibitions on interest and is meant to give investors a share of a tangible cash-generating asset.

Ideally, sukuk would be secured instruments with the risk of non-payment linked more to the asset performance.

Sukuk instead provides returns in the form of lease rentals (for ijarah structure), profits (for musharakah structure) or agency fees (for wakalah structure) – analogous to coupon payments.

The increasing interest in sukuk in the past decade stems from the need of sovereigns and corporates to tap funds from the Islamic capital market through the issuance of Islamic bonds. Hence, it is important to structure sukuk (similar to other Islamic financial instruments) that complies with Shariah values and principles so as to ensure investments from Islamic investors. From a Shariah perspective, money is not an asset but merely a value measuring tool; thus, receiving income from money alone (without an underlying asset in the transaction), in other words the notion of “money generating money per se” is not allowed. This generation of money from money (in simple term: interest) is riba. Therefore, the trading of debts and receivables (other than at par), conventional loan and the usage of credit cards are not permissible.

While it may be rather well known that Islamic finance is based upon the

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prohibition of interest (riba) in its commercial activities, activities containing elements of risk or uncertainty (gharar) and gambling or speculation (maisir) are also restricted by Islamic laws. Gharar is the element of deception, either through uncertainty in the existence of an underlying asset or uncertainty in the contractual terms of a transaction. Gharar is divided into three types, namely gharar fahish (excessive), which vitiates the transaction, gharar yasir (minor), which is tolerated and gharar mutawassit (moderate), which falls between the other two categories. A transaction can be classified as a forbidden activity because of excessive gharar.

Lastly, maisir refers to any activity that involves betting whereby the winner will take all the bet and the loser will lose his. Unlike the structure of a conventional bond that is limited to securitisation of a loan upon which interest is imposed, sukuk can be structured from innovative applications of Islamic financial contracts. Nonetheless, sukuk

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Terms

Definition

Bai’ A contract whereby the payment is made in cash at the point of contract but the Bithaman Ajil delivery of asset purchased will be deferred to a predetermined date.

Bai’ al‐Salam

A contract whereby the payment is made in cash at the point of contract but the delivery of asset purchased will be deferred to a predetermined date.

Ijarah

A contract whereby a lessor (owner) leases out an asset to a lessee at an agreed lease rental for a predetermined lease period. The ownership of the leased asset always remains with the lessor.

Istisna

A purchase order contract where a buyer requires a seller or a contractor to deliver or construct the asset to be completed in the future according to the specifications given in the sale and purchase contract. The payment term can be as agreed by both parties in the contract.

Mudharabah

A contract made between two parties to enter into a business venture. The parties consist of the rabb al‐mal (capital provider) who contributes capital to finance the venture, and the mudharib (entrepreneur) who manages the venture. If the venture is profitable, the profit will be distributed based on a pre‐agreed ratio. If there is a business loss, it will be borne solely by the provider of the capital.

Murabahah

A contract that refers to the sale and purchase of assets whereby the cost and profit margin (mark‐up) are made known.

Musharakah

A partnership arrangement between two or more parties to finance a business venture whereby all parties contribute capital either in the form of cash or in kind for the purpose of financing the venture. Any profit derived from the venture will be distributed based on a pre‐agreed profit sharing ratio, but a loss will be shared on the basis of capital contribution.

Wakalah

A contract which gives the power to a person to nominate another person to act on his behalf, as long as he is alive, based on the agreed terms and conditions.

has similarities to some conventional bonds as sukuk are structured in tandem with physical assets that generate revenue. In most sukuk, returns for investment are linked to cash flows and performance of the underlying assets.

Sukuk are structured based on any or a combination of two or more of the Islamic contracts of transactions: contracts of participation (‘uqud ishtirak) of Mudharabah and Musharakah; contracts of exchanges (‘uqud mu’awadhat) of Shariah-compliant assets of Bai’ Bithaman Ajil, Murabahah, Bai’ al-Salam, Istisna and Ijarah; contracts of agency (‘Aqd wakalah).

Besides these plain vanilla sukuk structures, from the continuous innovations and developments in the Islamic capital market, sukuk are also issued based on a combination of different transaction contracts and other Islamic principles. This innovative sukuk are usually structured to enhance credit ratings, to satisfy the issuers’ financing needs and to attract a larger pool of investors. For example, Sukuk al-Amanah Li al-Istithmar (ALIm) issued by Cagamas ltd., Malaysia’s national mortgage agency serves to meet the require-

ments of broader investors, especially from the Middle East. Cagamas’ mixed asset Sukuk ALIm, which includes a RM5 billion Islamic commercial paper and Islamic medium term note programme, completely precludes the elements of sale and buyback (Inah), trading of debt (Bai’ Dayn) and undertaking (Wa’ad) - concepts which are not be acceptable to some Syariah scholars, particularly from the Middle East. Sukuk Murabahah Suq’ Al-Sila is another instance of innovative sukuk.

From the Shariah point of view, it is essential that sukuk is backed by a specific, tangible asset throughout its entire tenure and sukuk holders must have a proprietary interest in the assets which are being financed. In addition, the asset backing the sukuk must meet the following conditions: exist physically, pure, useful (restricted to Shariah compliant purposes), owned by the issuer and free from encumbrances. The applications of these assets linked contracts ensure that sukuk are more investors friendly relative to conventional bonds and reasonably protect the interests of investors in the event of default.

The virtue of sukuk being structured

with underlying assets grants investors an undivided interest in the sukuk assets and hence, an opportunity to recover their investments in full or in part from the liquidation of the assets.

This property of sukuk attracts conventional investors who are particularly risk averse after the subprime crisis in addition to Muslim investors who invest in sukuk because it complies with Shariah principles. Now, it is also possible to issue an asset based sukuk which is fundamentally different from an asset backed sukuk. Recently, a series of high profile defaults in the GCC region highlighted the teething problems with the underlying contracts of some sukuk which has undermined its reputation as a safe investment product.

Sukuk issued on different transaction contracts results in different types of securitisation- the main difference lies in the ownership of the assets underlying the sukuk. In general, there are two kinds of ownership: ownership of the physical asset (case 1), its usufruct or services where there is a true sale of the asset by the issuer to a Special Purpose Vehicle (SPV) to ensure it is bankruptcy remote and ownership

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of the rights to the cash flows arising from the asset but not the physical asset (case 2). There is no true sale of the asset and the asset remains on the balance sheet of the issuer. Case 1 represents an asset backed sukuk where the claim embodied in the sukuk is not just an undivided interest on the underlying physical asset but investors also have the right to the cashflow arising from it and proceeds from the sale of the assets. Case 2 represents an asset based sukuk that evidences the indebtedness and grants investors the rights to the obligations attached to the financial assets. An asset based sukuk is the result of the securitisation of obligations or receivables and often, the underlying asset is taken as collateral for the sukuk to enhance the sukuk ratings.

True sale of the underlying asset of a sukuk isolates the asset from the issuer and hence protect investors from

The crux of the problem with asset backed or assets based sukuk lies in the fact that at times, investors are not aware of the structure behind the sukuk and therefore, are not aware of the risks that they are exposed to. exposure to the liabilities of the issuer (But not the liabilities of the asset). To provide an example of the benefits of an asset backed sukuk: Firm A which issued sukuk B is under severe liquidity pressure. Sukuk B is an asset backed sukuk which constitutes a true sale of the underlying asset of the transaction contract to a SPV. Therefore, even if Firm A files for bankruptcy, the sukuk holders will still be entitled to the cashflows and receivables of the asset as

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the asset had been removed from the estate of the issuer. On the other hand, asset based sukuk does not protect investors from the risk of bankruptcy of the issuer. From a legal perspective, the issuer still owns the asset and not the sukuk investors. In the case of a bankruptcy, certificate holders will be joined by other creditors to make claims on the asset and thus, may not be able to recover their investments.

The crux of the problem with asset backed or assets based sukuk lies in the fact that at times, investors are not aware of the structure behind the sukuk and therefore, are not aware of the risks that they are exposed to.

In addition to that, the near default of sukuk issued by the Dubai property developer, Nakheel and other sukuk defaults that include Kuwait’s International Investment Group and United State’s energy firm, East Cameron Gas (ECG) highlighted another inherent problem of sukuk- the untested application of English common law on Islamic financial products, posing a real legal risk to sukuk holders. More often than not, a firm in the midst of a severe financial distress will try to vindicate its legal obligations to creditors.

Take the example of East Cameron Partners (the originator) who filed for bankruptcy. ECG’s $165.67 million sukuk is asset backed and is secured by an interest in the oil and gas royalty rights on two gas fields in the Gulf of Mexico. Nevertheless, in the bankruptcy court, the originator tried to wrap up the sukuk holders’ assets and claimed that the transaction was not a true sale, but a secured loan disguised as a true sale. Under such circumstances, sukuk holders will lose their claims on the assets and will have to share the rights to the assets with other creditors. (Khnifer 2009), “There is a need to establish the sukuk holders’ ownership of the assets in such a way that the courts around the world recognize their ownership rights and rule accordingly. At present, the matter is unclear as to whether sukuk holders enjoy contractual rights to the assets like bondholders, or creditors, so that judges will therefore not rule in favour of their

ownership, or whether they enjoy propriety rights and are therefore considered by the court to be equity holders.”

After a year and half, the judge granted the certificate holders full ownership and possession of the assets with no claims on the assets by other creditors. Although investors are protected, this has led to another issue: the differences in interpretation of Shariah financial products by Muslim law and commercial law. The verdict brings the connotation “...In reality, sukuk do not have proprietary rights but instead, beneficial ownership. The legal standing of investors is therefore akin to that of creditors.” (ICM newsletter, December 2009, Securities Commission of Malaysia) This clearly violates the principle of musharakah and mudharabah where certificate holders are owner of the assets.

Another factor that might impede the growth of the sukuk market is the lack of standardization and uniformity in the interpretation of Shariah scholars from different parts of the world. For instance, Shariah scholars in Malaysia, currently the world’s biggest sukuk market are perceived as more liberal in their interpretations and applications of Shariah principle by their Middle Eastern counterparts. One clear difference in opinions of both parties is the trading of indebtedness. While the Middle East and most jurisdictions only allow debts trading (Bai’ Dayn) at par, Malaysia allows debts trading at any value so long the underlying contracts are Shariah compliant. Besides debts trading, sale and buyback (Bai’ Inah), trading of debt (Bai’ Dayn) and undertaking (Wa’ad) are some of the elements that are also frowned upon by some Shariah scholars, particularly those from the Middle East. Differences in Shariah interpretations may reduce investors’ confidence especially among Muslim investors, resulting in a drop in demand for sukuk.

Despite the hurdles that sukuk and other Islamic products may face in its path, it is still worth the effort to promote continuous growth of the Islamic capital market and the continuous inno-

vation of its products. Although Islamic finance is not spared from the financial crisis due to its interconnectedness and non independence from the global financial market as well as exposure to similar systemic and specific risks, its application in true form and substance will help Islamic finance to be more resilient towards economic crises.

Structural Incoherence in Financial Markets

By Emre Tarim, PhD Sociology, University of Edinburgh

W

e can highlight three important insights sociological studies bring from financial markets. The first is importance of social relationships (networks) in sense-making and pricediscovery, which undermines the notion of rational unitary actors capable of collecting and processing data/information on their own (Baker, 1984). The second is demonstration of origins and effects of social and organisational action that are not necessarily utility maximizing by looking at role of beliefs and culture pertinent to groups (Abolafia, 1996); and how markets and politics interact in shaping markets’ legal and cultural foundations and social actions that take place in markets (Fligstein, 2002).

The third insight is demonstration of human and non-human actor interaction, including application of theories and technology to markets, and how these transform cognition, calculation, and price-discovery activities in financial markets (Millo and Mackenzie, 2003; Mackenzie 2009). In all three insights, there is one common theme, namely reduction of uncertainty concerned with: rights and obligations attached to securities and actors that participate in issuance and exchange of securities; social value and legitimacy attached to these essential processes and markets in general; and finally subjective judgements about financial value of securities in relation to risks and returns.

In reference to the third insight, re-

cent research on financial markets demonstrate growing importance of digital representation and calculation technologies which have undermined the network based and face to face relationships in financial markets (Cetina, 2005; Cetina and Preda 2007). In this new environment, flows of funds and information presented on information and trading screens become text-like representations of aggregate market sentiment which market

In fact, digital revolution can be argued to have brought a new wave of disintermediation to financial markets... actors read, classify, interpret, and contribute to with trading actions. In this respect, market actors develop market knowledge via observation of market screens rather than by being physically in a market place, which had been a privilege for select few market professionals before the digital revolution. In fact, digital revolution can be argued to have brought a new wave of disintermediation to financial markets, and enabled lay investors and small investment organisations to be more self-reliant in their observation and trading activities in markets.

Digitization of market places and automation of trading have therefore transformed the way market actors orient themselves to other market actors. More importantly, it has brought a more democratic access for professionals and general public alike to information/data and to markets.

Improvements in access to market and information however does not necessarily bring uniformity among market actors in their comprehension and interpretation of market screens.

As the nature of representation on market screens are now very much

dominated by summary proxy figures about anonymised actors, and about risks and returns associated with securities, market actors find themselves in a position to having to decode these figures to be able to gauge direction of markets and value of their investments. In that process, one’s market identity and epistemic, social, and economic resources become determining factors in how decoding is performed and results in trading decisions.

Irrespective of effects of digitization on generation and coherence of meanings in digitized financial markets, sociological studies have pointed to the origins and consequences of different interpretations in markets in the form of conflicting valuation models on securities (Beunza and Garud 2007) or worse, categorical discounts or total avoidance of securities (Zuckerman 1999) which seem not to fit the prevalent perception frames or knowledge standards in different pockets of a market (White 2000). The main source behind these structural differences in meanings are multiple roles actors and entities take on, and understanding of actors about other actors and entities’ roles and functions. Therefore, within a market there is a division in terms of not only concrete functions an actor or entity fulfils but also of perceptions held by actors about actors, entities, and their properties and functions. Although one would assume that over time there should be convergence between fact and perception as social order is based on consensus among actors over meanings attached to actions and entities, financial markets undermine such a need for consensus over meanings, especially about aspects of market which are not directly concerned with foundational rules, regulations, and mores to solve [social] value, cooperation, and competition problems in markets (Beckert 2009). In that sense, price of a security at any point in time need not reflect consensus about ‘right price’ in relation to financial risks and returns among different actors for it to be realized and used as a signifier to exchange securities. This is despite the fact that there needs to be a consensus about legitimacy of price discovery

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mechanisms in a market as orderly, stable, and fair to all participating parties irrespective of their market profiles.

Therefore, we can identify two planes of order in financial markets. The primary plane of order is comprised of ground rules and norms about what constitutes a security, how it can be exchanged in a given market, rights and obligations attached to owning a security, who can own it, who can issue it, and so on. The primary plane gives purpose and role to constituting elements of a market, draws the boundaries of competition and cooperation among participating actors in that market. The secondary plane accommodates actual practices by actors informed by the first plane as well as theoretical or vernacular constructs about financial valuation. Yet, knowledge and value outcomes generated in the second plane may not necessarily conform to categorical or a priori facts generated in the first plane. Simply put, shares of company A despite being categorically the same entity in the first plane, namely a security that allows investors to become shareholders in a company, may not take on the same meaning in relation to subjective financial valuations and/or reappraisal of their social worth and legitimacy by market actors who have different market roles and identities. Consequently, actual financial and social value and legitimacy performances may undermine legitimacy and social value of a given security and nullify a priori truth claims made about it. Similar mismatches between a priori truth claims about other components of a market and posterior perceptions held by market participants and wider public are probable and prone to create structural incoherency in meanings attached to markets and their components. This probability has been exacerbated by democratisation of access to market information, data, and knowledge by increasing number of people and organisations, which has diluted network-based and restricted mode of presence in market places.

Therefore both planes of social order in a market are closely connected to each other in a spectrum of mutu-

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ally constituting to mutually undermining relationships. The dynamism of multitude of actors and entities with diverse social and market identities being in constant market interaction leads to reappraisal of a priori and a posterior claims concerning securities and markets, and provides the internal and external stimuli for reform and change in financial markets.

Technological Finance

By Dr. Juan Pablo PardoGuerra, Science Studies Unit, University of Edinburgh

M

arkets are technological by nature. Whether through the selfservice check-out machines at Tesco or the telephones linking Sotheby’s auction rooms to unidentified bidders across the world, the spaces and institutions within which we create markets are inextricably populated by an ever-expanding and ever-changing arrangement of things.

Financial markets are no exception to this technological quality. And although they are essentially markets in promises, they rely on a vast network of artefacts that make exchange possible and commitments fungible. While embryonic varieties of finance depended on paper, wax and ink, contemporary finance is built upon global telecommunication systems, sophisticated computers and the cathedrals of glass and steel that serve as the architectural backdrop of financial districts worldwide.

Yet the material platforms of finance are not incidental mechanisms for recordkeeping and information management. Rather, the material environments and technological instruments of finance are pivots of the operation and evolution of the market. In a sense, the broader dynamics of finance depend not only on the promises that are exchanged in the market; critically, they also hinge on the structure of the material platforms that allow such promises

to travel across the globe.

The London Stock Exchange: A Case Study The centrality of technology in finance is illustrated by the history of the British securities industry and, in particular, by the events and transformations that took place within some of its key institutions. Of these, few have greater historical weight than the London Stock Exchange, an organization that until relatively recent times was the recognizable core of British finance.

Over the last five years, my work has examined sociological aspects of the evolution of technology within the London Stock Exchange. Specifically, my work explores the period between 1955 and 1992 during which the Stock Exchange adopted and implemented several generations of information and communication systems in and around the market.

... contemporary finance is built upon ... the cathedrals of glass and steel that serve as the architectural backdrop of financial districts worldwide.

Today, the London Stock Exchange provides some of the leading electronic trading platforms in Europe.

Thirty years ago, however, the Stock Exchange was quite a different place, performing a multiplicity of roles that included company listing, regulatory supervision, the provision of a marketplace, and the operation of an informal social club. Indeed, thirty years ago the Stock Exchange’s market was quite different from today’s electronic systems, existing primarily as a set of conversations between brokers and

market-makers (then called jobbers) on the bygone trading floor. The transition between the analog modality of finance whereby deals were negotiated on the trading floor and the current digital incarnation occurred on 27 October 1986 when a set of regulatory changes were instituted in unison by the Council of the Stock Exchange.

These changes, colloquially known as ‘big bang’, included the introduction of Stock Exchange Automated Quotations, a real-time, phone-based trading system that resulted in the demise of trading on the floor.

Moving from the ancient floorboards on Threadneedle Street to the polished marble on Paternoster Square was not straightforward, though. Like other financial intermediaries throughout the world, the Stock Exchange’s incursions into the world of electronic markets were a matter of constant experiments, both at the level of engineering as at the level of organization.

Indeed, the trajectories of the marketplace were bound to such experiments and, perhaps more importantly, to their designers, be they consultants, members of the Stock Exchange or hired staff.

Some of the most remarkable experiments in the Stock Exchange revolved around the use of novel technologies in the market of which computers and telecommunications had a prominent role. Effectively, computing and modern telecommunications entered the Stock Exchange in a piecemeal fashion, fuelled by a broad imperative to reduce operational costs, particularly in settlement. Traditionally, settlement involved matching thousands of orders by hand, an activity that required armies of highly-skilled (and thus, relatively dear) clerks. Settlement, however, was a rather algorithmic activity and, in this sense, was particularly amenable to the arithmetic and record-keeping capabilities of modern digital computing.

The introduction of computers to the settlement department of the Stock Exchange in 1964 triggered innovations elsewhere in the organization. In

particular, it set the grounds for the production of the first electronic price dissemination system in London, MPDS (Market Price Display Service). Operating on a closed-circuit black-and-white television system, MPDS provided mid-prices of the most actively traded shares to brokerages and investment offices throughout the City of London.

And although MPDS did not challenge the prominence of the trading floor (the prices on the screen were, after all, not real-time market prices and thus were useless for trading), the development of the system implied a fundamental organizational transformation: To maintain and expand MPDS, the Stock Exchange created a specialized technical department populated by a young, though experienced, group of innovation managers and telecommunications and computer engineers.

The arrival of technologists to the Stock Exchange profoundly altered the trajectory of British finance. Between the inauguration of MPDS in 1970 and big bang in 1986, technological services within the Stock Exchange grew almost exponentially: from a handful of individuals in the early 1960s to two-thirds of the total 3,000 members of staff in 1990. Importantly, the expansion of technological services within the Stock Exchange involved a reconfiguration of the power relations that shaped the organization’s courses of action. As time progressed, and as the technologists’ multiple innovations proved useful, their influence over the trajectory of the Stock Exchange consolidated. Effectively, technologists grew to command great power over the evolution of British finance by defining the technologies that would be ultimately implemented in its most important marketplace. They defined, in a sense, the makeup of the instruments through which finance was made. Indeed, most of the innovations that defined big bang in 1986 were the brainchildren of Stock Exchange technologists, including SEAQ (the realtime price dissemination system that altogether eliminated the need for a trading floor), the red and blue trigger screen (that represented market activ-

ity visually), and Britain’s paradigmatic market index – the FTSE 100 (which was conceived by Stock Exchange employees as an aid for trading options).

Markets at the Speed of Light The involvement and ultimate lead of technologists in the design of new generations of market platforms in London was symptomatic of two fundamental trends in modern finance.

Firstly, that financial markets are created at the intersection of multiple types of expertise, from the experiential knowledge of traders and the organizational skills of firm managers, to the technical instruments of economists and the technological capabilities of engineers. Secondly, the rise and rapid proliferation of modern electronic trading systems meant that a specific type of expertise – namely that related to the design of reliable real-time communication systems – was becoming increasingly critical to the market.

It is thus understandable that, after being disbanded in 1992, some of the leading technologists of the Stock Exchange became involved in the development of electronic trading platforms elsewhere. Effectively, through their participation in a multiplicity of projects, meetings and consultations, former Stock Exchange technologists along with their peers from other organizations transformed real-time information dissemination into a central and amply recognized paradigm of the market.

The rise of real-time information dissemination (largely advocated by the first generation of telecommunication engineers) converged with a related, though relatively independent, trend within the securities industry. From the 1980s onwards, the recruitment practices of investment firms gave greater value to the skills and expertise of technically-trained professionals, including physicists, mathematicians and computer scientists. Among other factors, this shift responded to a perceived need to develop more sophisticated investment and portfolio management techniques that were in line with the grow-

Special Reports | the analyst 11

ing availability of market information.

The consequences of this convergence are clear today. The incorporation of new forms of expertise into the design of the market not only resulted in a wealth of financial innovations – including, for instance, the engineering of a cornucopia of synthetic derivatives; critically, they crystallized the technological trajectories of finance that originated in the 1960s by making speed more relevant than ever. Specifically, the convergence between the work of a relatively young generation of ‘rocket scientists’ and of a by then relatively older generation of telecommunications engineers set the foundations for algorithmic and high-frequency trading, two of the most important trends in contemporary finance. These practices, which now account for an important part of trading volumes in London and New York, are overtly technological, depending on issues such

as network latency and server proximity. They make evident, in a sense, the technological fabric of modern finance.

But why should we care about the technological dimensions of financial markets? A partial answer may be found in the recent flash-crash of 6 May 2010. On that day, shortly after 2:45, the Dow Jones Industrial Average lost 9.2% of its value in a span of 20 minutes, constituting the worst crash in the history of American finance. Trillions of dollars evaporated from the books in an almost uncontrollable manner. The roots of the crash are not to be found in the logic of macroeconomic indicators; rather, they are found at the confluence of human-technological interactions occurring within a global network of traders, algorithms and communication systems. An urgent challenge for academics, regulators and members of the financial services industry at large lies in gaining a

better understanding of these largely opaque networks of interactions.

For too long, both scholars and practitioners have seen the technological platforms of finance as neutral instruments that merely aid calculation and exchange. In this tradition, the contribution of technology to systemic risk is only seen in terms of the probability of down-time of the systems. The flashcrisis showed, however, that such approach is no longer tenable. In a market increasingly populated by sophisticated technological arrangements, systemic risks emerge from a number of yetunexamined routine interactions. To manage the markets of the future will require a better understanding of these interactions. And in particular, it will require engaging with the experts that produce the technological systems that shape the evolution of the market.

12 1000 Times Worse Than Dubai? China and its Asset Market Bubble 15 2010 - Is it Time to Invest in Solar?

17 Defying the Financial Crisis: M&A in the Healthcare Sector 20 Consolidation Taking Off in the Airline Sector 21 Technology M&A Up in the Clouds

MARKETS 1000 Times Worse Than Dubai? China and its Asset Market Bubble

since 1931.” In fact, many fear a repeat of the 2007-2009 crisis should China fail to tighter regulate its supposedly overheated property market. Jim Cha-

By Hsien Sheng Wong

C

oncerns over the perceived frothing of speculative bubbles in China’s asset markets are understandable given the collapse of the property sector in Dubai in 2008 and the sub-prime housing crisis of 2007/2008 in America that sparked off the “worst depression

12 Markets | the analyst

nos, Founder and President of Kynikos Associates, famously claimed that there is a fixed asset bubble occurring throughout China that is at least 1000 times worse than that of Dubai, hyperbole noted. Chanos is simply incorrect.

While portions of the real estate market are certainly overheating, the prices of property in tier two and three cities are affordable and in line with market fundamentals such as rising wage levels. Moreover, the Chinese government appears to have successfully undertaken counter-measures to nib this speculative trend in its bud. Even for

properties in tier one cities, the speculative bubble may not be as large as commonly perceived. The argument put forth by Chanos on the extensiveness of the asset bubble in China will be presented and then promptly rebutted. More nuanced analysis will highlight the differences that exist within the Chinese property market. In particular, the insights provided by Jing Ulrich, Chairman of JPMorgan’s China equities and commodities business as well as Stephen Roach, Chairman of Morgan Stanley Asia will be expanded upon. Finally, the potential consequences of the bursting of the asset bubble in China will be explored, substantiating the conclusion that while these fears may be well-intentioned, they are not based on hard facts Chanos claims that this bubble is prevalent not only in tier one cities on the coast but further inland as well and that “signs of this asset bubble are everywhere.” On the surface, it is easy to be swayed by this argument. He argues that real estate prices in China are too expensive for the average couple with the ratio of real estate prices to incomes in Beijing standing at 27:1. JP Morgan reported that nationwide property prices in the 70 largest cities rose by 14% in the year ending in March 2010 with prices in cities such as Beijing, Shanghai and Shenzhen witnessing an even faster rate of appreciation.

Bloomberg noted that Beijing’s office vacancy rate was 22.4% in the third quarter of 2009. To accentuate matters, these figures do not include many new buildings about to open such as the city’s tallest commercial building; the 74 story China World Tower 3. In addition, Chanos estimated in 2009 that 30 billion square feet of commercial real estate were being built as of year-end 2009. This is sufficient to provide a 5x5 cubicle for every man woman and child in China. With these staggering figures, it is no surprise that Sun Mingchun, a Hong Kong based economist at Nomura told Bloomberg in an interview in June 2010 that the bubble in China’s property market is going to “burst very quickly, with prices set to fall as much as 20% in the

next 12 to 18 months.” However these statistics should not be understood in isolation. Importantly, Chanos and Sun have erred as their analyses fail to recognise the differences that exist within the Chinese property market.

It is indisputable that prices of property in China, especially in tier one cities like Beijing, Shanghai and Guangzhou are no longer accurately guided by market fundamentals. However in tier two and three cities like Dalian, Tianjin and Shenzhen, demand is still very strong and prices are actually keeping up with income growth. Chanos and co are inaccurate on a number of levels.

Firstly, they fail to understand how demand for this housing is real, especially in the tier 2 and 3 cities. China is experiencing a yearly rural to urban migration of 15 to 20 million people.

Ulrich estimates that urbanisation will continue for the next 20-30 years until China reaches a point where urbanisation hits 80-90%. Currently, urbanisation only stands at 40%.

With this long-term trend of migration from country sides to cities, Roach is right to claim that “the property market (in tier two and three cities) is not overheated and the demand for these properties is very, very solid.”

Next, cries of an impending collapse in the Chinese market fail to recognise the measures taken by the government to curb speculation and dampen demand for housing. These measures have so far shown to be effective. The government has attempted to curb

multiple homes buying by raising the deposit requirement for second-home purchases and by raising the mortgage rates applied to these purchases. In addition, cities experiencing above average property price rises such as Beijing have introduced further local regulations such as preventing banks from extending loans to third mortgages. In fact, China is considering introducing higher taxes on real estate, possibly even a US style property tax to cool down its booming property market.

Importantly, the government has also moved to restrain bank lending and rein in inflation by raising China’s bank reserve requirements. It has raised its required reserve ratio (RRR) three times since the end of 2009. Finally, while 2009 saw loan growth rise by over 33% year on year, it is expected to increase by only around 17% in 2010, and the decrease in transaction volumes hitherto seem to suggest their effectiveness. Local governments in the non-coastal areas are also ameliorating this problem, albeit indirectly via their developmental strategy of offering huge incentives to attract foreign business from coastal cities such as Guangzhou. This decreases the need for immigration, i.e. demand for housing, in populous cities. Initial signs have been encouraging with Foxconn, the world’s largest electronics contract manufacturer preparing to shift part of its production of Apple’s gadgets from populous cities in Shenzhen to north and central China.

The government has taken note of the impending problem and its remedies have the potential to prevent the growth of the asset bubble in China.

Finally, there are evidences that property prices in tier 1 cities like Beijing are more affordable than commonly perceived. It is widely thought that the average price of a house in China is substantially larger than the incomes of an average Chinese couple. In fact, many put the figure at 27: 1, meaning that the average price of a house is 27 times that of its owner’s income. They hasten to add that at the peak of the US boom, this ratio was roughly 6:1.

This statistic is misleading as it fails to

Markets | the analyst 13

compare the ratio of after tax income for an average couple to the price of the average real estate in each city.

Clay Fisher, executive vice president of The Private Client Group presents the following calculations: On average, a couple in Beijing earn ¥98,000 ($14,368). Most Chinese don’t pay tax, with income tax as a percentage of GDP less than 3% in China. (It is almost 9% in America). In addition, there is also no annual property tax in China.

For a couple in Manhattan, after paying federal, state, local and property taxes, they would be lucky to escape with 65% of their gross income. Since average household income is $126,000 after tax in Manhattan, a Manhattan couple earns 6.5 times the Beijing couple in nominal terms. On average, the price of real estate in Beijing is approximately ¥240 per square foot. The New York real estate industry estimates that Manhattan real estate averages $1,320 per square foot. This is around 6 times that of Beijing’s real estate. Hence, based on nominal income, the relative prices of Manhattan and Beijing real estate are fairly close, and any talk of bubbles should be taken with a pinch of salt. The property market in Beijing is not worst off than that in Manhattan.

While the actual existence of a property bubble in China is widely exaggerated, there is a feeling that should an extensive bubble inflate and subsequently burst its repercussions for China and the world would be dire. Most housing purchases in China are made with a 50% cash down payment (not outlandish credit) and the ratio of housing loans to GDP is still only 15.3% compared with a peak of 79% in America. However, mortgages account for over 20% of the total loans made by the Chinese state led banks. In fact for China’s Merchant Bank, it is around 24%. Loans to

property developers further account for another 8%. Many banks in China are already gauged to be insolvent according to Western standards. A further defaulting of loans brought about by a crash in the property market would be highly destabilising to the financial sector. This is ominous for an economy that much of the world’s economic recovery is thought to be hinged upon.

In conclusion, China is not “Dubai times 1000”. While an asset bubble may be developing in tier one cities like Beijing and Shanghai, it is still in the initial stage and government measures appear to be effective in tackling this problem.

Importantly, the property markets in tier two and three cities appear stable with rises in price levels underpinned by solid demand that will continue for the foreseeable future. While Chanos was vindicated in shorting Enron equities, his short exposure to Chinese real estate may prove to be his undoing.

2010 - Is It Time to Invest in Solar?

By Sheun Yeow Cheng

F

inding explosive stocks that could possibly rise three-fold or more isn’t always an easy task. It takes a great deal of research to find the right stock in the right industry that is growing fast and has the potential to make such a large move. Some of the biggest gainers in the beginning of 2010

were solar stocks. With the increasing interest of numerous venture capitalists in the solar sector, recent spurts of solar developments around the globe and analysts predicting explosive growth in renewable energy, it stands to reason why solar stocks achieved such big gains early this year.

Just recently, President Obama announced in his weekly radio address

“Renewable energy companies may tap financial markets for more funds this year instead of looking to mergers with utilities as a way of funding expansion,” that the Department of Energy has agreed to back nearly $2 billion in loans to two solar power companies for projects in Arizona, Colorado and Indiana.

The Spanish solar firm, Abengoa Solar Inc will receive a $1.45 billion loan guarantee to construct a 280 megawatt concentrating solar power facility in Solana, Arizona while the Colorado-based solar start-up, Abound Solar, will receive a $400 million guarantee to finance factory expansions in Colorado and Indiana. The plant will be built 70 miles

Markets | the analyst 15

in Latin America. Launched in 2007, the Euro-Solar project expected to reach 300,000 people in 600 poor rural communities without access to the national grid, providing energy through renewable sources they can use.

Earth Times reports that Belgiumbased Enfinity NV has announced plans to spend $82 million dollars to build a 40-megawatt solar farm in Thailand this year. Enfinity previously limited its operations, 90 percent of which are in solar farms using to photovoltaic technologies, to Europe and the US. In the South Asia region, India’s thirst for solar energy also contributes to the positive outlook for solar investments in the near future. The government recently launched its National Solar Mission – a $19bn plan to generate 20,000 megawatts of solar electricity by 2022. At the moment, solar power contributes a tiny fraction of that (less than 1%) to the national grid.

southwest of Phoenix, near the Gila Bend, Arizona and will produce enough energy to serve 70,000 households.

“Renewable energy companies may tap financial markets for more funds this year instead of looking to mergers with utilities as a way of funding expansion,” said Morgan Stanley, manager of the most initial public offerings for the industry in 2009. Morgan Stanley managed $2.85 billion in IPOs for wind, solar and biomass companies in 2009, surpassing the previous leader, Credit Suisse Group AG. Connecticut-based General Electric (GE), in its latest “Ecoimagination” report says it aims to boost its investment in cleantech research and development to $1.5billion a year by 2010. The company, the biggest conglomerate in the United States, has set a green-busi-

16 Markets | the analyst

ness revenue target of $25 billion for 2010, compared to $17 billion in 2008.

Furthermore, the largest solar park in Latin America is to be built in Argentina, which will produce between 1500 and 2400 megawatts of power, making it the largest solar energy producer in all South American countries and the countries of Latin America.

Construction is expected to begin in September this year and last for a period of 8 to 10 months. In addition to Argentina’s solar park project, the first solar park in Saudi Arabia has just been completed. The 2MW park consists of 9,300 solar modules erected on the roof of the King Abdullah University of Science and Technology in Jeddah.

In addition to solar parks, the European Union (EU) gave a boost to its pioneering program to bring solar energy to remote communities in 8 countries

India Journal also reports that a project is underway to develop a solar powered aeroplane, as early as 2011. “Solar Impulse”, the name of the aircraft, will be able to fly both day and night using solar cells on the upper surface of the wings and a battery tank to store energy. The aircraft has been created to fly around the world without burning any oil. Bertrand Piccard, a Swiss pilot will begin to test the Solar Impulse.

Dr PC Pande from Rajasthan’s Central Arid Zone Research Institute points out that the sun is not in short supply. “Here in the region [India], we have plenty of solar radiation,” he comments. “It’s full of sun. Three hundred plus days of sun a year, nine hours a day.” A third of Indians do not have access to electricity, but they do get plenty of sun.

Investment bank, Goldman Sachs appears to have upgraded their solar sector as well. In the last week of June, it is reported that Goldman Sachs came out bullish on the solar sector. In a note to clients on Monday, Goldman Sachs said it sees benefits from large-

Acquirer Pfizer Roche Merck's AstraZeneca Takeda Eli Lilly

Deal Amount (Billion) $68.0 $46.8 $41.1 $15.6 $8.8 $6.5

Target Wyeth Genentech Schering-Plough MedImmune Millenium ImClone

scale projects ultimately overwhelming near-term challenges and accelerating the transition from subsidized markets towards parity. More simply, the mass production of solar technology has created economies of scale, making once-expensive solar panels competitive with fossil fuels (think Henry Ford and Model T). While locations with high electricity rates have already reached parity, Goldman Sachs thinks it’ll be widespread as early as 2012. That’s “sooner than the Street expects”. Within just 3 sessions, First Solar Inc. (FSLR) has made an impressive swing up, gaining more than 10%.

Most solar stocks are now bullish on the short-term, but some resistances to new highs are to be expected over the next days. However, if the bullish move continues, we could possibly see a new mid-term uptrend starting.

As of July 6, we notice a breakout of the $5.22 resistance level. Based on the several long white candlesticks, JASO stocks look bullish for now, with a possible uptrend starting in the near future.

The solar stock ETF, TAN continues upwards alongside STP, FSLR and TSL. As for now, most solar stocks are observed to be bullish.

Defying the Financial Crisis: M&A in the Healthcare Sector

By Edward Kien Poon Chai, Kaushik Sudharsanam, Nicolo Colombo

2

009 began with the paralysing fear of worsening recession and skyhigh unemployment rate. Like many other sectors of finance, the merger

and acquisition (M&A) sector has seen one of its most inactive periods during the subprime mortgage crisis, yet some of the largest M&A deals in the healthcare sector were completed during this period of financial turmoil; the $68 billion dollar acquisition of Wyeth by Pfizer, Roche’s $46.8 billion dollar takeover of Genentech and Merck’s $41.1 billion dollar bid for Schering-Plough. With common drivers of M&A activity like CEO confidence, consumer confidence and the ability to obtain financing at their bottom low, what drove the M&A deals in the healthcare industry during this period of high economic uncertainty?

To address this question, we may refer to the words of Steven L.Pottle (Alston & Bird LLP), who recently commented on the general drivers of M&A in the healthcare industry, special reference to the specific drivers of such operations under economic difficulties. He said “With regard to the consumer market for drugs that are life saving, the demand and funding sources are more resilient [relative good state of capital markets and consumption patterns still strong] because they reduce the overall cost to the health care system by reducing hospital time, where the really expensive procedures occur.

As a result, the demand for innovating certain drugs should persist in a down market because, even though it takes hundreds of millions of dollars to get a drug to market over a significant amount of time, the payoff is incredible [there’s then an indirect scope for M&A transaction, and CEO’s commitment to these operations]”.

There are many rationales that prompted big healthcare firms to pursue acquisitions in the recent years, such as expiring drug patents for big pharmaceutical (pharma) firms, pharmaceuticals firm needing cover for their lack of innovation, increasing threats from generic drugs, regulatory issues, and abundance of excess cash.

Furthermore, the general ability for big pharma firms to get easy access to capital has worked as an incentive for consolidation in the industry.

To examine specific explanatory examples of recent trends in M&A for healthcare in depth, we will start from one of the “mega-deals” of last year: Pfizer acquisition of Wyeth. Similar to Pfizer, Wyeth is a huge pharmaceutical firm which has its own drugs patents but, in addition, Wyeth also boasts of a successful vaccines business, a lucrative line of consumer products and an expertise in biotechnology.

Acquisition of Wyeth by Pfizer is expected to boost Pfizer’s revenue to $71 billion dollar per annum from its current $48 billon dollar. However, the main motivation behind the acquisition is viewed as a strategic measure to prevent Pfizer’s revenue from dropping dramatically due to exposure to competition from generic drugs once Pfizer’s drug patent expires. Pfizer’s drug patent on Lipitor is set to expire in 2011. Lipitor is a cholesterol drug that earned the firm about $12billion dollar in 2008. At the same time, this may

...the demand for innovating certain drugs should persist in a down Market because, even though it takes hundreds of millions of dollars to get a drug to market over a significant amount of time, the payoff is incredible be a move to buy time for the research and development (R&D) arm of Pfizer to come up with a new drug patent.

Nevertheless, Charles Farkas of Bain Consultancy is of the opinion that the deal may not be able to buy sufficient time for Pfizer to find another ‘blockbuster’ drug to replace Lipitor simply

Markets | the analyst 17

because Wyeth’s top selling drugs will also lose patent protection in due time.

Huge pharmas have a lot of cash but they are innovation poor. The imminent threat of patent expiry drives big pharmaceutical firms to buy ideas by acquiring other firms. This is because they have failed to come up with new innovations in time to replace the expiring drug patents. Of late, there is a trend which suggests that big pharmas are moving towards acquiring large biotechnological firms instead of smaller start up firms to replenish and boost their research pipelines. For instance, Roche, an enormous Swiss pharmaceuticals firm acquired the remaining 44% (part it had not owned earlier) of Genentech, the world’s largest biotechnological firm by stock market value for $46.8 billion dollars; Eli Lilly (LLY), an American drug company, acquired ImClone for $6.5 billion; AstraZeneca, a British drugs giant, bought MedImmune for $15.6 billion and Takeda of Japan paid $8.8 billion for Millennium.

Regulatory risk is another factor which led big pharmas to acquire established biotech firms instead of new start ups. On the heels of a series of safety scandals concerning drugs (Merck’s Vioxx, GlaxoSmithKline’s Avandia and other problem pills), the Food and Drug Administration of America (FDA) is relatively stricter in its regulations. Acquiring established biotech firms with a proven track record will definitely make gaining approval for their new drugs a lesser pain.

Now, why is the trend bend towards the acquisition of biotechnological firms? Biotech drugs provide a shield against generic drugs known as “biosimilars”- Biotechnology products are much harder to be copied by competitors once the patents expire. Furthermore, a lot of countries including the States have not drafted a final bill concerning regulations that allow “biosimilars” and thus putting these firms in a good position to monopolize the healthcare market once they produce a novel drug and get it registered.

Lastly, biotech firms bring along with

18 Markets | the analyst

them a very different set of positive and successful culture in approaching R&D. For example, Genentech has flourished under its well known laidback culture towards R&D. Genentech produced Avastin, a breakthrough drug for cancer which is already earning $ 4 billion dollar per year and is set to be the world’s best selling drug by 2014.

Also, the strong financial position of the big pharmaceutical companies and their ability to raise funds amid the financial crisis contributed to the mega deals in M&A. The big pharmas have been sitting on huge piles of cash even after paying back their shareholders handsomely in the form of share buybacks and dividends. This provides a golden opportunity to financial institutions to dwell in the capital market without shouldering a huge risk of insolvency and default. Gary Brewster, Director of Houlihan Lokey said, “I’ve been looking at recent big pharma debt prices, which are an important indicator of the sector’s health. In other sectors, the debt issuances are being pummeled–that is, if they can get done at all. But the big pharma companies are generally the exception–they don’t carry a lot of debt, maybe 10% to 20% of their total value–and their prices have not really changed over the last year. In fact, their debt prices have held up very well.” To validate the statement and the financial confidence enjoyed by the big pharmaceuticals company, one only has to look at Roche’s successful sale of $ 16 billion dollars worth of bonds. Pfizer too, was able to obtain huge financing in its takeover of Wyeth – roughly 60% of the deal.

Now, the important question arises - Do these blockbuster deals make

strategic sense? Historical data suggests otherwise. Synergies have rarely been realized in the past pharmaceutical deals. Michael Rainey of Accenture in fact questioned the rationale behind the deals claiming ``nine out of the ten deals created no value or negative value.’’ This is because economies of scale created are not expected to be sizeable and improvements on efficiency could have been realized through restructuring programs rather than mergers. Roche, recently reported a 13% decline in yearly profit in the wake of expenses related to the Genentech takeover but expects sales to grow strongly. Pfizer and AstraZeneca plan to cut expenses and R&D spending by considerable amounts in order to wring efficiencies without sacrificing future product development. Yet, it should be considered that the big pharmaceuticals were left with no choice. With the major patents expiring, they were left with an option to either innovate or lose market share to the `innovators’ and the `replicators’. In fact, the generics firms were engaged in their own takeover frenzy in order to become more competitive. The looming threat led Pharmaceutical giants to revamp their business model through acquisitions This recent wave of pharmaceutical mega-deals is however receding as firms are getting more inclined towards becoming more efficient and penetrating emerging markets. Takeover of smaller firms will continue to persist.

Small biotechs which are financially strapped will be inclined to merge with the big firms in order to survive. Another trend in acquisitions will be in niches.

GlaxoSmithKline and Sanofi-Aventis are among those companies that are interested to purchase generic drug companies. Emerging markets such as India and China are consumer rich and a strategy which targets cutting costs at home and expanding sales in developing countries could reap substantial rewards. IMS, an industry consultancy, forecasts that sales in key emerging markets will reach $300 million by 2017.

Astrazeneca, a British drug maker expanded its operations in western China recently. With little foreign competition,

No bull.

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the firm experienced a 30% growth in sales in the particular region as compared to 2% in mature markets. With the cost of production being just a fraction of the amount in the developed world, the firm expects to obtain as much as a quarter of its global output from China in ten years time. Multinational firms have already established a strong foothold in India’s demanding markets. Novartis, the Swiss drug maker has started a pilot project in rural India which expects to tap 50 million clients by 2010. However India’s adverse attitude towards Intellectual Property protection may prove to be a setback to expansion of operations in one of the world’s fastest growing economies.

Top-selling, life-saving medicines, including the anticancer treatment Glivec from Novartis; anticancer drug Tarceva from Roche; and HIV medicine Viread from Gilead Sciences Inc have recently failed to win protection from India’s patent office or the judicial system.

Thus massive consolidation within the pharmaceutical sector made this industry the M&A heavyweight during the crisis. Innovation, focus on efficiency and capturing high growth developing markets will be the key factors determining the ‘efficacy’ of these mega-deals., Given the strengths and success of recent health care M&A activity, not to mention the re-entry of private equity into this industry during fourth-quarter 2009, a question remains to be answered : “Will healthcare be the next economic bubble?” We doubt it, but 2010 will definitely represent another interesting year for M&A in this industry.

Consolidation Taking Off in the Airline Industry

By Daniel Ross, King’s College London Entrepreneurial and Investment Society

$

25 for your checked-in bag, $7 for a pillow, $6 for a snack box, and $15 for a window seat- the airline industry is transforming fast. With the econom-

20 Markets | the analyst

ic downturn the industry has endured enormous pressure on price. Low-fare competition in the form of airlines such as Ryanair and Southwest have exacerbated this trend. Coupled with the unhealthy dependency that the industry has on ever volatile oil prices, the senior management of companies such as British Airways and American Airlines have a lot on their plate to worry about.

But have we been here before? In 1990 the Gulf crisis and another economic recession caused the airline industry to lose billions of dollars. Industry giants such as Pan-Am disappeared, and current market leaders such as Continental Airlines filed for bankruptcy. The invasion of Kuwait by Iraqi forces in August of 1990 caused the price of oil to rise from $21 per barrel in late July to $46 by mid-October. This directly affected the airlines’ margins as fuel was, and remains, one of their most significant costs.

It also contributed to a broader macroeconomic downturn which in turn reduced demands in tourism, further putting pressure on industry profits.

Although this episode suggests the airline industry lives and dies with the rise and fall of oil prices. Yet despite its effect on the industry, the 1990 oil shock was moderate when compared to the 1973 oil crisis. The support of Israel in the Arab-Israeli conflict in 1973 by the United States resulted in OPEC orchestrating an oil embargo which quadrupled the price of oil from $3 a barrel in 1972 to $12 a barrel in 1974. While the airline industry again suffered from considerable financial duress, the most significant outcome of the 400% rise in the price of oil was the sway of deregulation brought on by the introduction of the Airline Deregulation Act. This Act essentially increased the amount of competition within the industry by liberalising the standards for the establishment of new airlines, and increased the pressure on prices by eliminating government regulation of airline fares. With these measurers fares declined, adjusted for inflation, approximately 30% from 1976 to 1990.

Fast-forward to today, the recently approved merger between Continental and United Airlines exemplifies the trend for consolidation within the industry. Combating high oil prices and labour costs, as well as severe overcapacity met with falling demand, the Delta-Northwest and ContinentalUnited mergers are viewed more as desperate measures than reasoned alliances in pursuit of growth. As industry analyst Rick Seaney puts it, “Airlines used to live by the strategy of grow or die. Now basically they’re living on the strategy of survive and merge.”

The current fragile state of the airline industry can be viewed as an unfor-

“If you want to become a millionaire, first become a billionaire and then buy An airline.” tunate consequence of the the continuing trend of deregulation of the industry globally. In boom times such as 1995-1999 demand for travel increased, and with the peak of approximately $10 billion in total net profits in 1997, a flurry of new airlines were established. Existing airlines increased their capacity by adding new aircraft to their fleets, and they increased their flights to meet the new demand. With 9/11 and the subsequent recession, airline profits plunged to almost $55 billion in 2001. As demand plummeted many of the leading airlines once again filed for bankruptcy. Bankruptcy however was probably the best thing to happen to them. Under Chapter 11 the airlines underwent severe restructuring to position them more competitively for the future. Significantly, labour negotiations during bankruptcy freed the airlines of the heavy burden of previous compensation and labour agreements that served more as relics of the government-subsidised past than the relatively liberalised present.

While this has resulted in enormous layoffs and declining employee morale

and customer service, the restructuring has adapted the companies’ business models to an sufficient extent that for the first time fuel costs outweigh labour costs for airlines.

There is a strong consensus by figures within the industry such as Giovanni Bisignani of the IATA that further consolidation is inevitable, but it is unclear whether such consolidation will be enough to revive the ailing industry.

Despite its current liberalised state, it is still subject to heavy political influence.

The recent EU-U.S. Open Skies Agreement is an example of the improvements in competition that deregulation can bring as London Heathrow has been opened to other airlines, breaking the exclusive privilege of British Airways, Virgin Atlantic, United and American Airlines for the first time.

But while deregulation is increasing, it is in no sense completely global yet.

Another relevant issue is the infrastructure which is essential to airlines and which remains inadequate and expensive. Even with further consolidation, the inadequate infrastructure that is virtually endemic to the industry serves as a bottleneck to any growth. London Heathrow for example is running at 98% capacity, and without any more runway no amount of consolidation can increase the capacity required for more effective competition to take place at international hubs such as Heathrow.

The story of the airline industry which faces the difficulty of adapting to competition that was simply not present when the foundations of the industry were being laid down. Its volatility is expressed succinctly in the advice airline entrepreneur Frederick Laker gave to Richard Branson when he first created Virgin Atlantic, ‘If you want to become a millionaire, first become a billionaire and then buy an airline.’ Although some people view the recent consolidations as a signal that the industry will change as the market is dominated by three to four companies that have sufficient scale to pull through volatile fuel costs, the uncertainty over the underlying profitability of the industry definitely remains.

Technology M&A Up in the Clouds

By Daniel Ross, King’s College London Entrepreneurial and Investment Society

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his month’s heated bidding by HP and Dell for leading utility storage provider 3PAR has been the talk of the M&A town. The drama of the bidding war has been playing out on Bloomberg and CNBC as well as in the financial press for weeks. Two words have been repeated again and again by the talking heads and financial journalists, two words that at the time of writing HP values extremely highly as it revises its bid for 3PAR from $24 to $30 per share. The $2 billion in cash that HP is offering underlines the importance that these two words currently carry. These two words, which are both deceptively simple and widely misunderstood, are cloud computing.

The difficulty lies in that cloud computing proposes to fundamentally change the way we use computers.

Much coverage talks of a paradigm shift that will need to occur for cloud computing to become a household name, so if you are unfamiliar with multi-tenant clustering, thin technologies and autonomic management you are by no means alone. While mainstream awareness of it may be faint, there is a sizable will within the computing industry to acquire the first mover advantage in this field.

The analogy that is often given is that of the replacement of electric generators with electricity grids in the early 20th century. Capital-intensive electric generators provided limited access to electricity to the general populace. As the generation of electricity was centralised and grids were established people could switch on their lights by simply connecting to the grid and paying for how much electricity they used instead of having to purchase a generator. This reduced the cost for each user while making the generation and distribu-

tion of electricity vastly more efficient.

By the same token cloud computing allows users to use computing software without investing large amounts of money in hardware and software as the user becomes a subscriber instead of an owner. Ironically, despite the confusion as to what cloud computing is, many users currently use it every day.

Anyone who has used Google Docs, Google’s answer to Microsoft Word, may be a seasoned veteran of cloud computing without even realising it.

With Google Docs you can create a document just as in Microsoft Word, but when you save it the document is saved online instead of on your computer’s hard drive. Instead of installing Google Docs on your computer you can access it through an internet browser.

As fascinating as this is, there is a solid commercial reason why companies such as HP and IBM are seeking out acquisitions to bulk up their cloud computing services. That reason is growth.

As the personal computing market evolved towards handheld devices, HP and Dell have seen their desktop hardware revenue decline. Cloud computing allows a welcome opportunity for diversification with a potential for high growth. IBM reported that it expected the global cloud computing market to grow at a compounded annual rate of 28% from $47 billion in 2008 to $126 billion by 2012. For businesses cloud computing does make some sense on paper as large capital expenditures are converted into smaller operational expenditures which reduce the drag on profits that supporting an elaborate IT infrastructure can have.

To provide a hypothetical example, imagine Company A utilises cloud computing and Company B sticks with traditional IT practices. Company A pays $100 a month to subscribe to a large cloud computing provider. All of its data storage is centralised with the provider; the software it uses is owned by the provider as is the hardware. Company B on the other hand invests $1000 in new hardware, $500 for relevant software applications for

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the company and then spends $50 a month maintaining its hardware while it depreciates in value. Although this is a rough example, it should illustrate how cloud computing could make one company more competitive by significantly reducing costs while, in theory, providing access to the same quality of IT services. Supporters of cloud computing assert that it allows even greater quality of service because the centralisation of computing processes allows economies of scale which can provide virtually infinite amounts of memory storage and processing power at a price that is within reach of small and medium-sized businesses.

There are a number of concerns however, and some contrarian viewpoints of prominent figures within the market continue to irk the ever-persistent proponents of cloud computing. Larry Ellison, CEO of Oracle, is famous for his disparaging views of the concept of cloud computing. ‘Maybe I’m an idiot, but I have no idea what anyone is talk-

ing about. What is it? It’s complete gibberish. It’s insane. When is this idiocy going to stop?’ His criticism of cloud computing as a ‘buzzword’ strikes a chord especially with investors who recall the dubious valuations of technology stocks leading up to the dot-com bubble in 2000. Along with these general doubts, there are specific concerns related to security and privacy that may limit the uptake of cloud computing services with businesses and users at home. While supporters assert that the economies of scale afforded by cloud computing allow for even more expensive and sophisticated security systems than the individual user could ever buy, the fact is that the security of sensitive data is out of the user’s hands.

Privacy advocates also recall the use of data provided by several major telecommunication companies in America for a secret National Security Agency program in 2002 which involved collecting phone call records for millions of Amer-

icans without their knowledge. The centralisation of data involved in cloud computing would enable monitoring of sensitive data in a similar fashion and these concerns could slow growth in the personal computing market.

Despite these issues though there does seem to be a rapidly growing appetite for technology acquisitions such as Intel’s purchase of security-software company McAfee for $8 billion. With tech giants such as Cisco sitting on $35 billion in cash and cash equivalents and the current challenging business climate limiting growth, acquisitions provide a suitable way to put the cash to use while boosting revenue and investing in growing markets such as data storage and semiconductors.

Whether cloud computing is the bright future we can look forward to is a moot point, but no one can deny that cashheavy tech giants seeking out growth and looking to diversify will stimulate a flurry of tech M&A activity.

22 The Fundamentals of Financial Economics and The Great Depression 26 The Black-Scholes Pricing Model 28 The Fall of the Greek Titans: Aegaeon Storms and the Descent into the Hades 35 Excess Return Models and the Cash Flow Return on Investment Framework 38 The New Normal 40 The Value Investor

FUNDAMENTALS The Fundamentals of Financial Economics and The Great Depression

By Thomas Ng

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n this essay, I intend to recognise the paramount importance of financial economics by distinguishing its

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concepts from those of the Classical Model and primarily evaluating not only the significance of the cost of credit intermediation in Financial Economics, but also its role in the Great Depression, the unprecedented economic turmoil that took place in 1929.

Classical economists assumed several principles in their model. First, perfect competition exists in all markets. It is whereby markets always clear and

achieve equilibrium, as individuals act in their own self-interest, provided that there is perfect information about economic conditions. Thus, market efficiency and maximum social welfare are attainable without government intervention. Second, all economic agents behave in the same way and have the same preferences. In relation to perfect competition, the aggregate behaviour of economic agents is simply the sum of each individual’s behaviour. There is

ics is emphatic about the heterogeneity of economic agents’ behaviour.

Instead of looking at the total amount of liquidity or the money supply when examining financial activity, the provision of credit is the primary focus. In this context, credit is the amount of lendable funds that a financial institution is willing to provide. The supply of credit is mainly determined by the perceived default risk, which changes accordingly to the financial status of a borrower or to the future expectations of the economy. Therefore, as the assessment of risk is subject to a lot of uncertainty, the provision of credit is associated with financial volatility.

 therefore no real distinction between microeconomic behaviour and macroeconomic behaviour in the Classical Model. Nonetheless, the assumptions made in the Classical Model lead to a logical trap, collectively known as ‘the fallacy of composition. This logical trap implies that what is applicable to an individual is not necessarily applicable to the economy, which concerns groups of individuals instead. The Classical Model is also fundamentally flawed, as it neglects the importance and existence of financial markets. Not only does it perceive money as a medium of exchange, but it also ignores market failure problems in financial systems such as asymmetric information. In the Classical view, money is exclusively viewed as a medium of exchange and not as a financial asset, hence its only usage is the facilitation of trade. This omits the influence of money in financial intermediation and on the level of credit in economy. Similarly, the assumption of perfect information leads to a false assumption that financial markets are efficient because of the homogenous behaviour of individuals.

Modern financial economics is founded upon the foundations of Keynesian economics. It incorporates microeconomic behaviour of firms, financial markets, and households.

Their behaviour differs from that as prescribed by the Classical Model, undamentally because financial econom-

Another major disparity between modern financial economics and the Classical Model is that financial markets are imperfectly competitive, due to imperfect information about financial transactions. It so happens because within financial intermediation, borrowers have better information about their credit worthiness (i.e. their ability to repay) than lenders. This is a classic case of asymmetric information. For instance, a borrower who is unable to provide enough information on his credit history may increase his own perceived default risk, signalling to the institution that credit should not be provided. The problem of asymmetric information distorts incentives of lenders and borrowers, consequently resulting in a rise in default risk in two ways. Conservative borrowers, who have less need for a loan, are less likely to suffer a loss by gambling with their borrowed funds than borrowers with high default risk.

Therefore, the latter is most likely to seek loans. This problem, which occurs before any financial transaction takes place, is referred to as adverse selection. The second way that asymmetric information increases default risk is through moral hazard. After the credit has been provided, borrowers are encouraged to engage in riskier behaviour than they would otherwise.

This situation implies an incentive distortion; borrowers realise that the profits of the project undertaken do not go into the pocket of their lenders, provid-

ed that the projects turn out to be huge successes. Adverse selection and moral hazard, caused by asymmetric information, are significant in reducing the supply of credit, and in pushing the cost of credit intermediation upwards.

The absence of free market forces helps to facilitate a persistent disequilibrium in the financial markets. When there is strong pessimism in the markets, financial institutions may perceive higher than acceptable risk and in turn reduce the supply of credit. As a result, the aggregate demand for credit is not matched by the aggregate supply, so financial markets do not clear or reach an equilibrium; explaining the extreme volatility of financial markets.

Through the deployment of these four principles of financial economics, many of the unanswered questions of the Great Depression are unravelled and explained in detail. Since the behaviour of all market participants is heterogeneous, uncertainty is ubiquitous and can never be eradicated in all financial markets, not excluding those in the Great Depression. Originally, the US stock market plunge was initiated by the enduring recessions in its agricultural sector in the 1920s, which conveyed to the public the idea that the US economy was fundamentally weak and, in turn sparked uncertainty. Figure 1 presents the stock market volatility of the Great Depression. There is evident data to show the high instability that exists in the stock market, as the S&P Index soars from 30% at the end of 1920s to approximately 80% at the beginning of 1930, before plummeting to roughly 40% or lower during the early 1930s. This reasserts the consistency between uncertainty within financial markets and the high level of volatility shown by the S&P Index.

Although uncertainty in large part contributes to financial volatility, business confidence also plays a significant role as well, as both factors interact with each other. This view is reinforced by Figure 2, which reveals how real investment plunges from $160 in 1929 to $25 in 1932.

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fees. It is crucial to realise that the costs of credit intermediation are not only affected by asymmetric information in financial markets, which presents adverse selection and moral hazard, but they are also influenced by changes in net worth, which is equivalent to the total assets minus total debt obligations.

The Financial Accelerator Model, developed by Ben Bernanke and Mark Gertler, examines the role that the financial fundamentals of borrowers and lenders play in determining bankruptcy risk, which in turn affects the cost of credit and its aggregate level. Bernanke and Gertler stated that ‘the cost of credit intermediation is a function of the financial fundamentals of both borrowers and lenders.’ From the perspective of borrowers, the costs incurred in a financial transaction encompass the cost of providing information (such as credit history) and monitoring cost (to regularly provide additional information to a lender about the life of a loan). In most cases, borrowers often have to provide collateral as well. On the other hand, lenders need resources to moni-

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tor borrowers through the analysis of financial and credit history data, which also incurs significant costs of credit intermediation. As a result, these costs are passed onto borrowers through

During the Great Depression, there was a reduction in net worth caused by the increase in the perceived risk of the financial system as a result of the recession, which subsequently led to an increase in the bankruptcy risk of firms. Hence, this increased the cost of obtaining future credit for borrowers, since lenders charged higher interest rates and demanded more information, collateral and monitoring to reduce their risk exposure. These higher costs of credit intermediation prevented some firms from obtaining additional credit in the recession, at exactly the time when they needed it most. Eventually, this created disequilibrium in the credit market; when the total demand for credit increased in the market lest any defaults and bankruptcy, the total supply of credit shrank due to the increasing awareness of adverse selection and moral hazard across institutions. This shrinkage in supply further deteriorated the already excessive demand for credit in the market. Figure 3 illustrates a decrease in the Bank prime rate, which is consistent with the increase in the cost of credit intermediation. The Bank prime rate is essentially the lending rate of banks. The outcome of lower

credit was the shortfall in investment and consumption, leading to an inward shift in aggregate demand. This is followed by deflationary pressure on the price level and a contraction in output, leading to an increase in unemployment. To put it simply, tighter credit constraints exacerbated the recession.

With the recession well underway, households experienced a slowdown in the circulation of money and further shortfalls in net worth, leading to a greater increase in defaults. These defaults reduced the net worth of banks and other lending institutions. As the net worth of borrowers and lenders fell, the cost of credit intermediation increased by greater amounts. Hence, the disequilibrium in credit markets continued to persist. In response, firms and households were forced to cut back their borrowing even further, which brought another wave of decline in investment, consumption, and aggregate demand. Furthermore, the cost of production increased because the production process was financed by costlier credit. At the same time, firms had to cut back on their production as well, since costlier credit increased the risk associated with producing more output, and excess outputs would be financed by the firms themselves.

Hence, the aggregate supply also shifted leftward. As this process continued to spiral downwards with sustained drops in aggregate demand and supply, the recession became larger and more persistent. Not only does this explain the mechanism of the financial accelerator model, but it also provides insight into the high bankruptcy rate in this debacle, where 9000 banks collapsed by the end of 1932.

Similarly, the plunge in asset and stock prices also led to a large number US banks becoming bankrupt. The simple explanation would be that imperfect information in the financial markets increased uncertainty about future profitability and future defaults, which sparked the panic selling of asset and stock. This, in addition to herding behaviour and a self-fulfilling prophecy, exacerbated one another. Such a

‘prophecy’ brings light to the fact that a crisis will take place if speculators believe that others foresee an impending crisis. Regarding the herding behaviour, it explicitly highlighted that if there is a large enough number of speculators doing something, an incentive is created for everyone else to pursue their behaviour. Indeed, this explains why the Dow Jones stock volume dropped 89% throughout the Stock Market Crash, shown by Figure 4 in below.

caused by the adherence to the gold standard. Nevertheless, the effects of deflation are best exemplified by Irving Fisher’s Debt-Deflation theory. Since the nominal amount of debt contracts was fixed, the nominal value of debts would be fixed as well. By applying the Debt-Deflation theory, the implication of deflation in 1929 was that a fall in the price level increased the real-value of debt. Meanwhile, it also reduced the real value of assets which were used as

The panic selling of assets could also be attributed to the herding behaviour, leading to a vicious circle.

To study the reduction in asset and stock prices in greater depth, the prevalent deflation at the beginning of the Great Depression must be taken into account. Heavy US deflation is illustrated in Figure 5. In fact, the deflation was Date

Dollar Amount

06/29/1935 28,700,892,624.53 06/30/1934 27,053,141,414.48 06/30/1933 22,538,672,560.15 06/30/1932 19,487,002,444.13 06/30/1931 16,801,281,491.71 06/30/1930 16,185,309,831.43 06/29/1929 16,931,088,484.10

collateral. For instance, ten pounds can buy ten cars in an economy. If deflation takes place, then ten pounds can buy twenty cars now, and the real value of assets (cars in this case) has dropped by fifty pence. This means that the real value of money has increased while that of assets has decreased. As the real value of debt increased, more market participants went into default.

The increasing inability to repay debts was displayed as a rise of delinquent loans in portfolios in banks. As a result, banks had to readjust their risk perception and thus reduced lending through restricting credit. Banks even sold less liquid assets for more liquid ones, on the account of the latter becoming less risky. As the real value of assets decreased, market participants began to sell off their assets in exchange for cash, before assets price plummet even further. The overall implication was that the falling asset value had become self-fulfilling. The panic selling of assets could also be attributed to the herding behaviour, leading to a vicious circle. Moreover, the increase in the real value of assets and the shortfall in nominal asset value again

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increased the cost of intermediation through the reduction of net worth, which had an adverse impact on the economy. The Debt-Deflation theory also highlights the erratic behaviour of market participants, as they are apt to overreact to conditions in the financial markets, creating significant amounts of volatility. On one end of the spectrum, lenders lend too much during a boom, fuelling an unwanted lending boom; on the other end, they tighten the credit constraints excessively during a recession, thereby exacerbating the fluctuations in markets.

After studying the cost of intermediation, we are brought to the realisation that crises such as the Latin American Debt Crisis, East Asian Crises and the Credit Crunch are effectively revolve around this indispensable topic - the effects of the cost of intermediation.

Meanwhile, despite the explicitness of financial economics, certainly the role of hedge funds should definitely not be downplayed in these crises as well.

The Black-Scholes Pricing Model

By Leon Beressi, Poh Wei Koh, Prithvi Murthy

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s a discipline economics has often been criticized for delving into mathematical never land. Recently, Amartya Sen was asked whether he thought that mathematics plays too great a role in economic science.

Sen responded that mathematics has acted as a catalyst to economic progress allowing economists to develop a level of rigour unparalleled in any other social science. The development of the Black-Scholes is the ultimate proof that the marriage of economics, mathematics and physics can yield groundbreaking results.

a long tradition of using events in the natural world to describe the movement of stocks. In the early 20th century, French mathematician and physicist Louis Bachelier noticed that the equations used to describe the diffusion of gas particles could equally be used to predict stock fluctuations in the Paris Stock Exchange. Sixty years later, a physicist Fischer Black, an economist Myron Scholes and an engineer Robert Merton expanded on Bachelier’s research and used the works of the late Paul Samuelson to develop an equation to predict price changes which related financial variables: time, price, interest rates and volatility for which they were awarded the Economics Nobel Prize in 1997.

When you think about some terms used by financiers such as ‘volatility’ and ‘liquidity’ you start to realise how much these subjects have in common. The ‘econophysicians’ that came up with Black-Scholes drew on

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Beyond the fact that Black-Scholes revolutionized the way we handle option pricing and derivatives, a truly fascinating aspect of this extraordinary model is how the congruence of economics, mathematics and physics led to a dramatic change in our society. Trading money, just like a physics experiment, means dealing with numbers and changing quantities.

Physics is about developing general descriptions - mathematical models - of the world around us. The models may describe different types of complexity, such as the movement of molecules in a gas or the dynamics of stars in a galaxy. In economics we use the same type of reasoning to develop models to improve our society.

What is the Black-Scholes Option Pricing Formula?

Application of the Black-Scholes Pricing Model

As its name implies, the Black-Scholes Option Pricing Model is a model used to calculate the value of an option. In order to arrive at the value, one would need to consider the five factors: firstly, the asset price (of the given option), secondly, the strike price (price at which the option can be exercised), thirdly, the expiration date of the option, fourthly, the risk-free returns (i.e. interest rate), and finally, the volatility of the stock’s return..

Once described as a “mathematical Holy Grail that forever altered the world of finance” the Black-Scholes Option Pricing Model is an important tool for writers of options, and is used by millions of agents in markets all over the world. Traders, in particular, find the Black-Scholes Pricing Model tool not only useful in estimating the prices of options, but also in calculating the volatility of markets and in hedging exposures (e.g. delta hedging). In the presentation speech given during the ceremony for the Nobel Prize in Economics 1997, the BlackScholes Model is credited for having “generated the explosive growth of new financial products and markets over the past 10-15 years.”

The derivation of the Black-Scholes Option Pricing Formula is quite difficult, and involves the use of differential equations and advanced probability theory such as the martingale.

Let C be a call option. We can express C as a function of S (spot price) and t (time expired).

Let P be a put option. We can express P as a function of S (spot price) and t (time expired).

Where the variables d1 and d2 are random variables expressed as follows.

A Critique of the Black-Scholes Model

Where: • N(d1) and N(d2) are cumulative distribution function of a standard normal distribution.

• (T – t) is the time to maturity.

• S is the price of the underlying asset.

• K is the strike price of the option.

• r is the risk-free return i.e. interest rate.

• Sigma is the standard deviation of the asset price

In addition to trading, the BlackScholes Pricing Model is applied to corporate finance as well. In valuating the equity of a troubled firm, the BlackScholes Option Pricing Model can be applied if the firm’s equity is modeled after a call option. Increasingly, the Black-Scholes Model has also been used in conjunction with the Real Option Analysis for capital budgeting decisions.

Despite the fact that the Black-Scholes Option Pricing Formula is widely applied in the financial world, the model has been heavily criticized for its unrealistic assumptions. Among the main critics include Nassim Nicholas Taleb, writer of the bestseller “The Black Swan Theory: The Impact of the Highly Impossible”,as well as Micheal Lewis, writer of “Liar’s Poker”.In one of his interviews, Micheal Lewis claimed that Taleb’s swipe on BlackScholes Theory explains the subprime mortgage crisis. Even Warren Buffet, arguably the best investor in the world, argued, in his newsletter to shareholders in 2008, that “if the (Black-Scholes) formula is applied for an extended time period, it can produce absurd

results” .

As you might have noticed from the formula above, one of the main assumptions of the Black-Scholes Option Pricing formula is that the movement of asset prices in markets follows a standard normal distribution.

As critics such as Taleb, and one of our teammates, Thomas Ng, pointed out on a previous issue of our Finance Review , this assumption can be a fatal one. In particular, the normal distribution underestimates the tail risk, i.e. the probability of an asset or a portfolio of assets deviating far away from the current asset price. In his book, Taleb argues that the model is invariably useless as it fails to predict the occurrence of random, high-impact events such as the recent financial crisis and the September 11 attacks.

Additionally, from the formula above, you can also observe that the model assumes that the standard deviation of the asset price is constant. In reality, volatility of asset prices is not static, but moves according to market conditions. In fact, the observation of the volatility simile (i.e. the trend that in-the-money options tend to have a lower implied volatility), is a direct contradiction of the model. Besides, it can be argued that in addition to volatility, the model fails to price uncertainty as well, which can result in a greater than expected deviation of asset prices.

Is the Black-Scholes Option Pricing Formula Reliable?

Although the model continues to be widely used in the financial landscape today, albeit with slight adjustments by “quants” to make it more realistic, it is ironical that both financiers and academics alike, have continued to deride the model, citing the fall of Long Term Capital Management (where Fischer Black and Myron Scholes used to work as the ultimate demise of the model itself.

Perhaps critics of the Black-Scholes Model has missed the point here. Far from claiming that the model speaks

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the absolute truth, Fischer Black and Myron Scholes have been careful to attach caveats when they unveiled their model. Most assumptions, such as the underestimation of tail risk and volatility risk, can be resolved for by hedging against out-of-the-money options and volatility. Financiers should know better that any model, at best, offers a realistic simplification to real world prices, and the Black-Scholes Model has been indeed a useful approximation. To end this article, I thought it will be relevant to quote what Warren Buffett had to say about the model and its critics:

“The (Black-Scholes) formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club of optimists is one that Charlie and I (Buffett) have no desire to join.”

the gigantic budget deficit the government has amassed. The deficit, now at around 13% of economic output, has stoked and catalysed fears that the Greek government may restructure or delay on its debt, perhaps go bankrupt.

Debt itself is at 125% of GDP, and interest rates on Treasury bonds are 15.1% of GDP. Currently the debate has been about Greece exiting the EMU because it has breached the Stability and Growth Pact, which limits deficits to 3% of GDP. Indeed European policymakers have already supported a bailout of the Greek government, namely France and Germany. Indeed, The EC are doing a variety of obligatory impositions, such as telling Greece to cut its public sector wage bill by a fifth, by replacing only 1 in 5 retiring civil servants.

The Fall of the Greek Titans: Plutus’ Feast, Aegaeon Storms and the descent into the Hades

By Dhruv Ghulati

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wo weeks ago, the Athex composite index fell 3.3% in a single day. This has been part of a series of inexecrable equity index collapses, and it has a covariance and correlation with

Why is the Greek sovereign debt issue so noxiously rancid? Because chances of recovery and a natural, endogenous ‘return to normal’ are starting to become increasingly probabilistic. There are several reasons for this: • There is a ‘no-bailout’ clause in the EU rules that prohibits countries from assuming the debts of one another.

• It is impossible for Greece to forcefully devalue its currency as it is within a monetary union. By devaluing, it would lower the real interest rate

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as well as yields on its government debt. This would raise the value of government bonds improving the success of capital raising, as people will buy them. Not only that, it would assist in an export led recovery and paying down of the budget deficit.

• If Greece could have lowered rates for a period in terms of national monetary policy, so that people who shorted bonds would have lost, this would have encouraged people to buy bonds, cut the rate on sovereign debt, and enable a natural reduction in the budget deficit through easier funding and less emphasis on credit deterioration trading methods.

• Greece’s long term supply side is weak, with one of the highest wageunit costs in the world, and lowest purchasing power. Thus, costs of labour, especially in the public sector, is both rigid and very high, putting even more strain on the deficit.

It also has lagging productivity and dwindling tax revenues from higher social spending plans – 20% of the population is below the poverty line.

• Greece has been in default about 50% of the time since its recognition as an independent country in 1832.

People have been quick to realise that this budget deficit is not cyclical but an ongoing structural problem. It has a triple deficit of current account, budget, and a soaring public debt.

trading products known as credit derivatives, originally developed by Andrew Feldstein of JPMorgan in the early 90s.

further. It is a self-reinforcing cycle.

What has happened is that due to the high budget deficit, people have been acrimoniously short selling Greek government bonds. Due to this, yields on these bonds rise (because investors want to be compensated for the risk that the Greek government wont pay back their loans, and so demand higher repayment rates), and thus it becomes very hard for Greece to gain cheap and easy credit from international investors as it needs to pay back higher yields on its bonds – funding the deficit through borrowing becomes harder.

There was a recent warning by ratings agency Standard & Poor’s that it could downgrade Greece’s sovereign debt within a month., with the effect of the spread of the 10-year Greek bonds spreads over German bunds hitting 3.55%. Greek government bonds are now almost worthless. Furthermore, as the € has been falling as well due to weak indicators in the Eurozone region, the value of any capital inflows anyway falls due to the fact that anything priced in € becomes less valuable. Investors do not have demand for € because interest rates for borrowing increase too much to want to order money from Greek banks. Thus demand for real money balances fall and money supply tends to rise as there are surplus in the market, and the € weakens

During times of recession it is through capital raising and not taxes that a government can really fund its stimulus packages. Essentially nobody wants to lend to Greece and buy its issues at auction.

The Negative Power of CDS My aim in this article is not to talk about bonds and economic indicator sentiment. It is to talk about a slightly different market, an OTC derivatives market

Credit derivatives assume many forms, but essentially the main type allows investors to invest in assets but repackage and sell the risk of these assets to others via securitisation, known as the CDS market. In structured credit markets, instead of a high government bond yield signifying government debt problems, it is the CDS spread (Greek CDS premiums over German Schatz CDS premiums) which is positively correlated to the risk of a sovereign default. This spread takes into account several things including the credit rating of the country, issued by valuation experts such as Moody’s & Fitch, base rates and government asset purchase programs among others. As well as the spread, there are less lucid indicators such as risk reversals.

The three main types of credit derivatives that can be used to profit from long volatility credit deterioration strategies are credit default derivatives; credit spread derivatives and finally synthetic products which allow investors to replicate the economic performance of an exposure to an asset without actually being obliged to buy the reference instrument.

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A CDS is essentially an insurance contract on debt – the insurer gets the right to gain premium rate payments, but there is a probability that at some point that company will have to pay out a huge principal in the case of credit default. Essentially then, it is a swap with indefinite payments on one side.

As the risk of default rises, the cost of insuring against default rises. This means that the CDS premiums that insurers receive rise. The more people buy insurance, the more that the market feels that the Greek sovereign debt is risky. Indeed this is exactly what has happened with Greece - the cost to insure against a Greek sovereign default using a CDS hit €429,000 annually to insure €10m of debt last week; soon investors shy away from even paying these premiums.

As insuring against high risk becomes even costlier, people feel that they might as well not even own the sovereign debt in the first place because it is too much of a hassle. This then also drives down stock markets as well as increases the chance of a dramatic, catastrophic, Armageddon-esque Greek downfall. In addition, banks now feel it is too risky to offer insurance on these bonds because trigger events are so obvious. So, supply as well as demand has dried up, making the whole CDS insurance market more volatile/illiquid.

Because Greek bonds are so illiquid, a

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large selloff is proportionately more disastrous than with other asset classes and translates to larger series swings.

As the collapse of AIG showed, insurers can no longer be described as shock absorbers, but actually contribute to systemic risk beta as even they can default. AIG used its own strong credit rating to sell protection against credit defaults, but ended up selling off more than it could buy back. Now banks may be actually buying back insurance they sold short to investors, increasing this negative sentiment.

During the ensuing crisis the majority of Greek CDS have had their definitions of default being something like Greece debt to GDP ratio going above a certain % ratio, or the Greek government not being able to raise a certain amount of money by a certain date, or it failing to pay on a debt issue by a certain overseas country. Another main thing was debt restructuring, i.e. a decrease in the rates due, extension of time span, reduction in nominal amounts due etc. for the Greek government as debtors. In fact very few if any CDS contracts that have been traded over the past few weeks have been based on Greece actually going bankrupt.

Essentially an investor who owned Greek government bonds transfers the risk of sovereign default, and thus the

collapse in the value of his bonds from speculative selloffs and funding difficulties, to a protection seller. He does this not by selling the physical assets (the bonds) but just paying the protection seller a premium every assigned period (normally quarterly), with the promise that if default does occur the protection sellers (usually large investment banks) would have to pay out the total loss in value of the investors bonds if the reference entity (i.e. the Greek government) defaults. The protection seller will not pay the exact loss that an investor incurs due to a credit event, unlike with a typical insurance contract.

As a result the investor now is only at risk if both the protection seller and the reference entity default, because he won’t be paid back. The protection seller is at risk on the reference entity, triggering the contract payment, as well as the protection buyer who may fail to pay the required premium payments.

Going long on a CDS is effectively short selling a government bond without going to the cash markets.

The reason you would have used CDS is that Greek bonds are actually nonliquid and thus it is hard to sell bonds at a favourable price because there is little competition. When I short a bond, or execute a repo trade, it is much harder because I must borrow the bond first to be able to sell it and hopefully buy it back at a cheaper price, but incurring a repo cost (the cost of borrowing the bond initially). It is also cheaper to just take a short position on a borrower’s creditworthiness, as opposed to the deterioration in value of the physical bonds he sells to you. With CDS I can take a long or short position with the exact maturity and size I want, be-

cause it is OTC, as opposed to indextraded cash market products like debt and bonds in the capital pools. People also use CDS to gain by offsetting tax liabilities (as they are often executed through SPV arrangements) - if my mark-to-market was strongly positive if I short sold a bond, I would generate a potentially high tax liability.

CDS trading allows one to have much smaller initial capital outlays because they are done in a margin fashion – to short a government bond I would have to borrow €10m, placing maybe €2m as collateral covering it later. This is a repo, or short selling cash. However, with a CDS, I may only have to make quarterly payments of about €400,000, putting up much less collateral for these payments. (maybe €0.5m). This advantage can be classified as coming from the fact that they allow investors to separate default risks from the other risks from buying bonds, as other credit derivatives are able to split up other risks into tranches, so reducing the cost of capital for business.

One important thing about CDS is that they are not based on the default of individual existing risks on specific bonds, but the actual general uniform credit risk of a reference entity, which enables you to prevent the risk of illiquid bonds or assets, issue sizes etc. In terms of settlement, the whole CDS contract can work with cash transfers, but also it can occur through physical settlement where the protection buyer has the right to sell to the insurer the physical Greek government bonds at par value, (so not what he initially paid for the bonds), when actually if the investor had been compensated correct-

ly, these bonds may even be worthless due to the occurrence of the credit event. You effectively delta hedged yourself due to an in-the-money put option, so your loss on buying bonds for too much is compensated by the cash payment you receive from the gain on the CDS.

odically according to the CDS premium on the reference entity for a specified maturity. In this crisis you would actually have had to pay higher premiums, almost like an FRN, or floating rate note, every time the CMDS reset. If I want to buy protection, I have to sell a CMDS.

The classic trade on a CDS is to short an asset, but buy protection, so you effectively hedge yourself – investors are now profiting from the fact that not only have bonds sold off, but the value of protection has also risen, multiplying the gains that you can make. However, you could potentially purchase a CDS without actually owning the underlying debt, allowing for a straight wager rather than a hedge.

This is like executing a repo where the repayment costs are variable. So, again people sold these interest rate swaps to gain from the Greece problem, selling CMBS’ and thus gaining from default because I could terminate payments and gain from not having future outlay costs, while my counterparty having to pay his CDS premium.

In the case of physical settlement, what I would do at the end, if I didn’t actually own the physical security at first but I just wanted to bet against the Greek government, is thus: by purchasing a CDS I also gain an option to source and buy the cheapest-to-deliver bond, i.e. the one which is cheapest for me to buy. Thus my gain when selling to my insurer is highest. The final method of payout is when the insurer fixes the amount of payment he will give – this allows for another element of risk accumulation because now I can profit on the CDS itself – if the fixed payout was much larger than the accumulated sum of all previous premium payments, I would gain via the spread.

This is basically a bond where the coupon payments are positively correlated to the risk of default, calculated by CDS spreads (the spread of CDS premiums over the yield on a German Bund/ Schaft). In fact banks in Europe were selling CLN’s as a way of buying protection – if the reference entity defaults, immediately the CLN issuer has the right to terminate coupon payments on the note he has sold and simply repays his loan in advance, thus incurring much less funding costs. When the bank actually repays, it doesn’t give back the principal, but an amount representing the market value of the securities in default, or an actual portfolio of obligations, i.e. the physical bonds of the Greek government, which are worth almost nothing.

CLN – Credit Linked Note

CMDS – Constant Maturity Default Swap This is exactly the same as a CDS but actually the premium paid is reset peri-

A CLN actually gives a higher yield to CLN purchasers/protection sellers from the higher risks involved – the coupon is equal to the sum of the Greek government CDS premium plus the funding spread of the CLN issuing bank above Euribor or Libor. The reason for the higher coupon is also because the issuing bank, or protection buyer, has zero counterparty risk. So, people have been actively selling CLN’s on Greek CDS many of the clauses in the loan documents have been triggered meaning they are no longer having to pay back premiums to investors.

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Credit spread derivatives: Forwards & Swaptions The final products utilised in the Mediterranean markets were credit spread derivatives, essentially taking the spread as a new asset class, and playing with options, forwards and futures on it. So, instead of simply using options on bonds, you take options on credit spreads which are seen to be more efficient in betting on default and credit risk. Credit spread options are structured on an asset swap, which is the bundling of fixed rate bond with an interest rate swap, creating a floating rate note depending on the creditworthiness of issuer. So, for example if I was long a credit spread forward on Greek government debt, in the future I have to buy a bond which pays out a certain rate, equal to the Greek CDS spread. I would lose because I have to buy a lower yielding bond than I would have (CDS spreads rose). As we can see, due to the nature and types of rates paid out, this is different to an IR derivative. My loss on being long bonds is offset by my gain on being long the credit spread forward (effectively short those same bonds).

Also, the bond you sell is one where you pay a lower coupon than the market. This is basically playing with floating rate notes via the combination of fixed rate bonds and IRSs. So a put option buyer gains if the spread actually increases, and a call option buyer gains if the spread actually falls. Being long on a put option on an asset is the same as being short on the credit spread. These are basically variations on interest rate derivatives, except for the fact that premiums are based on credit conditions. A few trading mechanisms used in the Greek

sovereign debt crisis were to do with default swaptions too. For example, people entered into payer swaptions on CDS, which are options giving you the right to buy protection at a certain level, and once CDS premiums actually increase your option becomes in the money, factoring in the price of the swaption. Generally people made the most money via being long payer swaptions and waiting for CDS premiums to rise (the cost of insurance). Most of these options offer are traded via credit indices such as iTraxx, which offer better bid offer spreads for the swaptions because here you will be betting on the default of many more entities, which is what was happening in Greece by net foreign investors. However, here they may also have been betting against Spain and Portugal.

Then there was spread trading. People who were bearish on the nature of Greek debt would buy call options on spreads via a bear spread method – buying a call option with a high strike price, and selling a call option with a low strike price. This is betting that bond prices will fall, but yields on cash markets and repos would rise. Then they could have done a strip combination, i.e. being long two puts and one call at the same strike price, gaining from being able to sell a bond at a high price (i.e. get the right to give out a lower repayment on your borrowing that you would have had to on cash markets).

As I mentioned, because it is very unlikely that whole government banking and reserve systems fail, many people in this crisis started using the defaultand-out barrier options which were much cheaper. If I bought a default-andout put option, it is exactly the same as a normal put where I make money on credit spreads widening. However, if the Greek government defaulted, I would lose that option altogether, and thus run the risk of being long a bond which I cannot sell because I would book a loss (as a credit event occurred), and this is having a massive liability on my balance sheet, in default. Thus, these options are cheaper because the option holder runs a higher risk–if

you just wanted to bet on spreads and knew there was no risk of the cancelling of the option due to default, you would trade with these.

Synthetic Structured Credit Essentially the final categories are known as total rate of return swaps, similar to abstruse CFDs, where one can agree with an investor to replicate exposure to a credit risk without actually buying the reference instrument.

One side, normally the TRS buyer, gets all the economic benefit of the Greek government note/bill, in terms of coupons and interest rate payments, as well as margin traded mark to market gains or losses in asset value for a certain period. This TRS buyer is actually the protection seller – in return for someone giving him these economic benefits, that someone being the protection buyer, he will pay the protection buyer a periodic coupon at a variable rate of LIBOR more or less a spread. So it is like a CDS but the CDS is now an actual interest rate swap as opposed to a contingent insurance contract. An investor who sold total return swaps was buying protection because he had the right to receive a LIBOR rate uncorrelated or under little covariance with credit conditions of the Greek government but pay progressively lower coupons to the TRS buyer because of the fact that the total capital loss on the Greek government bond would have been factored in.

Credit Curve Arbitrage The final method I would like to go through with how money could have been made with the Greek mean diversion is through the arcane concept of credit curve arbitrage. Indeed the 1 year CDS premium was much higher than the 5 year, emphasising the general assumption that Greek credit risks were temporary and eventdriven, from recessionary pressures and financial market disintermediation and misallocation. What investors did was to sell 1 year protection, and buy 5 year protection, thus gaining from the spreads of paying say 200 basis

Fundamentals | the analyst 33

points and receive 450 basis points, assuming they were sure that the credit defaults wouldn’t actually occur on Greece’s sovereign debt and obligation to foreign entities through a negative net factor income, when factored in for NPV and forward rates. Finally, as a slight aside, I could also have gained from similar short volatility arbitrage on the difference between asset swap spreads and CDS premiums Cross Currency Swaps Goldman Sachs helped Greece to legally circumvent the EU Maastricht deficit rules through arranging cross currency swaps. These enabled the highly indebted Greek government to conceal billions of €s of new debt from the public and regulators, and receive cash for budget spending without having to classify the proceeds as public debt because they were coming through in a different currency. At some point they will mature, and swell the country’s already bloated deficit.

With a cross currency swap, Greece would have been borrowing € on the FX markets and lending $ or some foreign currency (FC herein). There would be a comparative advantage for other countries to borrow $ as opposed to €, subtracted by the rate differences for Greece and say the US on a € loan, which would be the total gain to both parties in the swap. Greece overall has the worst absolute advantage, but does have a comparative advantage in borrowing € in terms of international FX rates measured by things like the LIBOR/Euribor.

People say these transactions may have lowered aggregate global interest rate payments from 7.4% to 6.4% back in 2002. Because this was OTC, regulators and reporting agencies were not aware of it. Also it was incorrectly classified as hedging and thus not subject to the same accounting, securities and tax legislation. Because it was treated as a currency trade rather than a loan, it helped Greece to meet European Union deficit limits while pushing repayments far into the future. The case

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with Goldman Sachs was that it actually recreated fictional exchange rates with a strong € which were off the counter and thus would not actually show up in FX markets, where the € actually weakened. This made it easier for Greece to make the dollar payments it needed to, as I shall explain.

Any bonds that the Greek government owned denominated in yen and dollars were swapped for Euros, in exchange for Greece paying out a certain yen and dollar rate based on exchange rules. In the case of an American bond seller or borrower, instead of now paying out dollars they would be paying out € and now receiving a dollar rate. That dollar rate would come from Greece.

Goldman itself took on €1bn of credit risk because it acted as the intermediary between the US and Greece, so receiving dollar payments from Greece to be given to the US and gaining a spread (about €200m in fees and charges). Goldman transferred the swap in 2005 to National Bank of Greece, the country’s biggest commercial lender.

NBG set up a special-purpose vehicle called Titlos and transformed the swap into a 20-year securitisation bond, which stayed on its books – thus giving the government a further breathing space.

Greece however needs to convert its new Euro loan into dollars when the bonds it sold mature (those bonds were USD denominated bonds issued by the Greek government), on the furthermost left. So what happens is that at a synthetic interest rate, when Greece needed to raise €, it could instead raise money in a fixed rate market such as $, thus maybe receiving $100m, and by the terms of the swap it would pay Goldman Sachs all the money raised in exchange for €s, at an exchange rate of €125m. It now needs to pay in €s and receives $ flows to help it pay off its $ loan on the furthermost left. At maturity, the company will receive the USD bond principal amount it owes the bond investors from the swap counterparty, and in return is required to pay 125m irrespective of the then spot rate. Using the Cross

Currency Swap, the company has created a synthetic €liability. If paired with a USD borrowing, the CCS converts the USD borrowings into a synthetic EUR one; if paired with a EUR investment, the CCS converts the EUR asset into a synthetic USD one. Essentially, instead of a standard FX transaction, you view the transaction and money you exchange and receive as a liability you need to pay interest on, and the money you buy as an asset you can receive interest rate payment on (give out a loan by buying a bond).

Because it is very hard for Greece to issue bonds based on its own Greek sovereign debt, as the rates are so high, it was using the CCS to convert these liabilities into say USD liabilities which were very cheap to fund, at around 40bps.

Exotic Options – Quanto Options & Composite Options With a quanto option, foreign investors were buying credit spread swaptions on Greek sovereign debt, but the option allowed them to get the same payout in € converted into their own currency, at a fixed exchange rate decided at the point of the quanto. So, say if I was a US investor wanting to buy a ratchet on Greek CDS spreads, i.e. a put option thinking that spreads would rise. I may make € 2m. But the quanto allows me to convert that €2m into say $3m from the prevailing spot rate when the transaction was decided upon. Say if the € weakened, as it has, I may have only been able to get $2.5m at the option maturity date, but here I have protected myself from foreign currency risk.

Lastly there is the composite option that was used where I could execute my opinion on CDS premiums rising via synthetic CFDs, but I actually fix the strike in my own currency and get a payout as well in my own currency.

Here I do have exposure to the exchange rate. The strike rate is based on current spot exchange rates. I calculate my gain say from a put option on Greek sovereign debt by now using the initial

conversion value in $ from € in terms of the strike price. If the bond price in € fell from 97.6 to 95.4, I would convert the new 95.4 into $ using new exchange rates – I would gain from my put the more my own currency strengthens (e.g. (95.4 x 1.5)as opposed to (97.6 x 2)).

Excess Return Models and the Cash Flow Return on Investment Framework

By Dhruv Ghulati During the course of this article I would like to give a brief introduction to how equity analysts, brokers and researchers come up with their reports and earnings forecasts, a crucial cog in the stock market machine and what makes and breaks share prices. This is beyond what most students may look at with personal investing; ratio analysis of P/E, PEG, EV/ sales, EV/ EBITDA, marketto-book and dividend yield, margins, ROEs and growth measures (e.g., sales growth, EPS and CFPS growth).

The key insights in valuation come from Modigliani and Miller who said that the value of any company is the sum of the present value of cash flows from existing assets and the present value of cash flows from future investments.

The standard equity model is based on discounted cash flow (DCF), which calculates the enterprise value of a company based on calculating the present value of future earnings. However, I want to go into something that is a little bit more practical and accurate because it only values cash and not earnings which are subject to manipulations. I attempt to explain the method of Cash Flow Return on Investment (CFROI) and bring up any problems one may face in finding key variables and parameters, given the limited access a retail investor would have to complex and pre-set algorithmic models.

CFROI essentially rules out two manipulations – one is to cut CAPEX and R&D for a few years and this increases your return on equity, even though this may in the long run actually cause depressed returns as returns will fall due to less productivity. So, it looks at Return on Gross Investment (ROGI).

Secondly, you add depreciation back to net income because depreciation is a non-cash expense, so it overcomes the weaknesses in the method of accelerated depreciation that firms use to improve their financial outlook.

Another key differences between CFROI and DCF is that CFROI includes a liquidation of non-depreciating assets in the final year of the asset life. These assets are essentially working capital such as inventory and cash which you can get rid of and are the final gross cash flow. The essential thing to remember is that the CFROI looks at a firm as a combination of hundreds of different projects. Another name for the CFROI is the internal rate of return, or IRR. The CFROI is the discount rate that gives a NPV of zero for the weighted average of all the firm’s projects, effectively, and is a better and more conservative measure than easily available ratios like ROI/ROA and ROE: CFROI does not account for goodwill even though it is an expenditure of shareholder’s funds for businesses above their book value. The reason is that it is not as such a gross investment or operating asset, because it cannot be improved upon or made efficient but is just there. To judge management’s effectiveness in M&A, you use the gross investment/gross investment, add it to the goodwill ratio, and then multiply it by the operating CFROI. A good way of understanding the CFROI concept is via the Collins Stewart QUEST model, which is actually Cash Flow Return on Capital (CFROC) which completely prevents a company from manipulating its capital structure

to disguise return. The CFROC spread and a company’s price/book ratio has high correlation which is a testament to its success.

CFROI adjustments – Deriving the Inputs This part is by far the hardest, as with FCFF and FCFE models where the weighted average cost of capital (WACC) needs to be estimated, or Dividend Discount Model (DDM) where we have to estimate equity risk premiums, expected rates of return and risk-free rates. For example, with the Gordon Growth Model we would need estimation of beta via publicly available regressions and the CAPM framework, as well as use of an estimate of ROE via the DuPont formula, then multiply it by historic plowback ratios (the percentage of distributable funds a firm retains) to gain an idea of growth rates. I will go through some steps by which one can gain the inputs for CFROI, which are based on hard data in reports as opposed to assumptions about markets and risk premiums, and how to account for any issues that arise. This will be helpful to any reader trying to analyse financial statements and learn about things such as deferred tax assets and provisions as well as amortisation etc. I use a company called BATM Advanced Communications and its most recent 31 December 2009 annual report as an example .

Depreciating Assets We have to take the end of year gross plant, which is the fixed assets + accumulated depreciation, and then we need to inflation adjust it to account for the different times that different noncurrent assets acquired have started depreciating. Then, we add construction in progress, capitalised operating leases (moving lease expenses from the P&L account to the balance sheet because essentially we want to show it as a crucial asset which earns a yield), capitalised R&D (to make it a gross asset as opposed to an expense), and inflation adjusted gross plant recaptured.

Fundamentals | the analyst 35

To understand a bit about gross plant, in notes to statements you will often read depreciation rates, from which one can calculate annual depreciation expenses. Gross plant, however may include held to maturity investments and deferred tax assets as well as PPE (not including land, which is non-depreciating).

However, for a telecommunications firm like BATM Advanced Communications, which relies on hardware and technology, PPE is a good way of finding out gross plant. For BATM, gross plant is simply the original cost of everything, including leasehold improvements (a static figure accumulated from additions) which can depreciate. The problem is that there will be no way of working out the cost of land because it comes under ‘land and buildings’ and thus you cannot split it up. At the end of 2009, it was $38.144m. Now, we inflation adjust this (we cannot calculate fair value, say of BATM’s wireless backhaul demarcation switches, which may have declined in price but be more powerful), nor do we know replacement values, but we can only restate historical asset costs on the balance sheet in current purchasing units.

The inflation adjustment is quite hard, and involves de-layering the current snapshot of fixed assets to account for the fact that they have been acquired over several years. We need to find a nominal average growth rate of fixed assets (not carrying but gross values), say for 5 years past (for BATM this was 48.4%), and then also evaluate average inflation over that time, which is about 2.61%. The formula is : $38.144(1.484^5-1) * 0.484 = $2.97m – the first asset layer We would then grow this figure for 5 years at 48.4% to get the gross assets of $38.144m. We then would inflation adjust each layer, for example the first layer is $2.97 * 1.0261^4=$3.29m and so on. The total gross assets in this case get an inflation adjustment of 3.066%,, where inflation adjusted

36 Fundamentals | the analyst

gross plant is $39.31m.

Next, we move on to capitalised operating leases. We need to discount operating lease rental expenses by the real debt rate, which we can calculate by the interest paid on BATM’s debt. If your analysed company has no publicly traded bonds, you can estimate the cost of debt via the weighted rate it pays on bank loans. From a 1.5m loan at 2.21%, a 3m loan at LIBOR + 1.5% (I have used the 1 year rate of 0.84% currently) and a 2.106m loan at Euribor + 1% (Euribor is at 1.413% as I write), the weighted average cost of debt is 2.33%. The forward expected inflation rate for 2010 is 2.0%, and so the real debt rate is roughly 0.0033%. Let us say that the average asset life is calculated by weighting the rates on buildings, fixtures and equipment and motor vehicles (not including computers and technology which have mixed and complex depreciation rates). This rate is at 5.42% from the following table: Buildings 2% Fixtures and equipment 10% Motor Vehicles 15% Computers and Manufacturing equipment 10-33% This shows the asset life to be roughly 18 years roughly, although leases are for an average of 6 years. I believe that 8 years is a better and more standard estimate for the industry. The annual lease expense seems to be $2.166m, because we cannot include an estimate of future minimum lease payments under non-cancellable operating leases, and so we would be discounting this for 8 years to get capitalised operating leases of $16.84m.

Now, we need to capitalise R&D. Technological innovation generally results in accelerated obsolescence, so we need to capitalise less R&D expenses. This unfortunately is very much based on intuition. We have to evaluate the R&D expense for each period, and multiply it by that year’s inflation factor. This is gross R&D and not net, for example with synergies with different companies or acquisition/sharing arrangements. So now if I take R&D expenses

adjusted for changes in accounting policies which actually increased R&D expenses due to government grant consideration under IFRS, and divide by inflation adjusted factors, we get a total capitalised R&D, for the years up until 2009, of $65.71m. Note that the 2009 R&D cost being $12.715m which is more than the expense in the P&L of $11.76m. Our total depreciating assets so far amount to $121.86m, not including inflation adjusted gross plant recaptured.

Lastly, we need to find what is known as gross plant recaptured. The net assets of an acquired firm are booked at fair value/held for resale , which nets off costs to sell. This differs from the historic cost the acquirer paid, which is the gross figure we need. This relies on the net plant to gross plant ratio of the

... the world is in the midst of a major national and global realignment, caused by powerful underlying factors that have existed before the crisis, but catalyzed by the financial crisis itself acquiring company. Because BATM has acquired non-controlling and controlling interests in 7 companies, fully owns 16 small firms, and is connected to 25 firms, it is very hard to calculate gross plant recaptured. Thus, I will now stop my calculation of exact CFROI and explain the method: So, if BATM has gross plant of 1000 and accumulated depreciation of 500, this ratio is 50%. If it buys a company with gross plant of 400 and net plant of 100, so a 25% ratio, but post ac-

curate figure would be a 3 year median but this is still very precise). Capitalized leases have an average life of 8 years, which is more than stated in the annual report of 6 years, but this is due to industry standards and my intuition. The capitalized R&D project life was 6 years as I mentioned before. Relying on accelerated depreciation to calculate project life will result in a lower life and so an underestimated CFROI. Gross Cash Flow quisition BATM had 1200 gross plant and accumulated depreciation of 500 (net plant of 700), so a ratio of 58%, which is too high because it is not fully accounting for the actual figures of the acquired company, and in reality it should be a 43% ratio (1000+400/ (1400-(300+500)). The gross plant recaptured would be 700/50%, or 1400, minus 1200, which was the reported figure (200). So, we try and restore the ratio from 58% to 50% which is the best estimate we have. Then you would multiply this recaptured figure by an inflation adjustment factor for the acquisition year to reflect its value now, and would probably have to do it for all acquisitions. This is why investment banking models are so much easier to use; these inputs can be easily fed in and sourced.

Non Depreciating Assets Essentially, these are net working capital, so current assets less inventory, less current non-debt monetary liabilities (things like accruals), inflation adjusted inventories and land, other tangible assets, and non-depreciating, non-goodwill intangible assets (things like patents and licenses). For BATM this includes investments which are not to be held to maturity but may be available for sale on an MTM basis. The figure for depreciation and amortization includes impairment of investments and is $8.22m. Current assets less inventories but including investments are $93.6m. It is difficult because there are ‘deposits and receivables’ of $65.503m but receivables of only

about $28m. We ignore held to maturity investments because they are noncurrent but include available for sale ones. Then we reduce trade and other payables of $21.624m (excluding short term bank credit). We do not subtract provisions because they are a non-cash liability that can be released at the end (for BATM they are onerous lease and warranty provisions). Now we have $71.98m. We do not have to subtract any long-term liabilities like deferred tax, liability with regard to acquisitions, and ‘forgivable debt to the office of the chief scientist’. We now add inventory which is adjusted for the FIFO gain (most companies record inventory on a FIFO basis). Finally, we add non-depreciating non-goodwill intangible assets and other tangible assets – in fact, BATM has none of these because it amortizes all its intangible assets (apart from deferred tax assets, consisting of deferred development costs, depreciation differences, deferred tax assets acquired, retirement benefit obligations and losses carried forward of $4.84m).

Then we have to add net prepaid pensions, which are included in wages and salaries, of $0.875m. This total figure comes to $77.695m.

Project Life To calculate this, we take the weighted average of the gross plant, capitalized lease and R&D project lives. To obtain the project life for gross plant, I couldn’t calculate gross plant recaptured so I used adjusted gross plant of $38.144m (pre-inflation adjustment), and divided it by annual depreciation of PPE of $2.865m to get 13.3 years (a more ac-

The next input is gross cash flow. We can calculate this based on the 2009 annual report. This is net income after tax + depreciation + amortization + interest expense + rental expense + R&D expense + monetary holding gains/losses + FIFO profits + pension expense + minority interest +/- special items. This would normally be calcuated by net income via tax, first of all, and by adjusting it like we would do in cash flow from operating activities, but in fact it is different. We first take NOPAT (not operating profit) of $19.315m.

CFROI recognizes the tax advantage

of the debt in the gross cash flow because NOPAT is after interest expense, but the riskiness of taking on more debt cancels out the tax deductibility of leverage, because effectively there is a rising WACC to discount it by in the denominator of the DCF. We then add on depreciation and amortization which amounted to $8.22m over the year. We add back the interest expense of $0.356m, which is only the interest on loans and not those to be paid on financial instruments, for example. We have to add back the R&D expense of $11.763m which is less than the R&D costs given of $12.715m in the notes. I will add back net rental expense, effectively from the group as lessor and lessee, or $1.9m for 2009.

Fundamentals | the analyst 37

The net monetary holding gain or loss also needs to be added back. This, interestingly, is not the mark to market change in available for sale or PVFP securities or investments, but just the impact of inflation on monetary assets. This would be the beginning net monetary assets minus net monetary liabilities multiplied by the change in the GDP deflator over the year, which is 2.14%. If I see note 36 under financial instruments, regardless of investments, and we get a value of $53.92m disregarding held to maturity investments, and we multiply by the change in the GDP deflator index for the US to get $1.153m of net monetary holding gain which you add to gross cash flow.

It is quite interesting to understand what ‘investments’ or ‘financial holdings’ actually are. Financial assets for BATM are classified into the following specified categories: financial assets ‘at fair value through profit or loss’ (FVTPL), ‘held-to-maturity’ investments, ‘available-for-sale’ (AFS) financial assets and ‘loans and receivables’. As it states in the notes: Where securities are held for trading purposes, gains and losses arising from changes in fair value are included in net profit or loss for the period. For available-for-sale investments, gains and losses arising from changes in fair value are recognised directly in equity, until the security is disposed of or is determined to be impaired, at which time the cumulative gain or loss previously recognised in equity is included in the profit or loss for the period. Impairment losses recognised in profit or loss for equity investments classified as available-for-sale are not subsequently reversed through profit or loss.

Impairment losses recognised in profit or loss for debt instruments classified as available-for-sale are subsequently reversed if an increase in the fair value

of the instrument can be objectively related to an event occurring after the recognition of the impairment loss Now, if we go into the FIFO profit calculation to more align the cost of goods sold to current prices and not to very old inventory prices, we have to take the beginning of year inventory, all of which is FIFO, and multiply it by the change in the PPI over the year to get FIFO profits. The change in the PPI for ISPs and wireless telecommunications providers was -1.63% from the BLS statistics, and so the FIFO losses are in fact $0.359m.

Finally, we have to add back the pension expenses the firm incurred, only the ones which were in the P&L as opposed to the balance sheet. This is current service cost plus the interest on obligations less the expected return on plan assets which is not really a true expense as it is firm guaranteed, less actuarial gains in the year, and this is $0.388m. We then would add back the minority interest of $1.912m on the balance sheet, different to the minority interests of companies acquired which reduce net assets as they go in. Lastly, special items (tax adjusted to account for the tax gain from provisions etc.) are added back. Amortisation of intangibles is $4m for 2009, and one off items were $2.5m including an exceptional dividend payment. We also have to add back the deferred tax benefit of $1.735m for the year. The total gross cash flow is $52.883m, which is extremely high, more than the net cash from operating activities of $20.234m or $28.095m of existing cash at the end of 2009.

Using the Excel RATE function, I calculate an IRR of 23%, which is much larger than the implied WACC for BATM I calculated earlier, and much higher than its ROE on one website of 14.3%

or ROI of 8.75%.

The New Normal

By Poh Wei Koh

A

s the world recovers from the recent global financial crisis, a common consensus among financial observers is that the crisis is fundamentally different from all recessions the world has experienced in recent decades, and that a major adjustment of the world’s economic order is taking place right now.

This trend is most succinctly described by the term “New Normal”, a term coined by Dr. Mohamed Abdulla ElElrian, Chief Executive Officer and CoChief Investment Officer of PIMCO, the world’s largest bond investor with over US$1 trillion of assets under management as of 2010. As the author of the award-winning bestseller When Markets Collide and equipped with an illustrious track record at the International Monetary Fund, Salomon Smith Barney and Harvard Management Company, El-Elrian is widely recognised as one of the most insightful thinkers of Wall Street. He believes that the world is in the midst of a major national and global realignment, caused by powerful underlying factors that have existed before the crisis, but were catalyzed by the financial crisis itself.

The main thesis of the New Normal is economic slowdown, especially in the United States, for a sustained period of time. Historically speaking, the World’s real GDP has been growing at an annualized rate of 3.2% from 1997 to 2007 prior to the crisis1, but the New Normal postulates a slower rate of growth at about 2.0% for a prolonged period of time. Similarly, there will be a persistently high unemploy-

38 Fundamentals | the analyst

ment rate, from about 5% historically as opposed to the 9.6% currently2.

The reasons for the pessimism are many. Firstly, it is obvious that there will be significantly less financial leverage in the system; this already a painful process of financial deleveraging is ongoing, as it can be clearly seen in the diagram.

Whether or not such deleveraging is healthy for the economy is debatable.

It has rightly been argued that leverage, in the past, was partially increased due to financial innovation – new financial instruments enable companies to have access to more methods of optimising their balance sheets, an act that contributes to the economy.

However, many of these companies were also market participants of the

credit bubble that was characterized by irresponsible risk taking, lack of regulation and even fraud. Ultimately, companies would suffer from the severe decline in credit and increased financial regulation of leverage, leading to slower growth in the New Normal.

While the financial crisis can be said to be the impetus for deleveraging, the same could not be said for the second reason: a decline in US consumption. Given the massive current account deficit of the United States, a deficit that has been ballooning consecutively since 2001 and reached US$ 803 billion at its peak in 2006, it

became increasingly clear to economists that US consumption as the driving force of the global economy was unsustainable. Although the deficit has since been corrected to a relatively reasonable level of US$ 378 billion in 2009, household debts in US and across developed countries remain alarmingly high. Coupled this with the fact that banks need to bolster their capital, and we can conclude that consumer spending in the developed world will be significantly lessened, even with the recovery of the crisis.

According to El-Elrian, as a result of this, the process of the “migration of growth and wealth dynamics from the industrial world to the larger emerging economies” will be accelerated.

Simply speaking, the world will be more reliant on developing econo-

mies, such as the BRIC (Brazil, Russia, India and China), as well as other parts of Asia, Latin America and Africa.

However, it is not immediately clear if the developing world could live up to the world’s expectations. For example, even though major developing economies such as China have continued to grow at nearly 9% in the midst of the financial crisis of 2008, they continued to be net exporters.

Traditionally speaking, a government has the propensity to increase its expenditure and help to stimulate the economy to expedite the process of a recovery, but whether governments

would do so this time around remains to be seen. Due to the crisis, governments have largely used up their ammunition – indeed, short term interest rates across US, The European Union and Japan are next to zero, and the US government, for instance, is running a deficit of about US$ 1.5 trillion.

These situations severely limit the effectiveness of government policies in delivering outcome. Indeed, having witnessed the potential dangers of a full-blown sovereign debt crisis, European governments, such as the UK, Germany and France, have been treading a cautious line, as evident in their focus on financial austerity.

Nevertheless, several observers, including Worldwide Managing Director of McKinsey, Ian Davis, predict that the New Normal implies a greater role for the government. This belief is reinforced by the fact that during the Great Depression in the 1930s, the Roosevelt administration permanently redefined the role of government in the US financial system. This role could potentially take place in two ways – firstly, as we have seen recently, in the form of increased regulation, especially financially. Secondly, there could potentially be a movement towards left-wing economics – even the conservative Cameron administration was forced to increase capital-gain tax and VAT in the United Kingdom.

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

- Charles Mackay As the author Charles Mackay noted during 1841 in his book Extraordinary Popular Delusions and the Madness of Crowds, a book that is quite incredibly still in print, it seems that men tend to be driven by market psychology. Witness the “tulip mania” at its height in 1637, where single tulip bulbs were sold at more than 10 times the annual income of a skilled craftsman, or even more recently, the dot-com bubble burst which saw the NASDAQ index fall drastically from a peak of 5048.6

Fundamentals | the analyst 39

to a trough of 1139.9, a fall that it has never really recovered from ever since.

One cannot be sure if the financial industry will experience what the technological industry has experienced over the last decade, but some would contentiously claim that the existence of several financial companies such as Lehman Brothers or AIG was undesirable in the first place. The impact of proposed financial regulations on entities such as investment banks and hedge funds remain to be seen. Regardless, it is obvious that businesses can no longer apply models that merely rely on reckless risk-taking and high leverage. Instead, they will be rewarded according to the old-fashioned way of productivity and growth.

The relative decline of the financial industry, if there is a decline, could be a double-edged sword for other sectors of the economy. On one hand, as Bill Gates famously put it, Microsoft’s greatest competitor is not Apple, Google or IBM. It is Goldman Sachs.

By that he meant that in the war for talent, the main competitors of Microsoft are the top investment banks. On the broader picture, talents could be encouraged to pursue careers that are not financially related, while investors could shift their focus from investing in the financial sector to investing in sectors such as technology or alternative energies. On the other hand, a weakening financial industry could lead to increased cost of capital, resulting in less funding for R&D purposes and for smaller businesses.

Some critics, however, believe that the New Normal is not likely to be the way forward for the global economy. Of these critics, the more optimistic ones predict that a V-shaped recovery that could see the US economy growing by as high as 3.7% in the near future.

Joseph Carson, an economist at AllianceBernstein, even coined the term “new mix”, painting a rosy picture of the global economy.

Another group predicts that the immediate prospect of the global economy

40 Fundamentals | the analyst

is bleak. The World Bank predicts that a double-dip recession is imminent in Europe, while Goldman Sachs increased its odds of a double-dip to 25% recently. Nobel Prize winning economist Paul Krugman famously wrote an article entitled “Lost Decade, Here We Come”.

The duration of the New Normal remains to be seen as well. Will the global economy eventually return to its pre-crisis growth rate, or will the New Normal growth effects be permanent?

Whatever the case is, observers are convinced that there remain opportunities in a more turbulent climate.

“Chance favours only the prepared mind”,the great scientist Louis Pasteur once said. Entrepreneurs would do well to heed his advice.

The Value Investor

By Cheng Sheun Yeow

T

he highly successful American investor, Warren Buffet, also known as the “Orcale of Omaha” and CEO of Berkshire Hathaway is probably the most successful investor noted for his adherence to the value investing philosophy. His value investing strategy took the stock of Berkshire Hathaway, his holding company, from $12 a share in 1967 to over $120,000 in 2010, beating the S&P 500’s performance by about 13% on average annually.

Value investing is the art of buying assets for significantly less than their true intrinsic values. The philosophy behind this was established by Benjamin Graham (author of The Intelligent Investor) and David Dodd, both professors at Columbia Business School who jointly wrote the seminal book, Security Analysis which laid the intellectual foundation of value investing. Incidentally, Warren Buffet was also a student of Benjamin Graham at Columbia.

Value investors seek stocks they believe are undervalued by the market, due possibly to a variety of reasons: overreaction to good or bad news; failure to appreciate the stocks’ fun-

damentals and their potential. Like bargain hunters, value investors look for bargain items not recognised by majority of other buyers.

While many books have set out numerous methods and approaches, determining the intrinsic value of a stock is not a precise science. Valuation is thus an imprecise art. For this reason, investors usually allow for a margin of safety or a discount from the calculated or their perceived true value of the company. This allows the investor to minimise downside risk by simply leaving room for error in their calculations of intrinsic value.

“Confronted with the challenge to distill the secret of sound investment into three words, we venture the motto, MARGIN OF SAFETY” - Benjamin Graham, Intelligent Investor In general, value stocks are characterised by low multiples, high payout ratios and strong yields. Common ratios include the price to earnings (P/E), price to book (P/B), enterprise value (EV), earnings before interest, taxes, depreciation and amortization (EBITDA) or enterprise multiple and many more.

Despite its imperfection, the P/E ratio is nevertheless the most widely used valuation by investors. Value investors view low P/E ratio stocks as attractive buys (undervalued). However, there is no specific P/E ratio whereby all companies having P/E ratios below that value would be deemed undervalued.

Investors considering a stock purchase should compare the current P/E ratio of the stock against its long-term historical record, current P/E ratio for the overall market, the company’s industry segment and two or three direct competitor companies. However, it is extremely important to only compare companies of the same industry. For example, utilities typically have low multiples being low-growth, stable industries. In contrast, the technology industry is characterized by phenomenal growth rates. However, a low P/E

ratio does not necessarily mean that a company is undervalued. Rather, it could mean that the market believes the company is headed for trouble in the near future. Stocks go down for a reason.

Although the P/E gets a lot of investor attention, other multiples are equally helpful. For example, the enterprise multiple or the EBITDA multiple is arguably more accurate because it takes debt into account – an item which other multiples like the P/E do not include.

In addition, the EV gives a better representation of a firm’s value than market capitalisation for takeover purposes as it accounts for the debt which the acquirer will have to assume. In short, there are numerous helpful financial ratios and approaches to determining the intrinsic value of stocks.

In addition to fundamentals, understanding a company is also imperative.

If you do not understand what a company does or how, then you probably shouldn’t be investing in it. A value investor only looks for businesses that he or she can easily understand to be able to make an educated assessment about the future earnings of the business.

Warren Buffet adamantly restricts himself to his “circle of competence” – businesses he understands. Buffet considers this deep understanding of the operating business to be a prerequisite for a viable forecast of future business performance. As Hagstrom (author of The Warren Buffet Way) writes, investment success is not a matter of how much you know but rather how realistically you define what you do not know. Buffet admittedly does not understand what the bulk of today’s technology companies does, hence he avoided investment in that sector.

Value investors want managers who act like owners. Good management adds value beyond a company’s tangible assets while poor management can destroy even the most solid financials. The best managers ignore the market value of the company and

focus on growing the business, thus creating long-term shareholder value.

Managers who act like employees often focus on short-term earnings in order to secure bonuses or other performance perks, sometimes leading to the long-term detriment of the company. For instance, some managers tend to boost earnings artificially when it comes to bonus periods. There are various ways to judge this, but one dead giveaway is the size and reporting of compensation. If you are thinking like an owner, you tend to pay yourself a reasonable wage and depend on gains in your stock holdings for a bonus.

Value investing contradicts the commonly accepted investing principle of diversification. When a value investor finds undervalued stocks, he or she should buy as much as he or she can.

When excess investment capital is available, your aim for investing should not be diversity, but finding an investment that is better than the ones you already own. If the opportunities do not surpass what you already own, you might as well buy more of the companies you know and love. Great ideas are scarce and when the market throws you a wonderful opportunity, you should swing hard by investing a meaningful amount.

Nonetheless, one obvious exception is Peter Lynch. Peter Lynch who was previously head of Magellan Fund averaged a 29.2% return during his tenure at the mutual fund. The fund had $18 million in assets when Lynch was first named head in 1977. By the time he resigned in 1990, the fund had grown to over $14 billion in assets with over a thousand individual stock positions.

Finally, it is important to differentiate between short-term market fluctuations and permanent capital loss. During the time when you hold an investment, there will be times when you can sell for a large profit and others when you are holding an unrealised loss. This is the nature of market volatility. A value investor must be patient to ignore trends in stock price fluctuations and other market noise 99% of the time.

Volatility does not equal risk, it provides opportunity.

It can take time for the market to present a truly compelling opportunity that coincides with your circle of competence. It also takes time for a catalyst to emerge that allows you to realise the value of the investment. In short, patience is a virtue and a value investor should hold dear to his or her conviction to wait for the opportunity to buy or sell instead of being distracted by short-term market fluctuations.

So how does Warren Buffet do it? Buffet takes the value investing approach to another level. He is only concerned with how well that company can make money as a business, not whether the market will eventually recognise its worth. He does not seek capital gain but ownership. He is not concerned about the supply and demand intricacies of the market. Hence his famous quote: “In the short term the market is a popularity contest, in the long term it is a weighing machine.”

Buffet focuses on return on equity (ROE) rather than earnings per share (EPS) from the past 5 to 10 years. Of course, Buffet understands that the ROE can be distorted by leverage; hence he examines leverage separately by considering the debt to equity ratio. Buffet generally prefers to see a small amount of debt so that earnings growth is being generated from shareholders’ equity as opposed to borrowed money. Buffet also ensures the company has a consistently increasing profit margin. This shows an efficient management which is successful at controlling expenses. Buffet also tends to shy away from companies whose products are indistinguishable from those of competitors and those that rely solely on commodity. Also, any characteristic that is difficult to replicate is what Buffet calls a company’s economic moat, or competitive advantage. The wider the moat, the tougher it is for a competitor to gain market share.

Finally, the kicker, the most difficult

Fundamentals | the analyst 41

part of value investing and Buffet’s most important skill is determining whether companies are undervalued.

Buffet first determines the intrinsic value of the company as a whole, and if it is at least 25% higher than the company’s market capitalization, Buffet would consider that company as one that has value.

Value investing today has morphed

42 44 45 47

into many shapes. Joel Greenblatt of Magic Formula Investing suggests purchasing 30 cheap stocks with a high earning yield and return on capital. His magic formula is said to have beaten the S&P500 96% of the time, averaging a 17-year annual return of 30.8%.

Seth Klarman, on the other hand, a conservative investor, often holds a significant amount of cash in his portfolio, sometimes in excess of 50% of the

Hong Kong’s Changing Financial Landscape How to Game Your Intership Why Now is a Great Time On the Spot: Head of Graduate Recruitment, Credit Suisse

total. He makes unusual investments, buying unpopular assets while they are undervalued, using complex derivatives and buying put options. Sir John Marks Templeton is noted for buying 100 shares of each company for less than $1 per share in 1939, making a substantial profit 4 years later. Despite the different methodologies used, value investing boils down to buying something for less than it is worth.

Careers and Interviews Hong Kong’s Changing Financial Landscape: An Interview with the Financial Secretary of Hong Kong

By Joe Chow

“

If he were alive today, ‘investor protection’ is a term that Milton Friedman probably would not like to hear from Hong Kong, but it is a sign of the times”, said Mr John Tsang, the Financial Secretary of Hong Kong. Indeed ‘change’ has been a main theme which governments across the globe have been embracing particularly after the financial crisis. Hong Kong, famously known as one of the Asian tigers in the 90s, was nevertheless no exception in this turbulent time. There were times where her capitalist system was questioned. There were concerns that austerity and prudence may backfire.

There were also moments when ac-

tions seemed inadequate. However, although in various economies the footpath to growth remains uncertain, as the Financial Secretary confidently argued, Hong Kong has recovered from the credit crunch and is recording noticeable growth figures. In the exclusive interview with the Analyst at the LSE, Mr Tsang examined in retrospect the policies of Hong Kong in response to the recession and commented on the future role of Hong Kong in China’s development.

Hong Kong and the financial crisis

Hong Kong has long been recognised as an open externally-oriented economy. Although it is indeed widely regarded as a virtue, in a time where international trade is threatened, it may lead an economy to a very slippery slope.

Mr Tsang quoted that in 2009, export of Hong Kong significantly decreased by 24%, the biggest reduction ever recorded. Foreseeing a downturn subsequent to the sub-prime mortgage crisis in 2008, the Hong Kong government

42 Careers and Interviews | the analyst

took immediate actions. There were four main approaches, explained the Financial Secretary. First, as finance is a ‘pillar industry’ of Hong Kong which accounts for 15% of local GDP, stabilising the financial sector seemed indispensable. Mr Tsang suggested that the Hong Kong government has always adopted a ‘conservative’ economic policy which emphasises the priority for market system. Therefore, instead of directly intervening into the financial industry, the government concentrated on facilitating liquidity. Moreover, Mr Tsang argued that stabilising confidence amongst investors was essential. The introduction of the 100% deposit protection scheme marked state efforts in this direction.

Third, as the impact spilled over the real economy, small and medium firms were in need of further supports. In so doing, 350,000 jobs were protected and the Financial Secretary examined that it was attributable to the relatively low unemployment rate. ‘The loan guarantee scheme was particularly

useful’, said Mr Tsang. Default rate of small and medium firms was low. Yet the government remained very careful with the outline of the scheme in hopes of avoiding moral in lending.

Finally, extension of benefits to disadvantaged families was vital. This included subsidies, free rents and other welfare payments. Mr Tsang stressed that it was an important step to sustain consumption in the economy to drive Hong Kong back to the footpath of growth. These were the four main approaches adopted by Hong Kong.

As the Financial Secretary touched on the interesting issue of Shanghai, his comments on the alleged rivalry relationship between the ‘twin engines’ were asked.

Mr Tsang’s response was positive and coined this relation as ‘complementary’.

Having discussed the policy responses, the Financial Secretary shifted the focus to what he named ‘exit strategy’.

Since the guiding principle of Hong Kong’s economic policy is ‘free market’, it is unsurprising that one day, state intervention have to retreat. Mr Tsang cited that the 100% deposit guarantee scheme will end in late 2010. However, to continue to safeguard depositors’ interests, it will be replaced by a new legislation protecting 98-99% of bank accounts. Indeed, since these measures are merely ‘counter-cyclical’, as Mr Tsang highlighted, the question of ‘What next’ will continue to be raised.

Furthermore, as banking regulations seem to be tightening worldwide, it

was also asked that as a free and open economy, how would Hong Kong respond to this ‘changing landscape’. Mr Tsang emphasised that Hong Kong has been following these discussions closely as an active participant of global forums such as APEC, G20, IMF and so on. ‘Huge talks’ also take place regarding BASEL III. He continued to maintain that Hong Kong has been a very prudent economy. Capital adequacy level is 16%, which is considerably better than Hong Kong’s counterparts.

Hong Kong’s economic relationship with China Particular interests were paid to the next five year plan of China which will commence next year. The Financial Secretary stressed that Hong Kong played ‘a different role’ in history but potentials should not be underestimated. ‘Hong Kong’s role will continue to be a big one’, Mr Tsang suggested. Hong Kong remains the only RMB offshore centre and since its establishment around 20 RMB bonds have been issued. Indeed, demand for RMB investment products was confirmed by their over-subscription and the fact that RMB deposits have been increasing. Hong Kong will be essential to RMB in terms of its internationalisation and ‘firewall effect’ to the Chinese economy. Mr Tsang therefore was confident that ‘Hong Kong will be more important in RMB’, and his optimism was echoed by HSBC’s recently published research.

At the current stage, although the details of the next five year plan are not yet published, the Financial Secretary described that it would ‘points to the direction of future’s China’. Hong Kong together with Shanghai will also be the ‘twin engines’ to China’s economy. As the Financial Secretary touched on the interesting issue of Shanghai, his comments on the alleged rivalry relationship between the ‘twin engines’ were asked. Mr Tsang’s response was positive and coined this relation as ‘complementary’. Be that as it may, he emphasised that Hong Kong does indeed possess advantages. Hong Kong was

the ‘first mover’ in economic development and has learnt acquired ten years of experience in playing a leading role in China’s economic modernisation.

Although it was challenged that recent league tables demonstrated that this advantageous position is diminishing, the Financial Secretary pointed out that careful scrutiny is important.

The underlying criteria employed and design of the table are factors which could underestimate Hong Kong’s position. This final defence of Hong Kong marked the end of the interview.

The lecture The Financial Secretary elaborated on various salient points made in the interview in his public speech given in the Sheikh Zayed theatre, LSE. The entire lecture hall was full and participants ranged from LSE students to professionals. It was organised by the Finance Society and the Hong Kong Public Affairs and Social Services Society and chaired by Sir Howard Davis, Director of the LSE. In 2008, in the midst of the financial crisis, Donald Tsang, chief executive of Hong Kong, also made a speech in LSE on the challenges and opportunities presented by this recession. Having gone through that most turbulent time, two years on, the Financial Secretary was able to introduce the progress the Hong Kong Government has made on rebuilding the economy. The four main approaches suggested in the interview were discussed further. In specific respect to finance, Mr Tsang stressed that ‘however, new lessons need to be learned. In particular, the global financial crisis highlighted the vulnerability of investors to risky products, suspect sales tactics and unrealistic financial goals.’ Government policies on this area aim to ‘shield our economy from the global financial crisis’.

Moreover, Mr Tsang highlighted on ‘cross boundary collaboration’. He maintained that ‘today, it is impossible to talk about post-financial crisis Hong Kong without mentioning the China factor.’ The Guangdong province has

Careers and Interviews | the analyst 43

been particularly important and the Framework Agreement signed earlier this year marked a great leap forward in cooperation within the Pearl River Delta. ‘… [It] covers a range of specific policies and facilitates the free flow of people, goods, capital and information.

Importantly for financial services, it supports the establishment of crossboundary subsidiaries for financial institutions from Hong Kong.’ Mr Tsang argued that these initiatives will be for ‘early and pilot implementation’ which are expected to expand throughout China. As indeed in the interview, Hong Kong’s RMB business was a main focus. The Financial Secretary commentd that ‘this is a positive start and there is huge potential for further growth. Today’s figures represent just a drop in the ocean…’. Given the full support from the Central Government, as Mr Tsang put it in the speech, his optimism echoed his responses in the interview.

In addition to the topics covered in the interview, Mr Tsang did further comment on Hong Kong’s business relations with overseas economies.

Emerging markets are encouraged to invest in Hong Kong and Russia is a prime example. ‘Not only is Russia a geographical neighbour of China, it is also a primary commodities exporter while China is a major consumer of commodities’, said Mr Tsang. This is exactly what globalisation means in the trade and finance perspectives.

In the subsequent question and answer session, the audience showed great interests in Hong Kong’s current issues and were eager to hear what the Financial Secretary had to respond.

The questions covered a huge variety of topics including income inequality, the minimum wage, housing prices, competition within the region and so on. It was particularly intriguing when Mr Tsang was mentioning those ‘swords’ which he is often confronted with on public occasions – Shanghai, Singapore and so on. These exchanges certainly further improved the audience’s awareness to the public affairs of Hong Kong.

Throughout the interview and the lecture, I conclude that Mr Tsang’s position was clear and firm – Hong Kong has and will continue to play an active role in the World economy even in difficult times. As he argued, ‘we have been learning new lessons from the financial crisis, building stronger links within our nation and reaching out to new markets around the world. I am confident that Hong Kong will continue to play a major role as a global financial centre alongside London and New York.’ Indeed financial landscapes are changing. Hong Kong nevertheless is always ready for it. The insights she has cumulated from her handling of external financial shocks and cooperation with China are the strongest proofs to it. However, the Financial Secretary revealed no sign of complacency in the interview and his speech. Only by continuing to learn from lessons can Hong Kong’s economic success be sustained in times of changing financial landscapes.

How to Game Your Internship By eFinancialCareers

S

o you’re lucky enough to be one of the few selected to do a summer internship at Bank X.....fantastic!

The question is, are you really prepared for the challenge ahead? Make no mistake - your internship place is no ticket to a graduate job. It is simply a chance to give that full-time position your best shot by showing the powers that be exactly what you’re made of!

Week 1 - 2 of any internship tends to centre around training, getting to know your peers (sizing up the competition!) and familiarising yourself with what will now be your home for the next 10 weeks. I mean this quite literally, because had I been able to bring my duvet and pillow and sleep a mere 3 hours a night during my internship, I would have been most happy.

After the initial uninspiring two weeks.....let the games begin!

44 Careers and Interviews | the analyst

Rotational internships The 8 week multi-rotational internships are in one sense inspired - they allow you to gain exposure and touch on every aspect of the business to see where you best fit in. Unlike the single desk placement where you only have to impress those working closest to you on your allocated desk, rotational internships are a constant beauty parade: you need to impress each and every person you encounter.

HR will provide you with a rotation time table for approx 3 weeks. The trick here is to attend each rotation, be focussed and personal, ask questions and seem interested even if it isn’t a product you like. The second you leave, your rotation host will be pinging off an email to the internship captains and HR providing feedback on you.

If your rotation is on a desk you are interested in, it is important to express that. Ideally, you need a project to work on (project simply means more time on the desk so they can see how suited you are).

The rely

second trick is not to on these rotations alone.

In most cases, the rotation schedule dictates your whereabouts for only two hours a day. This leaves the rest of the day for you to work on projects. The clever interns are those who make the most of every possible life line, and effectively use this time to create their own rotations.

Speak with your buddy, your mentor any rotation host you get a connection with - tell them your interests and which desks you are interested in and get that all important introduction!

Be aware of your environment and seek those desks which are actually hiring - do not be fooled, if a desk were to find a willing spring chicken who works hard and is willing to take on mammoth projects they will take advantage of this fact, even if they have no headcount.

Yes you may impress a few people,

you may get good feedback, but you haven’t secured yourself a contract.

The sad truth is that on both the multirotational programmes and the select desk internships, there are plenty of cases of interns working their butt off even though the desk isn’t actually hiring.

Select desk internships On the select desk rotations, the process is very simple. The desk either hires you, they reject you, or they put you into a pool where they effectively acknowledge that you are a good candidate but not for them, thereby opening you up to desks who do have a need for a hire.

The secret intern bidding auction Why have I blabbered on with all this detail? Often interns have asked me how do the big IBs whittle down 70+ multi-rotational candidates to maybe 20-30 full-time places and the simple truth is because all the above culminates in one final bidding auction in the final week of your internships.

All of the Captains meet in a room with HR, Some will have headcount quotas and some will not. Those who don’t are there simply to provide feedback and those who do have Intern Currency – effectively the power to bid on the intern they want and often each desk will have a reserve candidate also. OFF THEY GO! Each intern’s photograph pops up on a screen and the captains place their bids. You don’t want to be the intern who receives silence when their photo appears! Desks which are seen to have ‘a greater business need’ have more Intern Currency and will over rule another desk who may also want you but not have as much need. It is important that you too have indicated your preferences to HR: when two desks are battling for the same intern, this can sometimes swing the vote.

Interns are usually horrified at the discovery of this auction process but I

try to remind them that we work in an industry that runs on numbers, buy/ sell the bid/offer, currency and commodities, somebody wins, somebody loses. It’s the only thing we know and thus your job is to make yourselves that precious commodity or AAA rated bond then you’ve got all the traders right where you want them!

Why Now is a Great Time By eFinancialCareers

S

arah Harper, head of recruitment for Europe, the Middle East and Africa (EMEA) at Goldman Sachs, has agreed to respond to some of your questions on graduate jobs and internships.

1) With investment banks’ collective graduate intakes down 40% last year according to High Fliers Research, it hasn’t been an easy time for graduates who want to get into investment banking. Do you think things are now looking up? How do this year’s intern pool and graduate intake compare with previous years?

The hiring picture for students looking for jobs in investment banking this year is absolutely better than it was last year.

At Goldman Sachs, our summer internship and full time class sizes are close to where they were prior to the downturn.

We can’t speak for other banks, but this is likely to be the case across the industry: at a recent High Fliers conference we attended, research was presented showing that many more students than last year were applying to investment banks.

2) It’s evidently early days, but what’s the graduate hiring outlook for 2011?

Every year we try to align the size of our summer internship class to the size we expect the subsequent year’s full time class to be. We hope to offer full time 2011 positions to the majority of our 2010 summer class, which is significantly bigger than last years class.

3) Have you noticed any drop off in the number of students who want to be investment bankers as a result of the industry’s poor publicity following the financial crisis?

We are very pleased that, no, we haven’t particularly noticed this.

Looking back to the first term of this year, we had a very good number of students attending our campus events. The turnout was excellent and students are still very interested in working for us. This has been reflected in the applications we received.

4) Which business areas are you hiring people into this year? Which businesses have the biggest intakes?

All our divisions take both interns and full time analysts. Our biggest intakes are into investment banking, securities, operations and technology.

We always encourage students to think about the broad range of opportunities on offer - as well as the bigger and better known divisions, we also hire into areas such as legal, internal audit, and human capital management.

5) What’s your advice to students who didn’t get a summer internship for 2010 and still want to work in banking?

... research was presented showing that many more students than last year were applying to investment banks Any experience this summer will be important. You need to show that you are proactive and keen to learn and develop. Therefore, some sort of work experience - even if it’s not directly relevant, will be useful.

The key period will be next year’s milkround, when you will need to en-

Careers and Interviews | the analyst 45

HERE’S THE DEAL. ICAP is the world’s premier interdealer broker, connecting buyers and sellers in the global financial markets. You are an incredibly bright individual with a personality to match. We’re fast-moving, global, innovative and meritocratic. A place where talent and ambition thrive and where each day brings another opportunity, another challenge, another chance to prove your potential.

We have a range of full-time and internship opportunities.

Careers in global financial markets www.icap.com/careers Joselyn Lee Broker, London

©ICAP plc 2010. ICAP® and other service marks and logos are service marks of ICAP plc and/or one of its group of companies.

All rights reserved. Entities within the ICAP group are registered as applicable.

Careers and Interviews | the analyst

sure you are attending any presentations that are made by investment banks, and are aware of when you can apply for positions for 2011.

On the Spot: Head of Graduate Recruitment, Credit Suisse By eFinancialCareers Jim Richardson, the head of graduate recruitment for Europe, the Middle East and Africa (EMEA) at Credit Suisse, has agreed to respond to some of your questions on graduate jobs and internships.

1) At this stage, do you think 2010 will be a better year for investment banks’ graduate recruitment than 2009 has proven to be?

Yes, our graduate recruitment numbers are up against our 2009 numbers.

2) Which business areas does Credit Suisse expect to recruit most graduates into in 2010?

We continue to have significant graduate programs in Investment Banking, IT and Securities.

3) Are there any business areas that you don’t expect to recruit graduates into during 2010?

No, all areas with established Graduate Programs are recruiting graduates in 2010.

4) Why should students be applying to Credit Suisse investment bank?

Credit Suisse is one of the world’s premier banks. Most people who join us do so because of ‘the people’. We

appeal to intelligent and outgoing personalities who want to work together in an atmosphere of co-operation and respect. We need individuals who bring something personal, special and unique to the business. It’s not just that different jobs call for different skills and aptitudes; the creativity, flair and agility that make Credit Suisse successful flow directly from the special mix of people who work here.

5) What’s the most common reason for you to reject someone?

Applicants inability to demonstrate genuine knowledge of and motivation for the investment banking industry through their studies, experiences and interests. We also reject candidates who do not have the specific language requirements to suit our business needs.

Credits Founder Greg Silver

Publication Director Harris Ho

Co-Founder Johnson Ta

Principal Analyst Edward Chai

Editor-in-chief Joe Chow

Careers and Interviews Director Kunal Shah

Marketing Director (External Campus) Dhruv Ghulati

Layouts Director Harshil Shah

Marketing Director (Corporate Relations) Niharika Khanna

Graphics Shiqi Shan (Director) Sze Ying Lee Deborah Adigun-Hameed Gar Jun Lau Vishal Bhadresa Chen Hung Wong

Treasurer Richard Opong

Contributors Vladimir Shamanov Emre Tarim Juan Pablo Pardo-Guerra Hsien Sheng Wong Sheun Yeow Cheng Kaushik Sudharsanam Nicolo Colombo Daniel Ross Poh Wei Koh Thomas Ng Leon Beressi Prithvi Murthy Cheng Sheun Yeow Jankee Gohil Elana Blatt Leonie Phua Surbhi Bansal Meen Teeraniti

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Careers and Interviews| the analyst

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