The Analyst: Issue 1

Issue 1

Lent Term 2010

Analyst

the

Uncovering the Underlying

Dipping into new investment pools

No spin.

Straight talking from KPMG. Graduate Programmes All degree disciplines When it comes to what we do, there’s no need for spin. We offer audit, tax and advisory services to everyone from oil companies to music gurus. And when you join us, you’ll do the same. Simple really.

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MARKETS >> Endemic instability in the inefficient markets >> Past performance does not indicate future performance: An Investment Outlook >> French armament sector flying high >> The history and future of gold >> The promissory premise of prediction markets >> Luxury sees the light >> Overstating China’s underconsumption

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FUNDAMENTALS >> After the crisis: risk management in the new world >> How private equity uses leverage to create value

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POLITICS >> A comment on Warren Buffett and the city bonus >> Hedge fund activists: the new corporate democrats >> Conditional Cash Transfers vs. Microfinance: Effective Anti-Poverty Measures >> The Financial Crisis and its implications on Sino-American Ties

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CAREERS >> Hedge fund manager profile: Steven A. Cohen >> Interview with Sarju Shah: an inflation trader at Barclays Capital >> Interview with Benjamin Lu: an options trader at Optiver >> How to make Bank X think you want to work for them >> The new normal: survey results on how LSE students view the job market in the aftermath of the Bloodshed

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SPECIAL REPORT >> The economics of climate change >> A peek into Barclays Capital’s tax strategy >> Film Finance: A star-studded earnings performance in 2009 >> A revolution in the Chinese private equity market >> The effects of the financial crisis on microfinance institutions

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Contents

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The Economics of Climate Change

By Jérémy Aflalo

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ver since climate change has become an issue of public concern, economists have been making life difficult for environmentalists and politicians. The main problem is that combating climate change requires sizeable investments that make rates of returns look unattractive. The benefits of investing in green energy solutions are uncertain and distant in comparison to the clear benefits of, for example, education in developing countries.

Nevertheless, politicians have decided that such investments will be profitable for the whole of society over the long term and that they are worth undertaking. Therefore, the question is no longer whether they need to do something to mitigate climate change, but rather how to do it efficiently and effectively. This article studies the three policy instruments they are using to accomplish this: regulation, carbon-pricing and subsidies.

Regulation is particularly useful whenever bad incentives are present.

For example, buildings are rarely designed to save energy, because those who build them are not the ones who pay the energy bills. Thus, they do not have any incentive to build energyefficient buildings. On the other hand, the buyers do not pay enough attention to the price of energy bills and

are still focusing more on criteria such as locations or views. In this kind of situation, regulatory changes have the potential to cut energy waste without having distortionary effects on the market. It is worth noting that, according to McKinsey, around a third of the necessary greenhouse-gas reductions will actually save money.

The second solution is carbonpricing. This method provides a way of internalizing the social costs of pollution by giving companies incentives to reduce their production of greenhouse gases. A carbon price can be set either by a tax or through a cap-and-trade system.

For political reasons, governments have chosen to select the cap-andtrade option. Actually, taxes are never very popular whatever their purpose.

The most advanced group of nations in this field is the European Union with its Emissions-Trading Scheme (ETS), which started in 2005. Although this solution could be very efficient because it keeps government out of decisions and gives companies the flexibility to choose the best way to cut carbon emissions, the results have so far been rather disappointing. The reason is that the quotas that were set have been too high, resulting in a carbon price that is not high enough.

In fact, the current carbon price ($22) is too low compared to the $40 needed, according to the Grantham Research Institute.

The second way of pricing carbon is through a tax. Norway and Sweden already have a carbon tax and France will soon. It seems that a carbon tax would be the most efficient and effective way to mitigate carbon emissions as it keeps the government out of decision (once the tax level is defined) and is easy to practically implement. The only hurdle to

The main problem is that combating climate change requires sizeable investments that make rates of return look unattractive.

this solution is the governments’ fears of the consequences of this policy on their popularity among the electorate. However, it is becoming clearer that in most developed countries, where levels of debt relative to GDP have risen sharply since the beginning of the crisis, tax hikes will be needed anyway. This could be the perfect opportunity to implement this policy.

The third way to combat greenhouse-gases emissions is through subsidies. The rationale for the use of this tool lies, again, in the need to modify incentives in order to improve the well-being of society. As a matter of fact, R&D in green technologies is too risky for most companies to undertake on their own. On the other hand, it offers enough social benefits to deserve government support. Thus, there is no doubt that subsidies could be useful.

However, governments have decided to subsidize heavily in ethanol, wind and solar power without knowing for sure whether these technologies are really promising or not. That means such subsidies can be “sub-optimal”.

The worst example of a wasteful subsidy is America’s support for homegrown ethanol, which has led to an increase in global food prices (and thus malnutrition). Therefore, even though subsidies seem to be the most effective way of combating climate change they also seem to be less efficient ones.

To conclude, the intervention of governments is needed in order to find a solution to the climate change issue.

However, governments must pay close attention to not distort the market mechanisms that are still the best tools for allocating resources efficiently. 

A peek into Barclays Capital’s tax strategy

By Dhruv Ghulati

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bout 8 months ago, a trader from Barclays disclosed clandestine information to the Guardian. This described the types of models that investment banks were holding for the avoidance of tax – in this case a whole

ing so contravening relevant laws.

- Tax evasion is when income and/ or principal are misstated to tax authorities – usually to the extent that they are not stated at all.

The Ramsey Principle has recently been applied to Barclays and Scottish Provident. Barclays had purchased a gas pipeline linking Scotland and the Irish Republic. The pipeline had been purchased from an Irish corporation (‘BGE’) to which it was subsequently leased back. What the Inland Revenue had found unacceptable was that the

(Miller 1977) This equation shows that the tax gain from leverage is equal to the amount of debt you have taken on multiplied by a factor of corporation tax, and the personal tax rates for equity and debt claimants. So this is how firms calculate the optimal capital structure.

Until a certain point, debt works because it is corporation tax deductible. However, soon firms need to issue taxable debt because deductible debt (convertible and municipal bonds) runs out, and doing this becomes harder as investors need to pay tax on their holdings. Firms need to pay compensation to these private investors on their tax loss vis-à-vis holding equity.

If this payment Rd is less than Rs, the corporation tax rate, it makes sense. R is the rate of interest on tax deductible debt, such as municipal bonds. When the public demand for bonds is less than D*, we’d be encouraged to lever up further and induce investors to borrow, and thus we would be saved from paying corporation tax on dividends.

The Market and Methods of Tax Avoidance I would now briefly like to go into what type of complex structures typically exist for the purpose of tax avoidance.

One thing that is common to each of them is that they use offshore entities, sometimes known as SIVs or SPVs, to benefit from the fact that these entities or holding companies are domiciled in more investor friendly countries with near-zero rates of corporation tax, such as Bermuda, Guernsey, Dubai or Switzerland. One can then have this offshore entity make a business loan to

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it - If the after-tax cost of debt is lower than the company’s Net Return on Assets, it should take on as much debt as it can. Similarly, if net profit margins are higher than net interest rates you can maximize your ROE by minimizing equity and maximizing debt.

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transaction was part of a series in which very little money actually passed between Barclays and BGE. The overall effect, however, was that capital allowances available to Barclays were passed on to BGE in the form of reductions in the rental payments. For Scottish Provident, SPI and its financial adviser, Citibank, granted each other options over a number of gilts.

The pricing of the options was structured to ensure that under the old tax rules which were just about to change, SPI would not be taxed on the inflated premium it would receive on selling its options. SPI would also be able to claim a relievable loss under the new rules when Citibank exercised its option at a correspondingly high discount. Lastly, by virtue of the cross-option, Citibank would not be exposed to real market forces on the gilts it would acquire from SPI. Because of the cross option, no gilts would physically change hands, and so Citibank would earn a fee and SPI would generate a tax loss without suffering a commercial loss.

An analysis of the activities that the ‘Structured Capital Markets’ division at Barclays Capital was carrying out involves a discussion of leverage, and the optimal capital structure ratio that all companies use to gain capital for funding operations.

This is known as the debt-equity ratio, and works on the basis that interest payments on loans you take on bonds you issue are tax deductible by law, but dividends paid out to equity shareholders are not. Yet this would imply we should be 100% debt financed, especially because this way we do not withdraw any stake in our company. Of course, this is not true, because of the fact that debt is a risk which has a number of disadvantages. For example, it must be repaid or refinanced, it requires regular interest payments, and collateral assets must usually be available to issue

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team of 110 individuals on a mission.

This caused huge outrage among industry cynics, who already had enough to smash windows about given government rescues, unemployment, asset repurchasing, and bankers’ bonuses.

One reason why the Barclays tax avoidance projects were so large was that tax is actually one of the largest expenses and current liabilities for a firm. Thus far, little has been discussed in terms of what types of instruments these operations really involved – the purpose of this article is explaining them.

First of all, let us define what is known as the Ramsay Principle, from Lord Wilberforce, which distinguishes what structuring is legal, and what is felonious. This was drawn up after the infamous Ramsey case in the Rossminster affair.

- Lawful tax avoidance is essentially structuring one’s fiscal matters to minimize tax to be paid, and maximize benefits, whilst observing all relevant laws.

- Illegal tax avoidance is arranging one’s tax matters and by do-

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6 your firm’s onshore operations; apart from having domestic tax advantages this transactional set-up means that you can legitimately ship more money offshore as you ‘repay’ the loan, as well as transfer off your downside investment risk.

Wash sale rule. With this, traders could gain deductibility by realising on capital losses that didn’t exist. If they had bought a stock and sold it when it went down (at a loss), through complicated algorithmic programming they could immediately buy a call option on that stock knowing that it would appreciate over the long run. Thus, they cancel out the short term loss, as well as gain tax deductibility on the whole process, because it is structured so that only the initial capital loss was recorded.

There are tax duties on broker commissions (0.5%), where you pay even when you complete a share transaction. However, there are ways you can classify your dealings as spread betting – in this case (but not for instruments like CFDs) you could be allowed full tax deductibility, as spread betting is classified under gambling.

Cross-border arbitrage. A company buys an option in one tax jurisdiction, where the cost of the option can be offset immediately against tax, so that any domestic capital gains tax is cancelled. Then, it can sell the option in a different country (at a net profit) once it has appreciated in value, but for this country it is not taxed when it sells the option for a gain – the only person taxed is the holder’s income when the option is exercised.

If carefully structured, options can also be used to create hybrid instruments that are treated as equity for rating and financial reporting purposes and debt for tax purchases (and thus you gain tax benefit on the interest paid, and you forget paying tax on the dividend paid on the equity). Hybrid bonds typically are issued as loan capital, but the issuer retains the right to exchange or convert the bonds into preferred shares with similar conversion rights and income. The purpose is generally to ensure that the bonds (as loan capital) are tax exempt of loan

interest, but could perhaps pay gross to qualifying investors, so they can gain from reinvesting elsewhere without having to pay capital gains taxes.

At the same time, the ability to change the bonds into cumulative or noncumulative preferred capital should mean that they pose less balance sheet risk. The issuer only achieves the best of both worlds if the hybrid bond is structured so that non-payment of interest does not constitute an event of default. Effectively a high tax-paying shareholder can benefit from the company securitising gross future income on the convertible, income which it can offset against taxable profits.

The ‘CoCo’, or contingent convertible bond. Any debt that you have can be converted into ‘contingent core tier-1 capital’, where all the debt you have sold to the bank can be redeemed if its equity capital falls below 5%.

Tier-1 capital is always tax-deductible.

CoCos are convertible into stock only when the price of the underlying shares rises sharply, and were designed to be excluded from calculations of Fully Diluted Earnings per Share of Common Stock, so thus you would be exempt from paying capital gains tax on them.

‘Dividend Wash’, a method of tax arbitrage. At its simplest, an institution based in, for example, Britain, agrees to lend its holding to an investment bank that has a subsidiary in country where tax is low, such as Luxembourg. Once the dividend is paid, the stock is returned to its owner and the two parties split any cash saved in the process. You bought securities and shares cumbonus and cum-dividend and sold them ex-bonus and ex-dividend. Dividends are tax-free and bonus shares are not considered as income. The fall in the share value after bonus and dividend results in a capital loss in respect to the original shares, which can be set off against other capital gains.

Broken Repo – here, you effectively buy a bond or some debt-related instrument in return for some payment in full towards a counterparty, say in shares, with the agreement to buy back those shares in the future.

However, through complex offshore

planning and the use of holding arrangements and accounting periods, you can ‘break’ the agreement. Then, the counterparty sells those shares on as a profit, not encountering any capital gains because legally the repo arrangement shielded it from tax. In terms of dividend payments, it also transfers these, which are not tax deductible, as it has sold the shares.

If we look at some classic cases of tax avoidance, we need not look further than the Rossminster affair, run by the two great Kings of the business, Roy Tucker and Ron Plummer, in the 1970s. I will elaborate on a few of these schemes, which were sold to investors. The first, in 1973/74, was the ‘non-deposit scheme version 1’.

It involved using Rossminster Acceptances, a subsidiary, to offer loans to the taxpayer client. He would pay the years interest upfront, to gain tax relief immediately. Then, Tucker would get another company to take over the loan the client had taken.

This would be at a lower price than the loan itself. Thus, the gain that the taxpayer made from being able to sell off his loan so quickly (in net terms, loan amount subtracted by the value of ABS) could cancel out all the interest he had paid earlier on that loan.

The next scheme, in 1974/5, used the same concept but this time the client of Tucker and Plummer had to borrow money to fund business, in order to hide from authorities like Inland Revenue. Basically, it went like this: 1. A firm borrows a large sum of money from a Rossminster Bank (here it was First London Securities). This is to pay some of your ‘loan for business’ as interest, and gain tax relief on that interest. You would lend that sum of money straight onto Tucker and Plummer; with an interest to pay of 20% (you still have the interest liability even though you have transferred it). Some money was paid to Tucker, and about £1000 was paid in as partnership capital.

2. Pay all the interest you owe from the loan for business – some of it is through your own resources, and some of it is through the money paid

4. The customer previously paid about £78,000 of the £100,000 interest owed. But, now a new finance company took over the customer’s loan of £600,000 for £522,000, releasing him from the interest liability to FLS for further years. Then, the customer withdrew £78,000 to recoup his cash.

So you kept the money for the tax, as well as earned money on it.

Through some extensive research and searching on illicit with held file-sites, I managed to read a copy of some of the correspondence of the SCM team. In this section, I will attempt to explain what was going on. The main companies involved were BB&T (Branch Banking & Trust Company) and ‘BarLux’, an offshore vehicle in Luxembourg set up by Barclays Capital. The opening statement of the proposal states:

Project Knight involves BarLux establishing a new UK limited partnership (“UKLP1”), which subscribes $4,000m for a limited partnership interest (the “Subscriber Interest”) in a UK limited partnership (“UKLP2”) established by BB&T. UKLP2 will

lend its funds to a company in the BB&T group (“BB&TSubS”). UKLP1 will agree to retire as a partner in return for payment from BB&T in 3 years’ time. Project Knight results in net funding of $4,000m to the BB&T group, which is fully collateralized with real estate and vehicle loans from BB&T and its subsidiaries. UKLP1 will receive an enhanced pre-tax return from its investment in the Subscriber Interest.

In this way, UKLP1 gained from the fact that its stake in UKLP2 gained an above LIBOR dividend yield, its borrowing rate or cost. In fact, it would gain an immediate yield of $270m from it, without any risk or issues. This would be deductible, because UKLP1 was issued by a Luxembourg domiciled holding company, in Luxembourg. The post-provision re-

turn on the whole Project Knight deal would be 15.6% and about $16bn would be saved. The portfolios of Lux HoldCo and UKLP1 comprised mainly of USD denominated government treasuries, where obviously yields would be tax deductible (this is a classic method used by banks).

Here is the structure for UKLP2, in which UKLP1 has a stake: Either BB&TSub3 or UKLP2 itself could, by agreeing with each other and thus passing the tax laws, cancel the loan. (UKLP2 has English tax laws, but BB&TSub3 benefits from being constituted in Delaware). Then what happens is that UKLP2 not only has a stake in UKLP1, but ends up joining a limited partnership. This also has tax exemption benefits. The subscriber interest would then finish after 3 years, after which UKLP1 would give up its stake to BB&T for a sum (the retirement amount, the calculation of which is rather complex). The whole retirement agreement is collateralized

by BB&T, with vehicle and real estate loans, as it acts on the part of UKLP2.

So, to summarize how Project Knight made money, we see the following: UKLP2 is making money through loan interest from BB&TSub3, which is deductible under the limited partnership rule. Then, UKLP2 repays the money it was lent by UKLP1, as well as gives the rest of its money back to BB&TSub2 and Sub1. Barclays gains by receiving a 1m USD Libor, and paying out a 3yr USD swap rate to BB&T – obviously a form of Interest Rate Swap which it could additionally profit from. Then, after 3 years, all this activity that UKLP1 has been doing will go off the books, as it would become purposefully insolvent after that point by the structuring team.

Due to the link between UK HoldCo and Lux HoldCo, there wouldn’t even be the 1% capital duty on the shares created in the links, under the ‘whole business contribution’ rule. 

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Knight Structured

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3. Another company was set up to give you an identical £600,000 loan (same amount as FLS), but this time it is interest free. That company would then take on the loan you received from FLS. It could also have an option to enter the partnership scheme (LLP, which had tax benefits).

Project Capital

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to Tucker (about £22,000 roughly).

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Film Finance: A star-studded earnings performance in 2009

fantasy-teen film rival, is mortal after all. The sequel film, New Moon, brought in $230.7 million in domestic gross after only 10 days in theatres, compared to the $250 to $317 million brought in by the Harry Potter films.

May the force be with you - the force to set prices, that is

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MARKETS

By Greg Silver

Historically, the mass media industry ecession, jobless claims, volatility; has been wrought with conglomerate all themes that have crossed the holding companies that control large headlines countless times since summarket shares. This integration at the mer 2007. Not so for the film industry. top has typically created a ripe enviSo far the industry has tallied up $9.5 ronment for pricing-power. Since the billion in revenue for 2009, and with dawn of the motion picture industry the holiday season still ahead of it, that in the early part of the 20th century, figure should easily surpass the annual there has been a feud between antirecord of $9.7 billion set in 2007. Box trust agencies and film financiers – office analyst Paul Dergarabedian put culminating in the landmark 1948 the odds for a record-breaking year Supreme Court Paramount Pictures bluntly, “we’re going to buzz past it.” vs. United States. The defendants, the Motion pictures have long been big-8 motion picture houses, which inregarded as products that can weather cluded Paramount Pictures, lost 7-1. economic downturns with solid sales.

Yet today, integration in the inWhen the consumer is tight for cash dustry seems alive and well. In No– possibly because the variable rate on v e m b e r, his mortgage Disney paid Hours Worked vs. Box O!ce Sales has gone up $4 billion or because he for Marvel has lost his job Entertain– he searches ment Inc., for substitute giving it leisure goods rights to a to compenlibrary of sate his deover 5,000 mand at a characlower income. ters. On 4 Since films December are a relatively 2009, Comcheap form of family entertainment, cast bought NBC Universal in a $7.25 box office figures remain buoyed. billion offer (90% cash, 10% other This year little Billy’s $300 famperks such as programming) to Genily trip to Disney Land will be suberal Electric. This deal was massive, stituted with, say, a $12 trip to see attracting advisory services from virtuAvatar – which is sure to be a better ally every bulge bracket bank includride than most roller coasters anyway. ing JP Morgan & Co., Goldman Sachs and Morgan Stanley among others. In Spellbinding Numbers terms of last year’s revenues, the assets acquired by Comcast would have Although aggregate figures may be grossed the company $51 billion – a impressive, the major spikes in receipts top-line that tops those of Walt Dishave more frequently been coming ney, Time Warner and News Corp. from fewer films. Summit EntertainThe deal is sure to turn a few heads ment LLCs Twighlight saga has alat the US Department of Justice. ready proven that Harry Potter, its Altogether, concentration at the

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top of the ladder is significant. In 2009, the sum of studio market shares for the 4 largest firms (commonly referred to as the “four-firm concentration ratio”) was a relatively high 60.6 percent, which by some standards would be comfortably referred to as oligopic.

A duel against digital On balance, however, record profits at the box office have not offset the severe decline in retail DVD sales faced by the distributors. Online media sites such as Hulu, Watch- Movies.net and other websites that offer viewers content through slightly “less-legal” standards, have inflicted collateral damage on the earnings of studios.

In 2005, the Motion Picture Association of America found that the industry lost $18.2 billion due to piracy. Reports like this one have motivated industry players to take legal action against peer-to-peer sites. TorrentSpy, a website that formerly hosted peer-to-peer sharing services has since been shut down due to a successful lawsuit against it by the M.P.A.A. However, the most such a ruling can do is set a precedent, since there are dozens of other online services that perfectly replicate those of TorrentSpy. Big production houses have come up with a variety of ways to fight back. One such method being used is the development of a licensed interface, Movieclips.com. Using different tactics, production company Troma Entertainment, known for its often-quirky operating decisions, has recently used humor to ward off users of pirated material. The company’s president, Lloyd Kaufman, has plans to create a deluge of fake versions of his films to be released online. In his words, the company will “combine five minutes of the film with an old Tarzan movie and we’ll see what happens.”

A dessert of liquidity for independents Though director James Cameron was able to fund Avatar, which has footed a bill of over $450 million, and will set the record for the most expensive film

Special Report

By Channy Wong

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ith the credit crunch rattling financial markets across the globe, private equity firms in the U.S. and Europe are finding it hard to tap the credit they need to fund their acquisitions. These funds are expected to remain stagnant in the years to come. In contrast, private equity in China has got back to the growth track, with RMB funds (the Chinese currency) leading the trend.

“More than 190 funds denominated in the Chinese currency, with more than $30 billion in combined capital, have been established during the last two and a half years.” according to Ze-

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A revolution in the Chinese private equity market

ro2IPO, a Beijingbased research firm.

A few weeks ago, Stephen A. Schwarzman, chairman of the Blackstone Group, the world’s largest private equity firm, signed a joint venture with Shanghai’s municipal government, creating the first Blackstone fund denominated entirely in RMB. This $732 million fund, together with the recently opened ChiNext Stock Exchange and the new legislation allowing the formation of Limited Partnerships (LP) by foreign private equity firms, all seem to indicate a revolutionary change in the Chinese private equity market.

Even before such significant changes in the legal system, global private equity firms have been striving to raise funds in RMB. Dollarbased investors are increasingly at a serious disadvantage in China’s private equity industry: investing is more difficult and deals take longer to close than competing investors with access to RMB. From the supply side’s point of view, China is definitely a good place to raise capital. With an expanding group of high-net-worth individuals and enterprises in China, the Chinese capital market is now flushed with cash that needs a channel to invest. The demand side factors are mostly driven by the government policy. As investing in large size corporations in China is often costly, most of the best opportunities come in the form of small and medium size enterprises (SMEs), with purely domestic structures, meaning they cannot easily raise equity in any other currency except RMB. However, Chinese banks loan much of

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rate of return of over 434,000 percent (original production costs were $15,000 and most recent revenues stand at $65 million). For the Weinstein Co., being strapped for cash appeared to be quite a blessing in disguise after the production company brought in 12 nominations at this year’s Golden Globes.

What all the producers want to know is how the Weinstein brothers are managing to pull off their impressive escape from financial insolvency.

Cofounder Harvey Weinstein cites the fact that “Everybody is making movies about toys. I am and want to make movies about people.” If the company can continue on this kind of streak, and US unemployment stays above 10 percent, there should be plenty of pleasurable moviegoing opportunities for little Billy and his family. 

The shoestring budgets that have become the new normal have resulted in a type of Schumpeterian creative destruction for the industry.

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ever made (just after Mr. Cameron’s prior blockbuster, Titanic), lower budget movies are finding it very difficult to gain funding. Smaller production companies, such as the Weinstein Co., that used to provide the core financing for independent pictures have resorted to extreme costcutting efforts as well debt restructurings. Goldman Sachs had originally projected the company to earn $160 million in profit and to release 30 films a year. Next year it is slated to make between 8 and 10, that is, after it restructures $600 million of its debt.

Angel investors and specialist film finance firms such QED International, have stepped in to provide lifelines to the liquidity scarce independents.

Sarah Siegel- Magness, heiress to the tea company Celestial Seasonings, recently decided she wanted to become a film financier by committing $12 million to the risky new film Precious.

The movie is about an obese AfricanAmerican woman and includes undertones of incest. The Director of the film, Lee Daniels, has stated, “No way, no studio would make a film about an overweight black girl.” As this alternative form of financial backing gains in popularity, it is likely to result in the production of more racy films, like Precious, that do not require the approval of corporate executive producers.

The shoestring budgets that have become the new normal have resulted in a type of Schumpeterian creative destruction for the industry. Adam Goodman, CEO of Paramount Pictures, has devoted $1 million of the company’s resources to finding 10 to 20 films annually films costing under $100,000.

In 2009, rates of return on a multitude of low-budget films, such as Paramount’s Paranormal Activity, have risen well above industry standard hurdle rates: Paramount’s goldmine picture achieved a paranormal

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their money to stateowned enterprises (SOEs) instead of these SMEs. This is because many of the banks lack the necessary tools for analyzing the credit risks of developing companies.

Adding to the point that most startups lose money for years before becoming profitable, making fixed debt payments is difficult to bear. It turns out that their only possible source of capital comes from private equity. With both supply and demand sides’ factors standing strong for nearly a decade, one might wonder why such a revolutionary takeoff of RMB denominated funds has not occurred until now.

Indeed, not until this year did the Chinese government start to relax the restrictions on foreign investments in local enterprises. In the past decade, only Chinese investors in onshore RMB funds could opt for the limited partnership structure, which offered tax advantages and caps on liability.

To get around government restrictions, the foreign funds helped the Chinese companies create offshore holding companies, putting the deals largely beyond the reach of Chinese regulators. However, these non RMB denominated funds often had to go through tedious procedures in order to get the stocks listed in another market, which significantly lengthened their exit time. Under the new regulation, which will be put into place in March 2010, foreign investors will be permitted to set up limited partnerships in China either on their own or with local partners, allowing them to raise RMB directly.

“As for venture capital enter-

prises and private equity funds, we still lack necessary knowledge regarding whether there are big risks, what the risks are and whether strict rules must be adopted,” the State Council said in a statement explaining the new regulation. Though it remains unclear how far reaching such a move will be, the door for foreign private equity investments in China is half opened.

Soon, state-controlled banks, insurance companies and pension funds could be allowed to invest through these foreign private equity firms.

Regulators have already made it easier for private equity investors to take pre-I.P.O. stakes in private companies that plan to go public in China. The launch of the ChiNext, a Nasdaq-like exchange recently opened in Shenzhen, increases the flexibility and convenience for private equity firms by providing an additional IPO channel. In the third quarter this year, 85% of the PE funds listed their investees in the stock exchange as an exit option. It will also promote the fundraising of RMB funds, facilitating the industrial upgrades of VC investment and truly realizing the “domestically raised, invested and exited” cycles of internal capital.

“Now, many entrepreneurs are starting to turn away from foreign currency funds,” Mr. Wang at China Equity said. “They say they can

take an RMB investment and not go through a lengthy process to list offshore. And they see the Shanghai or ChiNext exchange as viable listing places.” Although analysts warned that the stocks going listed on the ChiNext might be overbought by the fervent investors and an opening policy to foreign investments might pose excessive liquidity to the Chinese capital markets, Chinese entrepreneurs now have more choices over whom to form alliances with. The Chinese private equity market is going through an unprecedented transition from offshore to onshore.

These changes are not only beneficial to global private equity firms, but are also of immense importance to the Chinese economic structure.

As an ostensibly communist country, China has been struggling to reach a more balanced structure of its growth factors, i.e., shifting from an economy driven by government spending to private sector spending. The new system could reshape the way capital is allocated in China and serve as another step in the country’s transition to a more market oriented economy.

At the same time, a new play of global currency trade is under rehearsal, which is expected to put onto stage in the foreseeable future. If it were easier to invest in China in its own currency, there would be less need for the Chinese government to import dollars by buying U.S. Treasury bills.

It would also mean a growing international stature of the Chinese currency.

“Now, more and more deals are being done with local funds,” said Wang Chaoyong, chairman of China Equity, a large private equity firm based in Beijing. “Even internationally invested companies are switching to local currency.” Revolutions are nothing new in China, and it appears evident that a new one is currently under way in its market for domestic private equity. 

The Chinese private equity market is going through an unprecedented transition from offshore to onshore.

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s the ruckus over the apocalyptic ‘end of the world‘ for Wall Street banks quickly turns into a story of recovery, perhaps it is time to turn the spotlight onto its microfinance counterpart. When the term “microfinance” was initially coined it was primarily associated with NGOs, but as the concept gained ideological prominence and geographical breadth its structures also went through changes.

Many microfinance institutions (MFIs) have gradually moved towards becoming commercially-orientated and fully regulated establishments. This shift to a market-based competitive model offers a myriad of funding sources such as commercial banks and Microfinance Investment Vehicles (MIVs) to name a few. However, with the increased integration into the world‘s financial system comes higher risk, essentially, MFIs have been more affected by this crisis than by any other.

Based on the research of a project of the Student Microfinance Development Initiative (SMDI)- an NGO led by LSE students, this article will highlight effects of the credit crisis on MFIs and what this can tell us about their optimal structures. Finally, it

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By Priyanka Verma

The crux of the problem lies in refinancing risk (the ability to borrow to repay existing debt) that MFIs are facing from tightening liquidity. As the inter-bank rates increased and the global credit markets froze, so has the supply of money from international and domestic banks and investors who are ever more risk averse. In a time when ‘managing risk‘ has become the new buzz word it is no surprise that lenders are being cautious- after all microfinance still has counterparty risk and country exposure. This risk along with restrictions in raising cofinancing for MFIs with other donors is also deterring International Financial Institutions (IFIs) from providing funding. However, organisations that are lending are doing so at very high prices, with steep rates being reported from 250 bps in Eastern Europe, 400 bps in Latin American countries and up to 450 bps for top tier institutions in South East Asia. The hardest hit are the non-deposit taking MFIs who rely more heavily on these sources of funding. Unfortunately, this is not just a short term problem, most banks and investor funding of MFIs is of a one to two tenor, therefore, as loans come to mature in the end of 2009 and 2010 the refinancing problem will be equally relevant.

Perhaps the more profound question lies in determining who should bear these rising costs- should MFIs pass it on to their clients or incur higher operating costs themselves? In many cases MFIs have refrained from the former as it conflicts with the social objectives of providing financial services for the poor, but in doing so they are jeopardizing their own survivability. In fact, some MFIs are using cash originally reserved to make loans to service maturing obligations, putting them in a Catch-22. By reducing their loan portfolios, MFIs will need to postpone renewing loans which would destroy a key incentive in ensuring borrower repayment. As per an MFI in Rwanda,

needed liquidity into the microfinance industry. Additionally, the Microfinance Investment Vehicles (MIVs) have proven to be resilient to the credit crisis. They have grown by an average of 31%, and 5 new funds have already been created recently with a portfolio of 75% debt and 25% equity. In a 2009 MIV survey by State of Microfinance Investment it was indicated that MIVs plan to increase investment by at least 0.7 to 1 billion in 2009.

Foreign Exchange One of the largest sources of recent loss for MFIs has emanated from foreign exchange. Roughly 70% of MFI cross-border borrowing is denominated in hard currency, which is coming under pressure both from interest rate hikes and currency depreciation. At the start of 2009, local currency exchange rate against the dollar had moved down up to 20% and losses from FX over the past few years have been up to 7% - 43%1 (one Latin American MFI reported a 75% loss in one year).

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Refinancing Risk

clients are defaulting on loans as they lose hope of receiving new ones. This will deteriorate their repayment history and could potentially deter them from receiving loans in the future. Either way, the clients of the MFIs seem to be the ones who will suffer the most.

There does seem to be hope though, coming mainly in the form of Development Investors (DFIs). These DFIs alongside government agencies have been providing much of the

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will assess the future opportunities that have emerged for the industry.

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The effects of the financial crisis on microfinance institutions

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This is relevant primarily because of the role FX plays in DFIs, many of which will have foreign currency denominated loans as a large portion of their equity base. For the dollarized economies of Latin America, such as Ecuador and El Salvador, this will not be a problem, but the bulk of Latin American MFIs are actually in the countries whose currencies are decoupled with the dollar.

Eastern Europe is also at risk since FX exposure tends to exceed equity.

Considering the potential scope of this analysis, solely the two most pivotal effects of the crisis have been reviewed, though they are two amongst many. Suffice to say that many of the other components are integrated in the two afore-mentioned issues of refinancing and foreign exchange losses.

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Optimal Structure What does all of this tell us about how MFIs should best structure themselves? From the outset it is important to stress that there is no universal model and that much will depend on regional aspects. However, there are still key trends that are worth noting: the advantages of the deposit-taking model have resoundingly emerged.

Nevertheless, there are differences in the stability of certain types of deposits. In fact, much of the research points to a more ‘localised’ structure, which is perhaps counter intuitive to what many MFIs aimed pre-crisis.

Large institutional deposits are more volatile than local retail deposit. For

example, following the announcement of Lehman Brothers many MF Banks in Eastern Europe and Central Asia saw a steady withdrawal of deposits.

Instead domestically powered sources of funding are being advocated. Never to be under-estimated, savings also play a crucial role because they are in the local currency. Additionally, diversification, as in mainstream finance, is essential to managing risk in MFIs. The top-tier MFIs were less affected due to their diverse portfolio of funds and developed operating models.

While growth plans may need be adjusted downwards to more conservative levels, the relationship between borrowers and MFIs remains a cornerstone. MFIs must honour their implicit contract to give follow-on loans, as failure to do so will lead to a spiral of decreasing motivation of borrowers to repay and increasing delinquency rates.

Case studies of African and Latin American MFIs are particularly relevant to this topic. The African economies have not experienced the full impact of the crisis because African banks are significantly less integrated into the international financial system. Additionally, many African MFIs are savings led institutions, greatly reducing their exposure to the credit crunch. BBC‘s Martin Plaut has gone as far as to say that Africa may come out of this crisis ahead because of its conservative banking. By contrast, Latin American MFIs are being affected and responding by reorganising their funding structure. A sample of 10 deposit taking MFIs in Latin Amer-

ica has shown a decline in commercial deposit taking, a decrease from 10% to 2% in subsidized funding and an increase in deposits from 50% to 69%1.

Where to now?

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Once the proverbial dust settles, there will be an opportunity for what some have called an over-heated microfinance industry to introspect and improve. Better quality portfolios, risk management, infrastructure and more efficient operational models will be brought to the forefront. The long overdue consumer protection measures will also be accelerated. Deposit insurance will be extended to more MFIs, at it is an essential safety net.

Although many are already covered by a scheme, they increased their coverage in 2008 and broader mandates will also bring more MFIs into the scheme. Additionally, consolidation in the industry will mean that the MFIs that remain are healthier and perhaps will lead to a more robust sector.

Microfinance‘s previous tendencies to bounce back faster than commercial banks may give their Wall Street counterparts reason for envy.

Experience from the Bolivian crisis of 2000-2002 demonstrates that because borrowers tend to be micro-enterprises or small family businesses that are more flexible with their products and services, allowing MFIs to recover quicker.

However, this crisis has been like no other, and with the recent market rally and investment banks showing profits again, the next few months will be crucial in paving the road ahead.

Perhaps the greatest advantage MFIs have over Wall Street is its untapped client base since solely 10% of potential clients have been reached out to.

Though the crisis may have consequences on the scale of microfinance‘s growth, rather than risks or losses this is perhaps an ideal opportunity for the sector to consolidate, in view of making sustainability their focus: reviewing portfolios at risk, monitoring systems and transparency. The trade off is there: scaling or robustness? MFIs seem to have decisively chosen the latter. 

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and mainly used to avoid recessions, thereby encouraging excessive borrowing, as investors are denied the opportunity to learn that their excessive borrowing is indeed, excessive. Therefore, the debt stock is fuelled and financial instability ensues.

The Efficient Markets Hypothesis is largely fallacious and a scrutiny must be placed upon the asset market to help unravel the market inefficiency and instability that lie within the financial markets.

Within the asset market, borrowers take out loans from banks to obtain their desirable assets, such as property. There is an uncertainty among banks as to the likelihood of repayment and loan defaults. Therefore, banks collateralise loans to tackle this problem. Collateralisation is a process whereby banks grant a loan to a borrower, and in return, they take control of borrower’s asset, of which the value is comparable to the loan, in order to

Today, expansionary demand management policies are preemptive and mainly used to avoid recessions...

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The Efficient Market Hypothesis constitutes the fundamentals of finance. It states that financial assets are priced correctly, reflecting all information available at a given time period, thereby making the corresponding markets efficient. Therefore, efficient markets should be able to adapt to exogenous shocks.

It is worth highlighting the shortcomings of the Efficient Market Hypothesis, in particular during a recession, as the principles of the Efficient Market Hypothesis become inconsistent with the actual market conditions, such as during the Credit Crisis. This in turn leads us to a more plausible explanation, which is that the financial markets are inherently flawed. This is known as the Financial Instability Hypothesis, of which the Credit Crisis epitomises in its notions.

Let‘s begin with the introduction of the asset market. It forms an indispensable foundation of this work, as it illustrates the differences in market individuals’ behaviour between an asset market and a normal market for goods and services.

The fundamental difference between asset markets and normal markets for goods and services is that investors seek assets with a degree of scarcity value, one for which supply cannot be increased to meet demand. Thus, they can benefit from the profit. By inference, a rise in price signals to investors that the asset has become scarcer and it is the lack of supply that stimulates demand.

The Efficient Market Hypothesis calculates the entire probability distribution of potential future asset returns by inferring the manner in which asset prices move. The underlying premise of the Efficient Market Hypothesis is that asset prices are always correctly priced, based on both current economic conditions and the best estimates of how these conditions will evolve in fu-

esis and dismissed the notion of asset price bubbles, embraced demand management policy and frequently slashed and raised interest rates. This was reinforced by the regime of Alan Greenspan, as he steered the United States safely through a series of financial shocks from the 1987 crash to 9/11. Today, expansionary demand management policies are pre-emptive

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By Thomas Ng

ture. Only external shocks can cause asset price movement, such as the streaming of new information. Nevertheless, the problem of fat tails occurs, meaning that the theoretical statistics estimated by the Efficient Market Hypothesis do not match with those observed within real financial markets.

The figure on the left presents normal distribution with a solid line and fat tails with a dotted line.

Since assets are assumed to always be correctly priced and reflects all information available, the Efficient Market Hypothesis dismisses the idea that an economy can create asset price bubbles and excessive levels of credit, and that any economic expansion is regarded as a sign of an economy moving towards the hypothesised state of stable equilibrium. Furthermore, it is patently true that deviation from the equilibrium is short-lasting because according to the Efficient Market Hypothesis, the self-generating market forces will always bring it back to the equilibrium. Therefore, any economic contractions, from the perspective of central banks and government, are not viewed as free market processes and should therefore be counteracted by stimulus policies. This leaves us with an inconsistency concerning the ability of efficient markets to adapt to external shocks without stimulus policies because if the market itself is efficient, it should be able to adapt to external shocks and without any help, restore its equilibrium. So, should we blame the central banks and government for making the markets inefficient?

Interestingly, the U.S. Federal Reserve, which traditionally adhered to the Efficient Markets Hypoth-

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Endemic instability in the inefficient markets

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14 liquidate the assets for repayment of the outstanding loan. In addition, a method known as mark-to-market is used by banks to check the value of collateral against the prevailing market prices for the assets. The latest collateral valuation is then checked against the bank‘s outstanding loan. In the case of an under-collateralised loan, which means the value of corresponding collateral has fallen relative to the loan, the bank will require additional assets to be provided in order to secure the loan. Alternatively, the banks can charge higher interest rates. Now, the borrower is devastated by falling asset prices and rising interest rates.

The solution is to increase his liquidity by selling off the assets he has, so he can pay off as much of the outstanding loans as possible before the asset prices falls again. This briefly depicts the asset market, as asset price declines prompt asset sales, which in turn prompt more price declines, thereby creating a vicious circle.

On the contrary, everything reverses in the opposite direction.

Unlike normal markets for goods and services where higher prices trigger lower demand, in the asset market higher prices trigger higher demand.

This process of collateralisation gives rise to destabilising forces in the financial markets, which evolve into a boom-bust cycles with a continuous disequilibrium. We can now see that the Efficient Market Hypothesis does not hold anymore, while the inherently unstable forces within the financial markets seem to be consistent with

the Financial Instability Hypothesis.

The Financial Instability Hypothesis was theorised by Hyman Minsky. It is built upon the premise that financial systems are inherently unstable.

There are two internally-generated destabilising forces, which are the lack of supply and change in asset price, which affect demand, in turn causing further price movement.

Minsky identified three types of financial strategies. Hedged finance refers to situations where firms have cash flows that suffice to cover the service payments on their debt, which are

sets will appreciate and eventually, this will help them to refinance the debt, but cash flows are still insufficient to meet interest payments, so firms have to accumulate additional debt over time. Minisky also believed that individuals are irrational and tend to overreact at extreme times. During periods of strong growth, firms find it easier to repay debt, so they borrow more. Not only does this alter the financial strategy of firms, i.e. from hedge financing to speculative financing or even Ponzi financing, but it also helps fuel excessive credit expansion, which in turn facilitates into bubbles such as the housing debacle of 2007. Eventually, when a large default occurs, business confidence plummets and banks incline to pull back too much by restraining credit. Firms that engage in Ponzi financing suddenly find themselves in a situation where they lack the liquidity to keep them afloat. Panic selling of assets such as a fire sale takes place and drives down asset prices. The financial condition of indebted firms deteriorates, as the real value of assets fall relative to nominal value of debt, which is fixed.

Central Banks, as lenders of last resort, should fulfil their responsibility and be ready to bail out banks to an extent that it will not encourage excessive speculation by institutional investors in future. In fact, one may argue that the financial system becomes more prone to moral hazard as a result of the interference of the central banks, because when borrowers are granted a loan, they realise that they need not share any gains from the activities with others. Thus, it is of their interest to engage in riskier behaviour than they otherwise would.

However, this is why it is imperative for governments to strictly monitor and regulate the financial system in order to minimise financial instability as a result of speculative financing and Ponzi financing. The role of the governments cannot be downplayed. 

In fact, one may argue that the financial system becomes more prone to moral hazard as a result of the interference of central banks...

This process of collateralisation gives rise to destabilising forces in the financial markets, which evolve into a boombust cycle with a continuous disequilibrium. We can now see that the Efficient Market Hypothesis does not hold anymore, while the inherently unstable forces within the financial markets seem to be consistent with the Financial Instability Hypothesis. the interest and principal payments.

Speculative finance is where firms have cash flows greater than interest payments, but is insufficient to cover the principal they owe. The last type of financial strategy is Ponzi finance, which is the most risky. It occurs when Ponzi borrowers believe that their as-

Past performance does not indicate future performance: An Investment Outlook

15 percent, (1-a), of the portfolio at the risk-less rate, and invests the remaining percent, (a), in the optimal risk portfolio. As Professor Shiller has explained in his undergraduate teaching at Yale University, what really matters is not arguing for or against portfolio theory, but rather analyzing the valid-

which usually implies lower equity returns, and with the added shock of the recent crisis, volatility may remain near historical averages, but not below; thus, this analysis of expected returns and volatility, suggests a reduction of US equities in the optimal risk portfolio in favour of other assets

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By Andrew Slusser

and/or regions, such as bonds, commodities and the emerging markets.

At its core, portfolio management is truly about estimating where these parameters will be in the near to far future, and today, the expected returns of international equities seem to have a more promising future than US

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ity of the parameters, standard deviations of returns, expected returns and covariance of returns of assets, that go into building the minimumvariance frontier, efficient frontier.

Take today. A mature market in the United States sets the stage for lower than normal GDP growth,

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nvesting today or at any time requires a thorough understanding of portfolio theory, macroeconomics and psychology. And Confucius once said, “study the past if you would divine the future” thus, economic history may say a lot about how markets and economies will behave in the future.

Portfolio managers seek or should seek to allocate capital according to Harry Markowitz’s famed portfolio theory. Faced with risk and risk-less assets, an investment manager allocates a percent, (a) and (1-a), into risk and risk-less assets. Portfolio theory suggests that the efficient blend of risk and risk-less assets occurs at a tangency point along the minimum-variance frontier, where the portfolio manager, lends or borrows a

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16 equity securities, as a widely agreed upon estimate of expected return.

Understanding the fundamentals, price to earnings ratios and macroeconomic valuations, is however not enough, for valuing these parameters.

It is logical to expect higher growth in the emerging markets namely in China, India and South East Asia, but in normal times and especially in times of crisis, market psychology needs to be understood in order to value financial assets. As Keynes wrote about ‘animal spirits’ in The General Theory and Kahneman and Tversky formulated in Prospect Theory, humans act irrationally and not according to simple probability-weighted expectations. Humans are optimists, by nature, and thus, their collective behavior produces the booms and busts that have become so normal to everyone.

Economics and economic history also suggest over/undershooting in an economy as business cycles occur quite frequently, and furthermore, most crises over the previous 150 years have been monetarily induced. Excessive credit expansion in the United States largely caused the over building and speculation in businesses and railroads, which culminated in a run on banks across the United States and the New York Stock Exchange to halt trading in 1873. One only has to fast-forward to the extension of credit to US subprime borrowers and the securitization of misunderstood and mispriced risk, which caused the most recent market crisis.

But since the latest fall in financial assets globally, equities have rallied over 50% off their lows while fixed-income securities are as expensive as ever, in the Treasury, MBS and Corporate bond markets, which is somewhat of an anomaly altogether. As if to say, which market is right here? The equity or the bond market?

So if one is truly to understand the percent, (a) and (1-a) of risk and risk-less assets to hold in a portfolio, an objective sense for market psychology and where average market sentiment goes next is compulsory. The Fed will keep rates on hold for ‘an extendedperiod’, and thus in an effort to reflate

the economy through asset prices, the Fed is hoping for labour markets to unclog, business activity to increase and most importantly for consumption to increase. It is true that asset price reflation will through the wealth effect increase consumption; however, unemployment and depressed wages, will work to dampen this effect. The opportunity cost of consumption remains historically low with zero-level interest rates, but the net effect on consumption of (1) asset price reflation, (2) low opportunity cost of consumption and (3) depressed wages and high unemployment, remains negative.

With asset prices rich globally, in fixed-income, commodities and equities, investments must remain guided with caution in the financial markets.

If the labour market fails to see improvements in the United State there is no chance for recovery and this equity market rally will reverse. In a deflationary environment, the present time, fixed-income securities and high paying dividend stocks remain prudent investments, and it is recommended that investors pursue such strategies. There is nothing wrong, however, with riding the trend, and as more money market and cash funds enter risk assets and provide liquidity, markets will continue to trend upwards. Commercial real estate remains a thorn in the side of the economy as it has been affected by lower asset prices, high un em ploy ment, falling rents and tight credit.

If history is any guide to the future, than those assets which are most out of favour and distasteful to the mar-

ket, present buying opportunities.

In general, seek high-dividend paying stocks as the deflationary pres-

sures of the labour market should continue to make these investments attractive. Staying with the current trend cannot hurt unless standing at the precipice, which seems unlikely considering accommodative Fed policy. And as always- invest in companies with good long-term prospects, honest management and at an attractive price; such a formula allows the investor to focus on value and manage emotion. 

rench economist Olivier Pastré said “It wasn’t Dr. New Deal that cured the Great Depression, It was Dr. WWII”. Indeed, nothing helps an economy like selling weapons and exporting military technology. The Anglo-Saxon economies have spent the last decade criticizing France’s penchant for creating and supporting ‘National champions’, they may be forced to eat their words as French weaponry sales soar off into the sky.

Last week, French Defense Minister Hervé Morin ordered 60 new ‘Rafale’ fighter Jets from one of the world’s leading armament companies Dassault Aviation. Each ‘Rafale’ is reported to cost around €50 million, allowing Dassault to rack in a neat €3billion in revenues for a year that hasn’t been too bad overall. With analysts estimating its net profits to be around €400million for 2009, Dassault Aviation may be able to face off the multiple cancellations from its commercial airline customers if governments keep on buying up its fighter jets, Dassault CEO Charles Edelstenne spoke to French financial revue ‘Les Echos’ earlier in the year “2009 has been a tough year for our commercial airline divisions, but we are predicting strong signs of growth in all our military and armament technology divisions”. The European Aeronautic Defence and Space Company (EADS) a large Franco-German technology group was recently awarded a lucrative contract making it the sole provider or anti-aircraft technology to the South Korean government, Bloomberg reported this deal being worth over €7billion.

There are also signs that the Saudi Arabian government, usually more partial to US armament giant Lock-

The French have a long ingrained tradition of voraciously supporting their ‘National Champions’...

The case for commodities and currencies in 2010

By Tracy Wu

O

ne of the most defining economic trends for the year of 2009 was the continued steep decline of the dollar. Since a large portion of commodities are denominated in U.S. dollars, 2010 should be a good year to invest in them if the dollar remains at a lower level. Will the greenback go up in 2010? How the dollar will affect the world economy and the commodity markets still remains a concern for many investors through 2010.

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voritism (this paid off big time when Sarkozy and his wife C.Bruni flew over to Egypt in EADS private jets).

Ever since 17th century Finance Minster Jean Baptiste Colbert, France has carried on practicing protectionism in more intelligent ways than most, it’s no co-incidence that it has produced worldwide leaders in energy, luxury and now armament. However the close link between state and business has produced some undesirable effects, namely huge corruption scandals and conspicuous illegal arms dealing with rogue African States.

Yet it is undeniable that EADS and Dassault Aviation are going to carry on supporting millions of French workers and contributing to the French economy. Les Echos estimated that EADS contributed over €30billion worth of revenue for the State in 2008 (job creation, corporate taxes etc…). 

MARKETS

By Leon Beressi

heed Martin helicopters has placed a stealthy order for European Aeronautic Defence and Space Company (EADS) new H-72A training helicopter. Boeing executives were outraged last week as US Military revealed plans to buy over 216 H-72A’s between now and 2016. An anonymous Boeing executive was quoted in the Herald Tribune as saying “I deplore these unpatriotic actions, once again US jobs are put in second place”, maybe what he really meant was “Obama was played to protectionist for the automobile industry, can’t he do the same for us?”.

The biggest British weapons company BAE Systems is currently jockeying the Saudi Arabian government to get back its contract that EADS stole in June to provide the Saudi military with its new Mobile Arial Refueling Technology (A plane that can provide re-fuelling services to smaller fighter jets whilst on missions).

So why have French weapons companies been doing better than their US and UK counterparts?

And what are the broader implications of this for the French economy?

The answer to the first question is simple; the French have a long ingrained tradition of voraciously supporting their ‘National champions’ even if it means digging deeper into the public finance’s burned out pockets. Sarkozy gave EADS sole rights to supply the French military with all types of fighter aircrafts in 2008. This has allowed EADS to get through all its trials and tribulations concerning the delays with the Airbus A380 and its failed oil tanker projects. French protectionism has actually helped its main weapon companies stay competitive by giving them an incentive to increase their research and development of military technologies. EADS invested over 30% more in military research since the credit crunch in 2007 thanks to Sarkozy generous fa-

The greenback In 2010, the dollar will continue to be the center of focus. The dollar index declined sharply from its peak in March 2009 at 8962 to its low of 7417 in November. The index slid 17.24% between March and November, the largest decline for the dollar in any eight-month period since 1986. The main force that drove down the greenback was the near-zero interest rate

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French armament sector flying high

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18 many other investors anticipate that the dollar will become devalued, ultimately triggering inflationary tendencies.

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Gold

policy adopted by the Federal Reserve.

The strong economic recovery in areas including Asia and Latin America has led Americans to invest more heavily in overseas markets; about $46 billion were invested in overseas markets. Investors also pressured the dollar by using carry trade strategies. This involves borrowing US dollars at lower interest rates, investing in vehicles with higher yields, such as commodities, and in currencies with higher interest rates, such as the Australian dollar.

However, some investors like to invest in exchange-traded funds that mimic actively traded currency funds.

These funds apply the momentum trading strategy, which attempts to read the immediate direction of currency markets, buy the currencies with higher interest rates, and sell those with lower interest rates. The basic idea of the strategy aims to follow the trend in the market than to move against the trend. The momentum strategy worked well in 2009, but not in 2008 when the market turned against the trend unexpectedly. The expected volatility conditions in 2010 will make it difficult to execute momentum trading strategies as well.

At the end of 2009, the crisis of the Dubai World bond caused investors to reconsider investment in the dollar. The U.S. dollar rose 2.5% consequent to the crisis. Some investors now anticipate more dollar rallies in the coming year, as they believe that U.S. is on the road to recovery, though the climb may be bumpy. However, the Federal Reserve has been increasing the money supply dramatically, so

If the dollar continues to decline, the best investment may be gold. In general, people believe that investing in gold may safeguard their capital from high inflation, especially from the current turbulence in the world economy. The best way to participate in the commodity markets is through professionally managed funds, such as SPDR Gold Shares ETF. It owns gold bullion directly, and costs only 0.45% as the expense ratio fee. That fund has a cumulatively annualised 3 year return of 21.07%.

Energy The most attractive aspect of commodities is probably they all seem to be very tangible, that is, a trader could, in theory, actually take delivery of the product. Historically, commodities have seemed to be a better short-term hedge against temporary currency inflation than a good long-term investment. If we look at a portfolio consisting of only corn, it only gives you a 2% annual return if you invested since 1930. To leverage commodity price movements, some investors would invest in the S&P CTI index, which follows short-term trends in commodity futures.

The International Energy Agency (IEA) projects that global oil demand will rebound in 2010 by just 1.7%. There is stronger demand growth in the countries that are not members of the Organisation of Economic Cooperation and Development (OECD) than in the more industrialized western members. The non-OECD oil demand forecast for 2010 is estimated at 40.0 million barrels/day, a gain of 3.5% per annum,

close to levels seen in previous years and following zero growth in 2009.

The OECD oil demand is estimated at 45.2 million barrels/day, a gain of just 0.2% over 2009. This is due to the gradual economic recovery in most of the countries. “Nevertheless, the engine of growth will arguably be North America, as the recovery in Europe and the Pacific is likely to be slow,” write IEA economists.

However, crude oil is quite a volatile investment. Crude oil prices reached a record $147.27/barrel in July 2008, and a year later, they were less than $60/barrel in New York.

The latest IEA report says there are still many growing concerns about the path of economic recovery. This fact will likely deter investors from purchasing and investing in crude oil and its downstream products.

Supply and Demand Supply and demand are the main factors that affect the price of commodities. Though there is an increased demand for commodities, it is still hard to develop the infrastructure to drill for more oil, or exploit soil to grow more corn. Figuring out where the shortage of supply is the main challenge.

Jerry Jordan from Jordan Opportunity Fund, has beaten 99% of its fund peers in the past three years, because he had a 25% exposure in commodities with supply levels that are difficult to increase. He recommended offshore drillers Transocean and Diamond Offshore Drilling. “These offshore drilling companies are trading at ridiculously cheap levels relative to the value of their assets,” he says.

A good indicator of commodity prices could be Chinese property stocks, such as the Shanghai Composite Property Index, which consists of 33 Chinese real estate and construction companies. It is widely agreed that China is one of the nations that with the strongest demand for commodities, and it stimulates its economy through real estate and infrastructure construction. The 33 company stocks listed on the index are sensitive to prices and are the first to detect inflation.

h e ”

The history and future of gold

a s n e . e e t d

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d r e . d e t e g y

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d t y e s .

By Edward Chai Kien Poon th November 2009 saw gold rocket to a historical high of $1100. Ever since the price of gold broke through the significant, psychological resistance level of $1,000 per ounce in September 2009, there has been a series of heated debates between gold experts in the investment industry making predictions on the future price of this shiny and expensive commodity.

Gold is a precious metal of rarity, and has been used as a form of currency throughout the ages of history from the Lydians (the first civilisation to invent coins according to the Greek historian, Herodotus), to the Persians, the Romans, the ancient Chinese, right down to the present day of modern capitalism in the 21st century.

Despite the abolishment of the gold standard in 1973, Central Banks all across the world, notably China and Russia continue to demand for gold to build up their currency reserves which has also been widely regarded as a safe haven by investors during times of political and economic unrest. For instance, during the 1940 invasion of France by Germany, it was possible for refugees fleeing from the invading Germans to trade in their gold for petrol when paper money was deemed worthless.

Fo l l o w ing the recent economic crisis, institutional investors traders have become more risk averse, preferring lower risk and lower

But the question remains. Will this rally continue or will it be a short lived illusion?

In general, most gold watching experts are of the opinion that the bull rally will tend to continue for some time.

Goldman Sachs Investment Strategy Group noted in a report dated the 31st May 2009, ‘just like crude

oil in mid2008, if enough people worry about the dollar and inflation, momentum can carry gold to much higher levels beyond any measure of fair value.’

“Gold is not at any peak. The world’s money supply has increased and gold hasn’t kept pace. We’re now in a period where gold is catching up,” said Martin Murenbeeld, chief economist at Toronto based DundeeWealth Inc., which manages $58.5 billion in mutual funds and brokerage accounts.

At the same time, John Brynjolfsson from the hedge fund, Armored Wolf LLC, offered the prediction that bullion will top $2,000.

Peter Krauth, editor of MoneyMorning.com, which is one of the leading sources of investment news research for global markets, provided us with a technical analysis on gold, with a mention of the ‘Golden Staircase’ – which gives us the foundation for a long term uptrend in the price of gold. Most of us are aware that the prices of financial assets do not usually increase linearly and smoothly on the chart, but often fluctuates due to a variety of market factors such as the supply and demand and the changing perception of value of assets. For instance, during an uptrend, there will always be regular dips in the trend line as traders seek to cash in on the profits, known as profit taking. There will also be times when the market will consolidate, where the prices trend sideways.

It is during this period of consolidation that led to the horizontal step in the ‘Golden Staircase’ (see

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yielding assets such as gold. This phenomenon was triggered since the collapse of Lehman Brothers and the ensuing large number of corporations from different industries requiring bailouts from the government to sustain their businesses; such as General Motors, mortgage giants Fannie Mae and Freddie Mac, the insurance firm American International Group (AIG) amongst many others. After the Lehman Brothers’ collapse, the financial system fell into a state of paralysis, fear and panic. A general lack of confidence in the financial markets and uncertainty as to the extent of the damage done by the crisis prompted many investors to escape the increased fluctuations and volatility with attempts to preserve their capital by moving them into less riskier assets, so as to live to see another day when the markets revive (whenever that may be).

Combine this with capital injections of multitrillion dollar bailouts by governments all over the world and we can see an increase in inflation due to the oversupply of money in the market. These situations will further increase the demand for gold as it is often regarded as a tool to hedge against inflation and hence, will drive up the price of the metal.

As the economy begins to show green shoots of recovery and show signs we may be pulling out of the recession, investors’ risk appetite seem to be returning as we observe increased activity in the financial markets and saw a general diversion of capital resources away from gold into higher earning assets such as stocks.

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If the index starts to decline, it means that investors expect the Chinese government to tighten its monetary policy; if it goes up, it means the demand in China will continue to expand. 

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76% from year 2003 till April 2009.

The central banks also became an overall net buyer of gold in the second quarter of the year since 1987, where the total sum of purchase of gold by all is more than what they have sold.

As investors lose faith in their government’s ability to contain the financial and economic crises, many are calling for gold backed currencies, much like the greenback until early 1970’s, to safeguard the value of their currencies from the stimulus packages handed out by the governments. The stimulus package will result in an oversupply of money in the market and thus, resulting in inflation and reducing the value of their currencies. Even Zimbabwe, which only a year ago had hyperinflation running at 231 million percent annually, is now considering reintroducing the Zimbabwe dollar, but this time fully backed by assets, including gold. In order for this to happen, countries would have to purchase enough gold to fully support their currency – putting more pressure on gold supply, pushing prices even further.

Asia, with more than two and a half billion people, has a major impact on investment demands. Asians have a longstanding cultural affinity for gold as a form of storage of wealth. India is the world’s largest gold consumer. At the same time, before 2009, the Chinese authority has forbidden its citizens from owning gold. Yet today, Chinese investors even have access to gold linked checking accounts. As a result, demand for gold in mainland China is expected to triple in the next few years.

China government has also been buying gold discreetly for the past couple of years to diversify the reserves.

The bull rally for gold is very likely to continue for a few years into the future. However, it is essentially very hard to predict the financial markets and gold is no exception. No one foresaw the current economic crisis, the 1997 Asian crisis or the World Wars; and it will be safe to say that no one can accurately forecast what is going to happen to the future of this shiny commodity. Only time will tell whether the bulls will persist, or whether the bears will dominate. 

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Besides this, large investment organisations such as sovereign wealth funds like the China Investment Corporation and the Government Investment Corporation of Singapore, hedge funds and pension funds are all buying gold to protect themselves against the inflation of paper currencies as governments across the world engage in “Quantitative Easing” by injecting more and more capital into the system to fight the current recession.

Gold Exchange Traded Funds (ETFs) are also gaining popularity among retail investors. Standard & Poor’s Depository Receipts (SPDR) Gold Trust (NYSE:GLD), the largest physically backed ETF is currently the 6th largest holder of gold bullion with more than 1,000 tonnes. As a result, the i nve s t m e n t demand for gold in the first half of 2009 is 150% higher than that of the first half of 2008, according to the World Gold Council.

T h e Central Bank Gold Agreement (2001), which limits the amount of gold the European Central Bank (ECB) and the International Monetary Fund (IMF) can sell to 400 tonnes per year has recently been renewed (revised down from 500 tonnes), further straining the supply of gold in the market.

The Federal Reserve in the U.S., the world’s largest gold reserve is also holding on to their precious commodity. Some governments are going even further. Venezuela passed a law which required 70% of gold produced in the country to be sold domestically, severely restricting gold’s export. At the same time, Russia, Ecuador, Mexico and the Philippines are all buying gold, with China having increased its reserves by

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below). The formation of the newest step in the staircase started in the mid of year 2007 and that is when the $1,000 price level was first breached.

On 8th of September 2009, the price of gold broke the key resistance level after attempting to do so on four previous occasions. Each of these attempts has helped define the $1,000 resistance level. But in a ‘Golden Staircase,’ the resistance eventually becomes a new support level. So once the $1,000 price point is broken in a decisive manner, it will become a key support level for the price of gold. You can also think of it as the top surface of a new step and this is precisely the position of gold in the market.

If technical analysis is showing us that the foundation for a long term uptrend in the price of gold is positive, then the fundamental analysis will provide an even more staggering signal of a bullish trend by gold.

As a non renewable resource, annual production by gold mines worldwide has been decreasing by 9.3% since 2001, and sourcing for new mines have been proving even more challenging. Even if new mines are discovered, these mines are either located in obscurely remote places like La Rinconada in Peru, the island of Sumbawa in Indonesia or Menzies Landing in Guyana; or in politically unstable areas such as the Democratic Republic of Congo and Uganda, for example. Gold mining companies cannot afford to explore these areas because of the high risks involved and the very cost to mine in these areas. Thus, it is hard to push up the supply to meet the demand for gold – resulting in higher prices of gold.

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The promissory premise of prediction markets

diction market in terrorist activity, but this plan was abandoned due to political sensitivity. Hillary Clinton, then a US Senator, claimed it would have been “a futures market in death”.

So how exactly would such a prediction market work? To illustrate how this game is played, we will need to have an event. Let’s take an example such as your friend (who we will here name Sarah) who will be taking an Economics exam in one month’s time.

Now I think she will do extremely well in her exam because I always see her studying in the library. And I bet she’ll get a First class in Economics by scoring at least 70% in the exam. You disagree because you think she’s been doing some stalking on Facebook all this time, and so you bet me that she will score below 70%. Well then, game on! You sell me a contract which has a payout of £100 only if I am right and your friend nails the exam. For this contract, I will pay you £60, because I think that is how much this contract is worth. So we have a bet. Now we have to wait we find out Sarah’s score in the exam. A few months pass and we find out that I was proved right as she scored 90% in Economics. I win the bet and you pay me £100, making me a handsome net profit of £40 (£100-£60). You on the other hand, make a loss of that £40. It’s a zerosum game. However, if Sarah scored less than 70%, let’s say 65%, then you win the bet, and you keep the £60 premium I paid for this contract. You’re

By Richard Opong, Paul Chau & Thomas Ng The creation of prediction markets was built upon the premise that anyone can speculate upon the outcome of any future event, be it who will win a boxing bout, or whether or not a government initiative will be successful. There are two different parties betting on different outcomes. This in turn creates contracts, and the market in which they are traded. Hence, the current market price reflects the perceived probability of an event, as assessed by the market participants. Although prediction contracts are similar to futures, they are much more speculative, essentially bets, as the underlying ‘asset’ is nothing more than risk.

The Iowa Electronic Market,

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been available in the over-the-counter financial markets and only became available on exchanges in 2008 with the approval of the U.S. Securities and Exchange Commission. IG Group, a spread betting company, is one of the trading platforms that offer binary contracts. It offers many different kinds of contracts linked to indices, FX, commodities and individual shares. A typical one is an up or down bet on the FTSE 100. For example, say a “FTSE 100 to finish up” price is quoted at 34.5 - 38.5 and someone buys 1 unit of this option at 38.5. If the FTSE 100 finishes higher than yesterday’s close, the payoff on the option is 100 - 38.5 = 61.5. Otherwise, if the FTSE 100 finishes lower than yesterday’s close, the payoff is 0.

The reversed bet can be made by selling the same option at 34.5 and profit when the FTSE 100 finishes down.

Notice how in this example there is a loss of profit due to the spread regardless of the winning result. This is one mechanism by which the spread betting firm makes its profit, as ideally for every person placing a buy bet there is another placing a sell bet, meaning that one will win and other lose, while the firm (which makes the market) pockets the spread. However not all bets are hedged by the company. If the market-maker decides to take a position, it can simply just not hedge the bet – not offer clients one side of the bet – in order to profit from their loss on the available bet.

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a non-profit company that operates for research purposes, epitomises the prediction markets. It allows market participants to trade contracts based on political events and economic indicators. The significance of prediction markets is that they can aid decision-making by firms and government as they aggregate information.

However such avant-garde markets have proven controversial at times, one such time being 2003 when the Pentagon proposed to set up a pre-

up £60, and I’m down by the same amount. These kinds of contracts can be traded until the date of settlement (or in this case, when the exam is taken). From this example we can see that these contracts have a fixed upside and downside. Specifically, these contracts are binary in nature, paying out either a fixed amount or nothing at all.

This style of contract has long

The above example may seem simple for those risk lovers, and for them most online platforms offer exotic binary options. These exotic options include “HiLo” and “Tunnels”, and they are as their names suggest.

A “HiLo” is a bet that speculates on the trading day’s high/low to be above or below certain level. A “Tunnels” bet speculates on the index’s today

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While the intricacies of prediction markets may be interesting, we must ask ourselves, how well do they function?

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Betfair and Intrade, in which real money is at stake, will yield accurate results as there is a vested interest for any party in being correct.

There is also the example of the Iowa Electronic Markets in which some markets are open only to academics, where they speculate over such pertinent issues such as the spread of the H1N1 virus. In this particular market, over 240 scientists and medical professionals have collectively made accurate predictions as to how infectious the virus would be in the U.S. and the resultant mortality rate. This is an example of a prediction market with an inherent economic benefit.

One ought to consider that prediction markets’ expiring lends them to be more efficient than non-contract markets. This is because the binary payout incentivises speculators to take a position in the belief that an event will (or will not) happen.

In this case, parties take a more objective view of the underlying event rather than a subjective view of the market price – as would be the case in the theoretically ever-lasting equity markets. Moreover, regardless of how initially inefficient the market was, prices should become efficient by expiry as the market will have factored in all relevant information.

While there will always be conjecture as to the efficiency of prediction markets, and all markets in general, what can we conclude? All that has to be said is that prediction markets – which have only came to the fore during the last decade – propose an exciting method to speculate upon whatever possibilities one can fathom. It is perhaps for this reason that the LSE has its own graduate, Ed Murray, who is now a professional prediction markets trader. 

FUNDAMENTALS

hence the best options being highlighted in the middle for both sides of the bet. The numbers underneath the prices indicate the amount of money available to be used as a stake at the corresponding price. Here, in order to work out the implied percentage of the event happening, one simply takes the inverse of the bet price on offer. For example a price of 4.6 suggests that Real Madrid have a 22% chance of winning the match.

You will probably also have noticed the percentages next to the “Back” and “Lay” headings. These numbers aggregate the implied probabilities of the back and lay sides on offer to show how efficient the prices are. Obviously the sum of the probabilities of all the events occurring should be 1 so the closer these percentages are to 100%, the more efficient the prices are. It must be noted that the prices will almost never reach this figure due to the price ticks.

However, the speculation only gets interesting when the market becomes animated (known as ‘turning In-Play’ for betting exchanges, occurring when an event such as a football match begins). In all markets where expiring contracts are traded, contract duration and price volatility are correlated, creating markets with differing risk-reward profiles. The reason for this is simple: the longer the duration, the more chance that new information will change the level of conviction in the eventuality. In traditional futures markets, we see that this leads to higher price premiums for contracts of longer durations.

While the intricacies of prediction markets may be interesting, we must ask ourselves, how well do they function? Clearly there is the argument that betting exchanges such as

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movement to be within certain range.

Above is an example of a “Tunnels” binary option on the FTSE 100, the binary event is for the FTSE 100 to stay within plus or minus 30 at 5330 level. In the above picture, the FTSE 100 rose above the upper bound and so the payoff of this binary option is 0.

There are many advantages to trading these binary contracts in the financial arena. Binary options enhance the dimensions of trading, i.e. instead of the usual long and short strategy, one can bet on day’s high as an alternative. Also there is the gain made from a profit and loss cap, as one can more easily understand the risk and reward dimensions of their trading. This is also helped by the fact that the odds calculated by the bid-ask price can be interpreted as the likelihood of the binary event occurring.

We will now see the prediction market in another context, as we turn our attention to Betfair, which employs the exchange model - where people bet against each other rather than a bookmaker. It specialises in markets for sports and horseracing, handling more daily transactions than all the European financial exchanges combined.

Here is a Betfair market for a football match. The “Back” side is selected if one believes that an event will occur while the “Lay” side is selected if one believes that the event will not happen.

For example if I believe Barcelona will win I could back them at a price of 1.85 which means that for every 1 pound at stake, I could potentially gain another 85 pence. In order for me to be able to back, someone else must lay, in other words the prices being offered to me for backing have been offered by people “laying” the outcome.

The lay side in this example therefore follows that, at a price of 1.85, someone laying an event with a stake of 1 pound would only risk the 85 pence premium while looking at a potential win of their initial stake. In the picture above, we can see that the best price available to lay at is 1.86, meaning that someone else has offered to back at a price of 1.86, with the prices 1.87 and 1.88 providing better bets for the backers, but worse premiums for the layers,

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Luxury sees the light

By Leon Beressi

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rada humbled, Ferré beaten down and Cavalli whimpering, the list of injured luxury goods conglomerates goes on; the financial crises has indeed dealt its blows, but is it packing any more punches?

With the drastic fall in purchasing power and consumer spending decreasing throughout Europe, the future looks bleak for the remaining luxury multinationals. Pinault-PrintempsRedoute (PPR), the second largest luxury goods firm in the world (listed on the French index CAC 40) reported a 7% drop in revenues in its third quarter for 2009 (€4.56 billion ); analysts predict its overall revenues could drop by up to 6.8% compared to 2008.

Ominously, net profit figures are yet to emerge for 2009. PPR‘s prolific chief executive Francois Pinault gave an interview in the French weekly financial review ‘Les Echos’ where he expressed his doubts about the much talked about recovery in fashion,’Trying times may still be ahead for the industry, especially on the European continent’. PPR is not alone. Richemont, the third largest Swiss luxury giant worldwide would be more than likely to empathize with this view as its revenues slumped by 12% in 2008. To give a little perspective on these figures, 2008-2009 have been the worst years in PPR‘s history; they have been

forced to close multiple stores across Europe and are discreetly selling some of the lesser known brands in their catalogue in order to raise capital.

These mediocre numbers have led PPR and Richemont and many others to start considering the sale of weaker subsidiaries in their respective groups and to re-focus their attention on their core brands in China and India.

So why have these companies performed so badly in recent years? And are they destined to carry on doing so?

The obvious answer to the first question is that consumer wallets have had to go on strict no ‘luxury diet’ for the past year, but there are much deeper and telling reasons why some firms have been hit so badly. Firstly, production costs have soared and wholesale activity has crashed, especially in Spain where many luxury products are produced (check your Louis Vuitton wallets if you don’t believe me). World leader in luxury goods, Louis Vuitton Moet Hennessy (LVMH), has been particularly hurt by the current wholesale problem. Secondly, the waves of tourists pouring into Bottega

Veneta and Gucci’s outlets in Milan and Rome have subsided, and have left the luxury industry exposed about just how dependent it is on affluent holiday makers. One could also hold the contention that during a recession the fashion tends to sway towards tightening one’s belt and refraining from making conspicuous displays of affluence. As a columnist in the ‘New Yorker’ quipped “It’s no longer fashionable to boast about buying a 3000 dollar bag, but it’s ok to discreetly say that you bought a 6000 dollar suitcase with a 50% reduction”. A convergence of higher production costs, a return to discretion and lower touristic activity has thrown a monkey wrench in the luxury goods industry wheels.

And yet, despair not o’ fearless luxury shareholders, there is light at the end of it all. Indeed, if one was to contemplate investing some money in stock markets, luxury goods companies would not be a bad bet because their share prices are currently undervalued but steadily growing (see charts). The huge potential for growth in emerging markets will most probably drag LVMH, PPR and many oth-

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LVMH Closing Price (Euro)

ers out of the abyss. In an interview with ‘Le Monde’, Diego Della Valle, the CEO of Tod’s which is the biggest producer of leather goods in Italy, was exuberating with optimism «I’m back from Asia. In China, in Korea, in Hong Kong, business is booming ». Tod’s profits show strong signs of growth, especially in the leather and clothing lines and so far, revenues are up by 3.4% in the first quarter (359 million euros).

Tod’s growth has been mostly organic as it has not pursued the strategy of buying up struggling rivals which is common place in the sector. Tod’s growth rate in India will probably surpass 25% according to Bloomberg. Sure, Tod’s numbers look impressive, but LVMH’s reports from the Far East look even better. LVMH chairman, Bernard Arnault’s (7th richest man in the world), massive expansion plans in

China will undoubtedly prove to be a gamble worth making. Just take a look at who’s buying luxury goods in Europe, that’s right, Asian consumers.

JeanJacques Guiony, the LVMH Chief Financial Officer, reported that over 40% of leather goods sold in France were to Asian buyers. LVMH shares rose 2.45 Euros, or 3.4%, to 74.90 Euros in Paris trading last week, the highest in more than a year. Whilst pessimists will point to LVMH’s champagne running out of fizz, as sales fell by 8.6% in the first quarter; or their watches not ticking since watch and jewelry sales dropped 22%, the French giant’s ability to appeal to Chinese consumers and tap into that ‘desire of sophistication’ as described by Arnault will stand the company in good stead Earlier this month, Bain Consulting released a somewhat long

“I’m back from Asia. In China, in Korea, in Hong Kong, business is booming.”

-Diego Della Valle CEO, Tod’s

winded yet interesting report saying that 2011 should witness the comeback of many of the main luxury players, with sales growth in China expected to surpass 25% by mid 2011.

So what does this all mean?

Simple, really. Buy LVMH and PPR shares. PPR was massively undervalued for most of 2008 and is showing signs of growth in 2009. PPR will almost definitely be listing some of its smaller subsidiaries (eg – Distribution firm ‘CFAO Group’ which is worth 2.2 billion). LVMH may be planning some big sales too; Moet Hennessy which has many a time been accused of being the group’s ‘problem child’ may be sold to Diaego PLC. There are also talks that LVMH may have its eye on Channel or Hermès. Moreover, LVMH’s new Asian strategy has tremendous chances of succeeding, revenue growth rate in India alone may surpass 13% in 2009 according to The Economist.

So it’s not all doom and gloom after all. With promising potential in Asian markets and rumours about M&A activity coming back on the map, the luxury industry is down but definitely not out. 

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here is no doubt that China has become much richer as a result of opening up to the West since 1978.

Its economy has grown on average by 9.7% per year, and the number of people living on less than $1 per day has also recorded a dramatic decline in recent years. Even amidst the crisis, detailed economic data released by China’s National Bureau of Statistics indicated that China’s GDP grew at a rate of 7.1% in the first half of this year, and that the economy is stabilising and improving. China’s rapid development brought hope to many emerging markets in the sense that they could all eventually come out of poverty and enjoy higher living standards However, a popular notion among many market observers is that China overinvests and underconsumes, thus implying that living standards might not have improved as dramatically as the public perceives. “China’s dramatic growth has become fundamentally unbalanced, with personal consumption making up less than 50% of Chinese output [the rest coming from exports and investment],” says Liu Mingkang, the head of China’s Banking Regulatory Commission.

In fact, if we were to analyse the available data more closely as well as being more cautious in choosing the specific types of consumption to take into account of, we would realise that China’s personal consumption is not nearly as low compared to that in the U.S. as perceived by many market participants. Two related but distinct concepts apply when we analyse the domestic and international dimensions of China’s underconsumption.

The domestic dimension of the issue refers to the underperformance of household consumption relative to the rest of the economy. Over the past decade or so, the growth of China’s household consumption has been outpaced by fixed investment growth and exports, and consumption as a percentage of GDP

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tion. Based on official statistics, the consumption of housing accounts for only about 3% of personal consumption in China. This obviously seems too low to be even close to the reality. To put this into perspective,, consumption of housing represents about 16% of personal consumption expenditure in the U.S. and 6.6% in India. The fact that house ownership ratio in China is over 80% suggests that the potential underestimation in this regard is quite substantial.

In addition, personal spending on health care is also one of the underlying factors to the underestimation.

While the share of spending on health care in the U.S. is 1516% of total personal consumption expenditure, the relevant share in China is only about 6%. There is always the possibility of black markets not officially captured by official statistics in health spending.

Despite this, the absolute level of personal consumption in China is not nearly as low when compared to that in the U.S. as perceived by many market observers. The absolute level of growth of China’s personal consumption is remarkably strong in a global context. The incremental contribution of Chinese consumers in US dollar terms to the global consumption of tradable goods started to exceed that of the U.S. in 2007.

Two approaches could be used to undermine the issue of underestimation of consumption in China. One of these is a top down approach. A more like-for-like comparison could be made by examining personal consumption of the non-services, tradable goods sector, where such underestimation is less of an issue, as mentioned in a research report by Morgan Stanley, published in early September. A comparison of consumption of nonservices, tradable goods between the U.S. and China indicates the gap between the U.S. and China is much smaller than suggested. In 2008, the personal consumption of nonservices, tradable goods in the U.S. and China was US$3.2 trillion and US$1.2 trillion respectively, indicating that China’s figure was about 38% of the U.S. level.

This is more than double the

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By Vivian Lo

is low and has been on the decline.

The more interesting aspect is the international dimension of China’s underconsumption. In a global perspective, China’s economy is a much larger producer than consumer. The consumption binge in the U.S. has made it an economy of US$10 trillion in personal consumption, while China itself is but an economy of US$1.6 trillion in personal consumption. Taking into account that the Chinese population is currently standing at over 1.3 billion people, more than 4 times higher than that of the U.S., it is hard to miss the extent of China’s underconsumption. If U.S. consumers were to stop spending, the negative impact on the rest of the world would be too large for Chinese consumers to play a helpful offsetting role.

Let us now focus on the underestimation of China’s consumption of services with respect to the international dimension. According to reports published by the CIA, the service sector accounted for 40% of China’s GDP in 2008, which is around 26%of total personal consumption. Moreover, the consumption of services in China is substantially lower than that in not only industrialised countries but also China’s peers among emerging market economies.

There has already been a substantial upward revision of GDP in 2005 after the first nationwide economic census was completed. In the 2005 GDP revision, China’s 2004 GDP level was revised upwards by 16.8%, and most importantly, 93% of the increase was due to a substantial upward revision in the service sector, such that the share of the service sector was lifted from 32% to 41%. One underlying factor as pointed out by the National Bureau of Statistics concerned the Material Product System (MPS), which was developed under the centrally planned economic system. In simpler terms, China has been using it in its national accounts statistics until the 1980s, resulting in weaker statistics in the service sector in particular.

Another key source of the underestimation of service consumption in China is related to housing consump-

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Overstating China’s underconsumption

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ratio of 16% as suggested by the two countries’ data for overall personal consumption. However, another possible method is the so called bottom up approach. A like-for-like comparison of specific categories of goods and services consumed by households in both countries can also give us an indication of the magnitude of China’s personal consumption relative to that in the U.S. In 2008, motor vehicle sales in China reached 9.4 million units, or 69% of the corresponding U.S. level. Also in 2008, the amount of beer and milk drink products consumed by Chinese households amounted to 38.8 million litres and 13 million tonnes, respectively, 158% and 59% of those consumed by the U.S. The influence of Chinese consumers on the rest of the world is already considerable and is expected to become even greater on both marginal and averages bases. In the aftermath of the 2007 financial crisis, the Chinese economy is expected to continue to expand at a considerably faster clip than the U.S. over the next decade.

For the Chinese authorities, promoting domestic consumption is a policy priority. As progress is being made in implementing its consumption oriented policies, we expect consumption growth to catch up with investment and export growth, likely to be initially in line with and subsequently outpace overall economic growth over the medium and long run. The unlocking of Chinese consumers’ potential will undoubtedly lead to significant value creation, especially for long term investors. 

After the Crisis: Risk Management in the New World CAREERS

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By Tracy Wu

R

isk management can be a very thankless profession. In bull markets, risk managers are viewed as those who stop the music by trying to drop people out of the dance.

It can be even worse in bear markets risk managers are blamed for the failure of risk management even in most cases they have limited the losses for the company to the greatest extent.

The ongoing financial meltdown draws attention to the effectiveness of enterprise risk management. In a recent cross-industry survey with finance executives, when asked to lay blame for the current financial crisis, 62% of the respondents blame poor risk management, ahead of other factors such as increased complexity of financial instruments. Improving risk management of their corporations is thought to be the greatest concern for the executives. So how do we improve risk management capability in the new financial landscape? In this article, we discuss the importance of understanding the risks and elements that we should be aware of in risk modelling.

Understanding Your Risks Any business decision is about gaining the greatest amount of rewards. Before we decide to capture the rewards, however we should first ask ourselves whether we understand the risks behind them. Any time you lend money to anyone, there is some risk that you might not get the money back. Every loan carries some risks associated with it, and the risks vary depending on the creditworthiness of the borrower.

Bearing the risk requires a certain amount of capital in case the counterparty defaults. Let’s start with a simple example to help us understand the risks embedded in the mortgage loans in the subprime crisis. Suppose Company A issues a loan, it will then put aside a certain amount of capital to act as a buffer against the possibility of a default, the amount of which will be based upon the likelihood of defaulting. This buffer serves as a risk management measure so that a default will not severely and unexpectedly impact the company’s cashflow.

If Company A sells the loan contract (debt) to Company B, the same amount of underlying capital is still required to cover the possibility of the loan default, but this time by Compa-

ny B. Company B now repackages this debt with debt bought elsewhere into a single debt instrument, and sells them on to a Company C, which will then need to set aside an amount of capital buffer to reflect the increased risk of the underlying likelihood of a default on this entire debt package, as it is now burdened by a larger pool of unknown borrowers.

Now you get the idea, no matter how the loan is sliced and diced, packaged and repackaged, an amount of capital that reflects the underlying risk of default is still needed to cover the loan. The example here resembles what happened during the current financial crisis when debt was packaged into various forms of credit derivatives, such as Collateralized Debt Obligations. However, many financial institutions seemed to have ignored the relationship between the debt and the capital buffer associated with it.

If regulators allow some or all of the capital needed to back the debt to disappear simply because the debt is now “reborn” with a new name, it is not surprising that severe consequences will occur. So what should regulators do? In the scenario above, Company A should reserve the capital attached with the debt until Company B is proven reliable on its capital requirement. Company C and Company D and so on should all follow the chain.

If the repackaging of the original debt has added on some levels of risks, then an additional amount of capital is needed to offset the excess risks. How about the financial institutions holding the portfolios of mortgage backed securities? Should they step back a bit before they take on the mortgage loans, contemplate on how big the liability is and the associated risks? If the financial institutions had thought about these issues, they could have avoided the dry up of capital and liquidity during the crisis.

Let’s look at the financial institutions using complex financial innovations, such as derivatives, to reduce risks or create opportunity to take on more risks through new products.

Many investors might have forgotten one of the most important risk prop-

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There are always doubts about what financial models can do. Models are useful to help us understand the business, but they are not decision makers.

There are two things that we need to keep in mind when assessing risks using models. Firstly, we need to understand the limits of the data being used. A relatively shallow pool of data can lead to an incomplete model. For example, mortgage credit risk models based on limited data from years of consistent rising house prices could only suggested limited risks.

A more robust level of data should be in place to forecast wider range of risks in an extraordinary condition. Secondly, we must realise that the accuracy of a model is limited to the accuracy of the input assumptions.

It is necessary to stress test key assumptions of the model. For example, in most risk models, the correlation assumptions between various risk elements will drive tail events. The models should be able to stresstest the impact of the increased correlation between risk elements in today’s rapidly changing world due to the internet and globalisation. Almost all the financial crises in the past demonstrated that corre-

Q1

Models: Are They Good or Bad?

the probability of U.S. housing prices lation in stressed environments is aldropping nearly 20 percent from 2006 ways much higher. Moreover, risk corto 2008. The mistakes showed that relations tend to change in response quantifying remote probabilities can to extreme events. We have seen the always be more difficult than quantifydomino effect take hold in the current ing the possibility. financial crisis. It could be very danThe culture that we have around gerous if we miscalculate the correlamodelling is also important. Anette tions between the seemingly unrelated Mikes, assistant professor at Harvard risk factors during the Business School, believes that there crisis. are two types of risk managers. One In the subprime mortgage crisis, type is “Quantitative Enthusiasts”. many sophisticated investors did in They blindly rely on their models and fact utilise complex financial models believe that they should be largely to measure the risks they were faced used to make business decisions. This with. Unfortunately, they were not type of risk managers tend to put too able to insulate themselves from losses. much focus on the output and too litWas it because the models were intle on the underlying assumptions of correct? It is possible that the models the models. The other type is called were not accurate enough, but most “Quantitative Skeptics”, who are likely it was the investors or modellers overly skeptical about the models and who missed the correct picture of risk. consider the major risks to be outside Many models took into account the the quantifiable risk variables. Both assumptions that house prices might extreme types do not demonstrate a decline, however the models failed to good risk management approach. A give an appropriate weighting to the good risk manager should combine likelihood of such a rare event. Howboth quantitative and qualitative ever, before placing the blame on the thinking to make better decisions. modellers, we should understand the UK House Price Index difficulty of mod1953‐2009 Beware of the elling rare events.

Black Swan House prices have not fallen this Nassim Taleb, presdrastically since ents a very interestthe Great Deing story of a turkey pression of 1929. being raised by a Given that the fifarmer in his book nancial landscape “The Black Swan”. A turkey gets fed has been changing vastly over the past by the farmer on every single day of its decades, how much weighting should life. Based upon that experience, the be in place for the occurrence of rare turkey sees no reason to be concerned events? There is no definite answer. when it gets fed by the farmer on the Though day before Thanksgiving. The turkey’s one thing fatal error in judgment is driven by can be the fact that it has never experienced sure, peoa Thanksgiving Day in its entire life. ple tend What do we learn from this story? to systemRisk managers should atically clearly understand the risks and the underestiriskreturn trade off. Always look for mate the the different ways in which risk can be likelihood presented to ensure that risks are not of rare overlooked. Modellers should provide events actransparent summaries of the model cording assumptions and their impacts to the to an emerging behavioural economic uncertainty of the estimates. It is nevresearch. In the current crisis, the biger easy to predict a Black Swan event, gest mistake was to underestimate Q1

erties of derivative options: “convexity” (also called “Gamma”). Convexity implies that as the price of an underlying asset falls, the price and risks of the option will increase. As the housing markets plummeted, the implicit put options would increase by a larger proportion, creating a huge liability and insolvency.

It is always a myth that financial innovations are the causes of the global financial crisis. In fact they are not, but rather the real culprits are how they are modelled and how well the management understand the concepts of the products and models.

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32 a low probability, high impact rare event. However, we can surely predict that companies ignoring the Black Swan events will find themselves having very unpleasant Thanksgivings. 

nominal GDP of Mexico and India, or forty times that of Kenya. On top of the relatively easy access these firms had to investor’s funds, their debt intensive operating models resulted in substantial tax exemption due to the tax advantages of carrying debt. Furthermore, most PE firms are listed as Limited Partnerships (LPs) or Limited Liability Companies, which the law does not require them to pay the corporate level tax. A leader of a buyBy Benjamin Lim out firm in the UK criticized the tax structure in which “buyout barons pay ue to the financial crisis, the topic lower taxes than a ‘cleaning lady’”. of business ethics has a growing Simmons - a former reputable emphasis in today’s discussion about mattress manufacturer - is a recent how a firm should operate. While the example revealing the effects that mulmajor banks and financial institutions tiple takereceived Total PE Deals Flow overs can much of have on the atthe firm. tention, Simmons we must boasts a also queshistory of tion the over 133 business years, but model of as sales some pribegan to vate equity fall in the (PE) firms.

1970s, PE These prifirms began to purchase the comvate equity investors would raise debt pany in the 1980’s. Since then, Simin order to purchase underperforming mons underwent 7 takeovers in the firms. Usually, the PE firms would atspan of about twenty years. Recently tempt to add value to the company it has been reported that the company through various methods such as rewill soon file for bankruptcy protecstructuring. However, when PE firms tion with the current owner’s intent incur the debt onto the company it to once again sell the invested in, some firms will drain all company. of the employees’ retirement funds in The private eqorder to repay the debt. Meanwhile, uity business model these PE firms are taking lavish fees requires a firm to and bonuses from the borrowed moncommit a small ey. Therein lies the central amount of cash, debate: is this type of business model while relying mostly ethically sound? on debt to purchase Prior to the credit crunch, many an undervalue firm. private equity managers such as Then PE firms atHenry Kravis of KKR considered tempt to add value the period to be the “golden age” of so that they can sell private equity. Credit came easy and the company as soon as possible for borrowing costs were cheap, as interest a profit. Therefore, PE firms’ motives rates remained low in the 2000’s. Prito change their acquired companies vate equity investment accounted for might not necessarily be in the compaabout $832 billion during 20022007. nies’ best interests. While this notion To put this figure into perspective, it makes sense for the PE firms to maxiis roughly equivalent to the combined

mize returns on their investments, in many instances, the acquirees were much worse off after than they were before the takeover.

In the case of Simmons, the company went from owing $164 million in debt in 1991 to $1.3 billion today. The most recent owner—Thomas H. Lee Partners, a Boston based PE firm - had already purchased Simmons prior to its current ownership. During THL’s first takeover in 1989, it stopped contributing to Simmons’ pension fund for its employees, and as the housing market collapsed, so did its stock ownership shares for retired employees. Out of the $1.1 billion THL paid for Simmons in its second acquisition of the company in 2003, over $745 million came from borrowed money.

While the Simmons profits did not experience a steady increase, THL has already paid itself lavish dividends, more than enough compensation to cover its cost. However, in order to guarantee itself this profit regardless of Simmons’ performance, THL borrowed more than $375 million extra to serve as its dividends, using Simmons’ assets as collateral. For example, in 2004, Simmons issued debt at an interest rate of 10% just to pay a dividend of $137 million to THL. In order words, THL received a free paycheque, while placing the massive financial burden on Simmons and its employees. As Simmons tried to repay these debts incurred by the divi-

How Private Equity Uses Leverage To Create Value

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dend payments, factories were closed down and workers were laid off to cut costs. Employees’ retirement bonuses and sets of mattresses promised for retired workers became nonexistent. Annual holiday parties and other compa-

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result of this transformation will be a lower expected return on investment for these buyout firms. A survey by Morgan Stanley revealed that the biggest transaction in 2009 did not even exceed $1 billion, compared to KKR’s enormous buyout of Boots of $11 billion in 2007. With less debt available as banks and other firms try to reduce their balance sheets, PE firms might actually need to create more real value in the companies they invest in their invested companies. 

SPECIAL REPORT

employs these ethically contentious practices; many PE firms also conduct the practice of dividend recapitalization (paying themselves dividends with debt). During the “golden age” of private equity from 2003 - 2007, 188 companies under private equity control paid more than $75 billion in dividends using debt to the buyout firms. However, as the economy recovers from the credit crisis, the past PE model will definitely undergo a transformation, and the industry should experience a downsizing. The short term

MARKETS

ny social events for the employees also disappeared. After a series of buyout firms passed Simmons around like a hot potato, employees who once enjoyed the comfort of a family oriented atmosphere, now face a schism of trust between the workers and management. According to recent research, when the PE firm introduces a new management, on average employment falls by 18.25% over a six year period, and workers are paid £231 less annually than other private sector workers.

THL is not the only company that

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For more information about our internship and placement opportunities for penultimate year students and our Industry Insight programme for Þrst-year student please visit our website.

SPECIAL REPORT

A Comment on Warren Buffett and the City Bonus

By Henry Palmer

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the Analyst

34

t is likely that anyone picking up this article is to be found progressing with a meteoric speed towards what they hope to be a long, fulfilling and rewarding financial career.

Unless by some freak of nature you have found yourself deep in a coma or locked away in the cooler for several months, you would have certainly noticed the recent financial turbulence. We are all aware of the impact this has had both politically, economically and the effect upon the public at large. As such there is no need to go into greater detail. What we must examine, however, is the reform this is likely to bring in financial regulation and methods. We must not ignore that the shift brought by the necessary intrusion of government into ‘the square mile’ and the level of public scrutiny to which many banks are now subjected, will alter both the nature and manner in which a career in finance will function in the near future. In the words of Mervyn King, Governor of the Bank of England; ‘never has so much money been owed by so few to so many.’

This is the environment into which we throw ourselves, so should we expect to reap the same rewards in terms of wealth? Can bonuses on the current model still be justified?

Now, though perhaps without intention, we have arrived at the altar of the Sage of Omaha, Mr. Warren Buffett. You will find admiration for the man on all corners of Wall Street, spread thick throughout the square mile and stretching from La Défense to Nihombashi, yet when it comes to taxes, equality and bonuses the city has quickly turned its back. Until now he was shouting into a gale but the winds have changed. Whereas before, politicians have found it to their advantage to fight the corner of the banks and turn a blind eye to their necessary extravagances, now not only are the banks in their pockets and

in many cases owned by the government outright, but the public mood has turned sour. Popular, and most importantly political opinion, now rests with Mr Buffett. The City finds itself in the trenches. The only question that remains is who will triumph?

Now in theory, you would think that at some point the author is bound to move onto the facts, in every sense the LSE bread and butter. Unfortunately you are to be disappointed. Pick up a paper around this time of year and you can be guaranteed to hear huge figures thrown about like confetti and with no correlation to each other whatsoever. The BBC, quoting the Centre for Economics and Business Research (CEBR) said, ‘payouts would hit £6bn, up from £4bn in 2008, because of rising profits and less competition.’

The Evening Standard, however, had rather different figures, ‘Bankers faced fury over their bonuses today as new figures showed they are in line for a £5 billion bonanza,’ they cried.

The Daily Telegraph, on the other hand, thought this figure rather too conservative; ‘Figures from the Office for National Statistics (ONS) show that between December and April, the five-month period typically regarded as peak bonus season, those working in the financial intermediation sector received bonuses worth £7.6bn.’

In just this small cross-section we see a difference of £2.6bn (34.3%) between the highest and lowest figure. Like the Mad Hatter of Alice in Wonderland, it would appear they are simply pulling rabbits out of hats. The fault, however, cannot be laid at the door of the press. Bizarre as it may be, the FSA and the Bank of England don‘t even provide bonus figures. Even the ONS provides only an estimate of the annual percentage change, though they make it perfectly clear that in no

way can these be described as precise.

The reason for this is simple; nobody knows the figure because none of the banks tell. On top of this there is not even a coherent method or structure by which bonuses are given out, each bank marching firmly to their own tune. In Working the Street: What you need to know about life on Wall Street, Eric Banks, a former Managing Director of Merrill Lynch, states, ‘the whole process is like a mysterious tribal dance – one that begins slowly and builds steadily through regular crescendos, and then reaches a frenzied climax: the final allocation of bonus pool.’

Really, this is about as lucid as it gets.

What though, of the debate the financial world finds itself embroiled in?

In the UK, financial regulation of previously unseen, unimagined proportions is perhaps soon to be implemented.

Alistair Darling has stated that, ‘the FSA will be given powers to “tear up” bankers’ contracts if pay deals reward unnecessary risk-taking.’

While he does go to lengths to underline the omitting of any cap, ‘We are not capping bonuses... What we are doing is ensuring that bankers no longer have bonuses in place that contribute to an excessively risky system’, it seems, should the government‘s bill on incomes policy come into effect, that the industry will be a very different place in a year’s time.

Mervyn King has added to the ever growing funeral pyre of bonuses, stating, ‘I think that banks themselves have come to realise in the recent crisis that they are paying the price themselves for having designed compensation packages which provide incentives that are not, in the long run, in the interests of the banks themselves and I would like to think that would change.’

Despite this onslaught over the last 12 months, the there remained a sense that surely the conservatives will

“Never has so much money been owed by so few to so many.”

-Mervyn King

35

By Nicolò Colombo ctivist shareholders have always played a fundamental role in agitating over-complacent Board of Directors in underperforming companies. In the 1980s, where buyout and takeover activities reached historical peaks, many activist investors - the socalled ‘raiders’ - proclaimed themselves guardians of shareholder rights and assertively and aggressively approached companies who did not persistently try (according to their opinion) to increase shareholders‘ value, but instead aimed at maximising the paycheque of executive managers. One of the most active activists (no pun intended) was the legendary financier Carl Icahn, who has been fighting the board of directors of ‘evil’ companies since the 1980s, reaping incredible successes as well as terrible defeats whilst acting on his motto, “A lot of people die fighting tyranny.

The least I can do is vote against it”.

The phenomenon of shareholder activists soon assumed such relevance that Oliver Stone‘s movie, Wall Street (1987), could not refrain from offering the general public a stereotypical version of such investors – Gordon Gekko. Nowadays, activism is heavily pursued through investment vehicles such as hedge funds, unregulated pools of wealth seeking absolute returns for a restricted circle of qualified investors.

Activist campaigns that have recent made the news include the ‘battle’ between Daniel Loeb‘s Third Point LLC and Star Gas Inc., Winnfield Capital LLC to Cornell Companies and Pershing Square Capital Management.

Those actions were often conducted with harsh tones. Daniel Loeb for example, dissatisfied with the company‘s performance attacked the CEO by writing in a letter that “It is time for you to step down from your role as CEO and director so that you can do what you do best: retreat to your wa-

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“The war for talent is in full swing...”

-Josef Ackerman CEO, Deutsche Bank

Hedge Fund Activists: The New Corporate Democrats

POLITICS

mon trading scandal of 1987 ended badly for Buffett when his attempts to clean up the bank‘s books, and reform its bonus culture ended with him being forced out as Solomon‘s bankers rebelled. The desire to reform this culture, which he has described as ‘infuriating’, has not left him.

In assessing the impact of the banking crisis he sympathised with public anger, ‘here nobody’s going to jail, in fact a lot of them are walking off with tons of money, which they got in many cases with preferential tax terms. So the American public’s exasperation at this is very understandable.‘‘ In an interview with Forbes in 2007, he also condoned a more progressive tax for the rich, stating that he only paid 19% of his income for 2006 in federal taxes, while many of his employees paid 33% federal tax despite making much less money. Warren Buffett is not the man that many of his fellows would have him be, he is in many ways the antithesis.

What we are witnessing is a battle for a way of life, for ethicality.

The forces of reform, however, blow strong. No matter which side you come down on, the present position is unlikely to remain. It may well be many years before we see the likes of Citi trader Andrew Hall‘s $100 million bonus again, but the politicians must be careful not to build reform around a public anger out of tilter with the reality. It is, however, difficult to know whether we are just beginning the tumble down the rabbit hole or are emerging out at the other end; one madness seeming much like the other and dealing always in extremes. What we do know is that when the graduates of this year come to enter the financial world, expectations of wealth may not be as easily met as they were before. I leave you though with the encouraging thought that if Buffett can do it without a bonus, so can we. 

CAREERS

see the sense of a deregulated and free financial market. Wrong! Whether as an act of political point scoring or a show of real intent, George Osborne has come firmly down on the side of reform, ‘We cannot wait for the promised land of a new responsible bonus culture which looks more remote than ever. We need to take emergency steps to support bank lending and move the economy forward...I am today calling on the Treasury and the Financial Services Authority to combine forces and stop retail banks paying out profits in significant cash bonuses.

Full stop. Then the cash that would have been paid out should be put on to banks’ balance sheets explicitly to support new lending. This should be a condition of continuing to receive taxpayer guarantees and liquidity support.‘ Perhaps, oh irony of ironies, it will be the Conservatives, who having given to birth the free and incentivised city of today, will be the ones to thrust the dagger deepest into its heart.

Yet a certain amount of spirited defence continues. John Thain has come out fighting, defending the reported $4bn 2008 Merrill Lynch bonus pool, saying that ‘if you don’t pay your best people, you will destroy your franchise,’ adding that on ‘Wall Street, people’s salaries tend to be relatively small and their bonuses are the vast majority of their compensation for the year.’

Morgan Stanley Co-President, Walid Chammah, said the bank were ‘against absolute caps on compensation levels,’ while Deutsche Bank Chief Executive Josef Ackermann chimed in that banks could not let star performers slip through their fingers by being tight-fisted; ‘The war for talent is in full swing...the question of whether we have learned something focuses too much on the question of bonuses and leaves out other aspects.’

Enter Warren Buffett. The Solo-

SPECIAL REPORT

Politics

SPECIAL REPORT MARKETS FUNDAMENTALS POLITICS CAREERS

the Analyst

36 terfront mansion in the Hamptons”.

One can safely define hedge fund activism as a new form of arbitrage, just like a merger arbitrage strategy, which takes a long position in the ‘Target Acquiring Company’ (which is being bought, so the price will go up) and at the same time shortselling the ‘Buyer Company’ (which is expending a huge amount of capital to buy the target) to possibly earn an arbitrage profit in what is considered a form of ‘Event-driven’ strategy.

In addition, this new form of activism relies on the legal structure of hedge funds as investment vehicles to optimally undertake activist campaigns towards inefficient companies.

Examples of such benefits are low regulatory constraints, alignment of investors and managers‘ interests and huge availability of liquidity. As one could sensibly imagine, Mr. Icahn had jumped onto the bandwagon of hedge fund activism with a complex structure of funds backing his activities, the Icahn Master Fund(s) LLP. Do companies that are targeted by hedge fund activist investors actually improve performance? What‘s the market reaction to such activity? Although a wealth of academic literature exists on the topic, we will show that the basic mechanisms to capture stock market reaction to activism and give some examples helping to understand what is the change (if any) in corporate performance after an activist campaign.

Leaving aside the reasons for which hedge fund activism tends to be preferred over traditional shareholder, we will introduce a tool – the event study – to depict market abnormal reactions to initiation of an activist campaign by hedge funds. You will probably argue that hedge funds‘ strategies are strictly confidential and private, but we can proxy the starting date of activism by referring to public available data, which indicate the hedge fund, the target and the purpose of the transaction: this magical information is contained in the SEC 13D form for the U.S. market. Such form must be obligatorily compiled by any entity buying ownership of more than 5% of a public company, and it has to

precisely indicate the purpose of the transaction. Next step is to collect the target company‘s stock prices and returns for a number of days around the announcement date (let‘s call it t=0, so that stock returns can be collected for the period t=-20 to t=+20 days). We expect that after t=0 the stock price increases more than normal because of the positive effects of the activist campaign. To precisely identify the phenomenon and simplify things, suppose we are modelling the so-called ‘normal’ returns using any form of asset pricing model, say the CAPM. Let‘s also take an example. Now very famous to our readers, Mr. Icahn decides to put pressure on BAE Systems to sell the company‘s assets to a strategic acquirer, as he thinks this could improve shareholders value. This happened on 14/09/07. We retrieve the corresponding 13D filing, and we start to calculate what would have been the returns in the 20 days before and after the commencement of the activism.

As we said, we use the linear model: Return(BAE Systems)t = at + B(Market Return)t + Et Simply put, we use a linear regression to get past returns and predict future returns for the 20 days after activism if things were normal, that is if Icahn did not proactively approach the company. Now, Icahn agitated BAE‘s Board of Directors, and the market understands that the company may be not performing very well, but relies very much on Icahn because shareholders think that the financier will fix up things and improve profitability, value and corporate governance mechanisms. In fact, if we calculate the company‘s actual returns using historical data in the same period of time, and subtract the normal returns from the results: Abnormal Return(BAE Systems) = Actual Returnt - [at + B(Market t Return)t + Et] We find a measure of abnormal returns, i.e. returns that are earned in addition to what one would expect (a

similar measure one can usually find is CAR = cumulative abnormal returns, i.e. the sum of all Abnormal Returns over the pre-established window of time). If Icahn‘s actions increased stock returns, Abnormal Returns would appear starting from t=1, after the commencement of activism.

This is indeed the case (see figure 1).

We also see that extraordinary returns are earned before the commencement of the activity, this is because some leakage of information has occurred or some insider-trading is going on. So Icahn efforts in shareholders‘ (but above all, his) interests seem to be valued positively by the market through a stock appreciation. One could even argue that hedge fund activism stimulated company‘s performance and reduces inefficiency such as managers feeling the pressure of possible activist investors, and having to put additional efforts into enhancing shareholders value and not just their own payoff.

Corporate Democrat, Carl Icahn, scored a personal success on the targeting of BAE Systems, since in January 2008, rival software maker Oracle ended up acquiring BAE for $8.5 billion, or $19.375 per share, which allowed him to cash a $300 million profit in just 6-months time. Although this may seem a selfish-investment, we should not forget that company‘s shareholders (see above) benefited as well, and hypothetically the long-term performance of the company may have increased since acquisitions are usually made to earn synergies or to pursue more proper strategic objectives whether it‘s growth, market share, integration or diversification. It would be very difficult to say if a company‘s performance definitively increases in the medium to long run after the commencement of activism, since academic literature and empirical evidence offer heterogeneous results. Stock prices go up, hedge funds and shareholders hypothetically reap profits, often exiting their investments in few years‘ time.

Hedge funds often pursue a new form of arbitrage, called Activism, whereby they engage the company‘s management and board of directors in order to improve performance, ef-

By Pooja Kondabolu

N

o longer is the traditional role of social assistance programs, redistributing income and resources to the needy, the predominant way to achieve long term equality and pro poor growth. Helping the poor overcome short-term poverty during periods of crisis is inefficient and ineffective. In high inequality environments, helping credit-constrained people become productive workers, and providing incentives for long-term investments in human capital, safety nets are now seen to have potentially important role in compensation for the market failures that help foster poverty. Both conditional cash transfers and microfinance anti-poverty measures address poverty by facilitating human capital accumulation in hopes to breaking

SPECIAL REPORT MARKETS

five percent of each loan is put into a group fund to stave off seasonal malnutrition, pay for medical treatments, purchase school supplies, recapitalize businesses affected by natural disasters, etc.

The first portion of this paper explores the effectiveness and efficiency of both anti-poverty measures in the past two decades. This paper looks at the effectiveness of conditional cash transfers in Brazil and Mexico in terms of improvements in education through primary, secondary, and tertiary school enrolment rates and improvements in access to health care through infant/ child mortality rates as well as how accessible a health clinic is to the household. Then, the paper will observe the effectiveness of microfinance in Bolivia and Uganda by testing improvements on the same aforementioned variables.

The conclusions of this section will compare and contrast the effectiveness of both anti-poverty measures and will examine each program‘s ability to reduce short term poverty and their respective strengths and weaknesses at attaining their individual goals.

Although both anti-poverty measures induce pro-poor growth and are innovative approaches to the delivery of social services in their own right, they have their respective weaknesses.

Since it will be difficult to control for confounding variables through a cross country analysis, the second portion of this paper will provide a case study of Bangladesh, where both CCTs and microfinance have been employed.

By providing case studies, the paper does not hope to claim a stylized fact about the general effectiveness of either anti-poverty measure.

It hopes to make a general hypothesis about the effect of the measure on a certain economy in hopes that it will lead to more broad and rigorous research. The primary question that was asked in this paper was whether both measures have the same potential to reach the poor and the two primary variables that were tested were improvements in education and health care. First and foremost, it is important to note that the impact assessment of the case studies of the five countries will be skewed. Each coun-

FUNDAMENTALS

Conditional Cash Transfers vs.

Microfinance: Effective Anti-Poverty Measures

the intergenerational cycle of poverty.

Originated in Latin America, Conditional Cash Transfer (CCT) programs target poor households in an attempt to foster their human capital capabilities along with their access to health care. Proponents argue they are more effective than commodity-based assistance because they allow recipients to make their own choices while fostering economic and social rights.

Evaluation in Ethiopia shows that cash grants were used to pay off debts, restore land productivity and help regenerate livelihoods. This program also helps households pool savings and allows rural farmers to sell crops when prices are high. The conditionality of CCT makes this new generation of social programs an instrument for longer-term human capital investments as well as short-term social assistance. Conditional Cash Transfers aim to reach goals of current and future poverty reduction by offering cash transfers based on human capital investments and other consumption transfers or workfare programs.

Originated in Bangladesh, microfinance offers small loans and other financial services such as savings to very poor people for self-employment and empowerment initiatives in hopes to generate income, allowing borrowers to become self-reliant and capable of financially caring for themselves along with their families. Microfinance was founded on the idea that human credit is a fundamental human right. In many developing countries, the selfemployed comprise of more than 50 percent of the labour force according to the 2009 Microcredit Summit Campaign. Access to small amounts of credit with reasonable interest rates instead of the exorbitant costs often charged by traditional money lenders allows poor people to move from initial, perhaps, tiny income generating activities to small microenterprises. Micro-entrepreneurs only need enough credit to purchase raw materials for their trade. Loans are given to a disproportionately large amount of females in rural villages as a form of female empowerment and autonomy.

In Bangladesh‘s Grameen Bank,

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ficiency and ultimately maximising shareholders‘ value. Stock market reaction to commencement of activism is positively regarded, as the BAE System example shows. However, one cannot be sure of what the long-term effects are of activism on corporate performance. Does Return on Equity (ROE) increase vis-à-vis with nontargeted similar companies? Firstly, hedge fund activists‘ investment horizon is usually calculated in months to a maximum of a few years so that real improvements in performance due to specific activist activity are hard to disentangle. Secondly, are hedge funds really interested in promoting a company‘s operations and performance or are they just interested in buying stocks low and selling them high, earning abnormal returns under the much more noble guise of ‘Corporate Democracy?’ After all, hedge funds activists are often compared to Locusts (Posteritati ardua sententiae), because of their opportunistic behaviour. 

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the Analyst

38 try has vastly different economies, starting poverty levels, resources and implementation strategies, and therefore there are many confounding variables that have not been controlled for.

Since the nature of the CCT program is for the government to set aside money to target poor households in an attempt to foster their human capital capabilities along with their access to health care, it is naturally more costly than microfinance, where independent banks prosper by offering small loans at a certain interest rate. For example, the Bolsa Familia uses approximately 0.8% of Brazil‘s GDP. Under this CCT program, the mothers of a family which earns less than 120 reais ($68) per head per month, are paid a benefit of up to 95 reais on condition that their children go to school and take part in government vaccination programs. Municipal governments do much of the collection of data on eligibility and compliance, but payments are made by the federal government.

On the other hand, with microfinance, microfinancing banks offer credit that would otherwise not available or would be only available at the very high interest rates charged by moneylenders who often charge as much as 10% per month. MFOS offer an average loan size of $370 while Banco Sol offers beneficiaries up to $530 in Bolivia. Households served by banks in Bangladesh the top quarter of MFO borrowers consume at a 15% more per capita than households in the bottom quarter. In addition, 62% of the school-age sons of MFO borrowers are enrolled in school versus 34% of the sons of eligible households that do not borrow. For daughters, the MFO advantage is 55% versus 40%.

Clearly, both anti-poverty measures have their advantages and by setting Bangladesh as the control country that experienced both antipoverty measures, one can conclude that CCT program and microfinance serve as complements to one another.

With the presence of the FFE program and various MFOs, Bangladesh experienced the greatest short-term poverty alleviation than any of the other case studied in this paper. 

The Financial Crisis and its implications for Sino-American Ties

By Koh Poh Wei

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iven that the world is still reeling from the aftermath of the recent credit crunch, it is far too easy to ignore the geopolitical effects of the financial crisis. Tension between the USA and China has existed since the era of President Clinton‘s administration, and antagonism in the Sino- American relationship is no longer novel news.

We have all seen worse, haven‘t we?

Ironically, the financial crisis has added impetus to the shifting geopolitics from the USA to China, a trend that has been occurring for a while.

On one of its issues, The Economist dedicated its cover and an additional 15 pages to updating readers on its views and research on the Sino- American relationship, implying that the world has changed drastically since the start of the financial crisis. In its article, The Economist argued that the Obama administration should exert more political (but not economic) pressure on China, because after all, “in terms of geopolitical power, China has neither the clout nor inclination to challenge America”.

Nevertheless, this article disa-

grees with the advice that The Economist dispensed to the Obama administration. In particular, this financial crisis has shifted Sino-American‘s geopolitical boundaries in two major respects. Morally speaking, although the current financial crisis has not amounted to the death of capitalism as argued by Nobel laureate Paul Krugman and other critics, the moraleconomic superiority which the USA established after the Cold War has taken an enormous hit. Pragmatically speaking, in the persistent SinoAmerican foreign exchange competition, China seems to have emerged from the crisis with the upper hand.

“History has ended! Free-market capitalism has prevailed!” proclaimed the famed political scientist Francis Fukayama in 1989, after the collapse of the Soviet Union and its centrally planned economy. Armed with a sense of economic-moral superiority and newfound confidence, Americanbased financial institutions such as the World Bank, International Monetary Fund (IMF) and the U.S. Treasury developed the Washington Consensus, a proposed global economic and financial framework which comprised of policy recommendations for countries suffering from a financial crisis. Several of the more controversial policies, in retrospect, include financial deregulation and fiscal policy discipline.

Many of the policy recommendations of the Washington

“The Washington Consensus is now over.”

-Gordon Brown

Indisputably China possesses the abiltity to cause a financial collapse in the U.S.

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tional global player, has no interest in publicly dumping and seeing the collapse of the U.S. currency, at least in the short term. Undisputedly, China possesses the ability to cause a financial collapse in the U.S.; but doing so would be a mutually destructive game she is not prepared to undertake.

The bad news for the U.S., however, is that given that China has now recognised the perils of accumulating the U.S. currency, we can be sure that the Chinese government would be keen to avoid making a similar mistake in future. The Chinese government, in actively championing the IMF to advance an alternative global currency, is sending out clear signals that it no longer considers holding the U.S. currency to be a viable long term option.

We might never know, but it is not hard to envisage a scenario where China quietly plans an exit strategy from the U.S. government debts. Having pressured the Chinese to appreciate the value of yuan relative to U.S. dollars over the years, U.S. policymakers might one day hope that they were more careful with what they wished for.

Many commentators, when writing about SinoAmerican relations, usually conclude their article by expounding their ideals for a deeper level of cooperation between China and the USA, but even that prospect has become increasingly improbable.

Due to the financial crisis and foreign- policy mistakes that the Bush administration committed, China no longer holds the USA with the kind of respect she once held. The last thing the U.S. could benefit from is to exert further political pressure on China.

Nevertheless, it still makes sense to believe that a Sino-American alliance is the only way to ensure a stable global economy and political order. If President Obama could manage what his predecessor failed to do, even his critics might have no choice but to agree that his Nobel Peace Prize was rightfully awarded. 

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global economic and financial system as it had over the past twenty years?

China clearly does not think so, having condemned U.S. economic policies harshly earlier this year. But perhaps UK Prime Minister Gordon Brown summed it up best for the rest of the world when he declared, during the 2009-G20 London Summit, that “the Washington Consensus is now over”.

As early as 2003, economists have already been aware of massive global macroeconomic imbalances existing between China and the USA. Although many observers, perhaps including the Chinese government, were aware that such a trend was not likely to be sustainable, they generally held the view that if there were to be a market correction in the U.S., it would generally be a gradual one.

With the benefit of hindsight, many economists, including those working in the IMF, are now claiming that the enormous U.S. trade deficit were a major reason of the financial crisis. In particular, it is argued that many net-exporting countries to the U.S., such as China and Japan, reinvested their trade surplus into the U.S. financial market, hence resulting in excess liquidity in the system.

This perpetuated a ‘false sense’ of growth, hence increasing the number and size of bubbles throughout the U.S. economy. The rest is history.

Unfortunately, even after the financial crisis, the macroeconomic imbalance between the USA and China remains uncorrected. Equipped with $2.2 trillion worth of U.S. currencies and bonds (or more than 10% of the world‘s foreign currency reserves), China, perhaps just by its sheer size, is now a serious player in the global finance. The good news for the U.S. is that China, as a ra-

FUNDAMENTALS

Consensus were discredited during its implementations on the Latin American in the 1980s and Asia in the late 1990s. Organisations such as the IMF, genuinely believing in the invincibility of the Washington Consensus, force-fed its policy prescription to aid-recipient countries.

For example, during the 1997 Asian Financial Crisis, the IMF recommended that recipient countries tighten monetary policies and reduce deficits by aggressively raising interest rates and cutting back on government spending. At one point in time, under the IMF‘s supervision, interest rates in Indonesia was as high as 60%! As you might have expected, these disastrous policies plunged Asia deeper into the recession. Not only has the failure of the Washington Consensus in this instance earned the ire of Asian politicians such as Malaysian Prime Minister Dr Muhammad Mahathir, it was also heavily criticized by prominent U.S. academics such as Nobel laureate Joseph Stiglitz in his book ‘Globalization and its Discontents’.

Despite having already lost a great deal of credibility over the years, the single event that led to the downfall of the Washington Consensus was the current global financial crisis, which was significant in two ways. Firstly, just like the way Titanic sank, the current crisis has proven that the USA‘s brand of ‘free-market capitalism’ is not as invulnerable as it was once thought to be. Secondly, in a series of bailouts and quantitative easing, the U.S. has knowingly contradicted the policies which they once advocated, a move that many labelled to be of a ‘double standard’.

There is no question of whether the U.S. should have proceeded with the bailouts; it was clearly inevitable.

Yet in proceeding with the bailout, another question has arisen – When this crisis has finally come to an end, will the USA still be able to command as much influence and legitimacy over the

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Hedge fund manager profile: Steven A. Cohen

By Kaushik Sudharsanam

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teve Cohen is one of the most revered money managers in the hedge fund business. He is the founder of S.A.C. Capital Partners, which manages over $14 billion in assets with an average annual return of around 40% since its inception back in 1992.

As such, Cohen is regarded as one of the most formidable forces on Wall Street, and has been referred to in the past as both “A New Prince of Wall Street” and the “hedge fund king”.

Cohen developed an interest in the markets at a tender age of 13, when he started to read the financial section of New York Post assiduously.

“I was fascinated when I found out that these numbers were prices and they were changing every day,” he told Jack Schwager, author of the book, Stock Market Wizards – Interviews with America’s Top Stock Traders.

He started following stock quotes regularly by hanging out at a local brokerage office. He studied Economics at the Wharton School of Business (University of Pennsylvania) where some of the more few useful knowledge he learned was the concept that 40% of a stock’s price movement was due to the market, 30% to the sector and 30% to the stock itself. Of course, the exact numbers are not something that is necessarily true, but it represented an idea that was conceptually sound enough for Cohen to believe in.

Cohen then headed to Wall Street to become a junior trader at the trading firm, Gruntal & Co. On his first day, he made $8,000 for the firm and eventually went on to making around $100,000 a day. After a successful stint at Wall Street, he went on to start S.A.C Capital Partners in 1992. Beginning with a capital of $25 million, S.A.C has grown to become a multi­ billion dollar hedge with over $14 million in assets. Attracting investors has never been a problem, and his flagship fund is now closed to new invest-

ments. What is most impressive about S.A.C are the returns – an average annual return of around 40% a year adjusted for its hefty 50% incentive fee which is 2.5 times the hedge fund industry average. This means that the average annual profit have averaged around an astounding 90% a year.

Cohen’s trading style relies on gut feel – an inner instinct which gives him a real sense of where the market is headed. Gut feel is a combination of experience and talent which Cohen developed through his years of placing thousands of trades. Laszlo Birinyi, President of Birinyi Associates Inc., an investment research firm in Connecticut, once said, “Cohen can absorb this huge amount of input and come out with music when most of us just come out with noise.”

The most important attribute Cohen looks for in his traders is a ferocious appetite for risk, but also stresses the importance of discipline in cutting losses quickly when a trade goes sour. One of the questions he asked when looking for people is, “Tell me the some of the riskiest things you’ve ever done in your life,” he wants guys who have the confidence to be out there and be risk traders.

He compiles statistics on his traders and his best trader only makes money on 63% of the time. So if traders are going to be wrong a lot of the time, it is essential they minimise their losses to a minimum whilst letting the good trades run in profi t.

Cohen himself has made mistakes. In one situation he shorted IBM stocks expecting a negative earnings report.

But his trade backfired when the stock rallied up $18 per share after the report’s release. Cohen however, acted immediately to cover his losses without rationalising his trade. Although he took a sizeable hit, had he waited till the morning the stock price would have gained another $10 against him.

All traders make mistakes, but the best ones limit the damage quickly.

In his interview for the book Stock Market Wizards by Jack D. Schwager, Cohen emphasized the importance of trading style. He said that each trader should experiment with differ-

ent trading styles and develop his own unique style suited to his personality.

At S.A.C, Cohen oversaw around 40 teams of traders who specialise and trade in particular industries and products. They are paired up with research analysts who have a thorough understanding of the respective industries and products and the factors that move the stocks. He gives his traders the freedom to play as long as they abide by the firm’s trading discipline.

Cohen’s primary technique consists of fast-­paced trades based on market predictions and catalysts. His firm’s doctrine relies on informational edge ­ obtaining new information and data before anybody else. Cohen has established this edge, through his flow of commissions, which has made him privileged to new trading and analyst information ahead of rivals. S.A.C on average pays securities firms 1 cent for every share it trades amounting to around $400 million in trading commissions each year. On a regular day, S.A.C alone accounts for about 2% of the overall stock market activity. A former S.A.C trader remarks, “Cohen’s presence, and market ­moving capability, is probably the largest of anyone on the Street.”

The firm focuses on Long/Short equity, quantitative strategies, convertible and statistical arbitrage, and bets on interest rate and currency movements. He primarily used to focus on fast­paced momentum driven trades by moving in and out of positions rapidly.

But over the years, S.A.C’s trading style has gradually changed in order to explore and adopt newer strategies. When too many traders start using the same strategy, the technique soon becomes exhausted and fails to make a profit. In fact, S.A.C sometimes makes head­fake trades in order to disguise its true intentions and preventing rival funds from duplicating their strategies. Cohen is currently focusing on more long­ term stock picks with earnings growth as a major driver. Some of his stocks are held for several months or even years.

Cohen has also installed psychiatrists in his firm whom he believes have a crucial role in the trading room. Co-

By Kunal Shah Before we begin, please give me some background information about yourself and study.

I am from the UK and have an MPhil in Statistical Science from Cambridge, where I also did my undergraduate degree.

How long have you been working at Barclays Capital and what is your specific role there?

I have been there for 1 year and 3 months as an Inflation Trader, part of the Fixed Income Division.

Any specific reason why you wanted to be a trader?

Well, it is a very interesting job which

As a trader what is your daily job routine like?

My day begins at 8 in the morning. The first thing I do is run spreadsheets to pull up our risks. After this I normally read the major headlines. Throughout the day we observe the broker markets and price trades for clients. Besides this I have long-term projects to improve our internal systems. Towards the end of the day, I flash our P&L estimate for the day which is sent to management.

Yes, definitely. Many of the graduates come from Cambridge, Imperial, L.S.E and Oxford. But again competition is stiff as graduates are competing with people from all over Europe and beyond.

If you had to pick the most interesting aspect of your work what would it be?

Expectation vs Reality. Judging for myself what is going to happen next and assessing what everybody else is pricing in, and then taking a position if there is a difference between the two.

If you were a recruiter for graduates in your division what would be the qualities you are looking for?

One of the most important is genuine interest in the economy and news of the world. Graduates should have a lot of attention to detail as mistakes can prove very costly in this business. Another quality is quantitative and problem solving skills – this can be very important when trying to fix a spreadsheet, for example. I would also look for people who are able to communicate technical concepts clearly, and who are capable of working in a team environment.

Do you see yourself as a trader in the long term?

Yes, either at a bank or at a hedge fund.

Having studied at Cambridge yourself, do you believe gradu-

(The views in this piece represent the personal views of the individual and not the firm). 

Interview with Benjamin Lu: an options trader at Optiver

By Ben Stemper What is Optiver and in what business does it engage it?

Optiver’s emphasis is on electronic trading. We do proprietary marketmaking, i.e. providing bid and offer prices to markets but have no clients.

Hence, you could say that we ensure that a market stays liquid. The special advantage of electronic trading (HFT) compared to a classical broker or pit market is that the exchange is about 60% cheaper. The other advantage is that there is reduced counterparty risk.

The vision of the future is that more products will be standardized so that they can be electronically traded which will make markets more transparent.

Why is Optiver a ‘proprietary’ firm, i.e. why do you only invest your own money?

What you have to know about electronic trading is that larger sums of money doesn’t always equal larger profits. In addition, the leverage afforded by de-

FUNDAMENTALS

Has your job changed since the economy went in to a recession?

Yes. A number of our competitors have consolidated, and more attention has to be paid to credit risk, for example.

What is your advice to L.S.E. students who want to become traders?

Read a lot about the industry and economy. It will take some effort but will be something important on your application that a lot of others will neglect to do.

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ates from universities like Cambridge, Oxford and London School Of Economics have an edge over other graduates?

POLITICS

Interview with Sarju Shah: an inflation trader at Barclays Capital

is very close to the market. Traders have a high decision-making power within the bank and a maths degree can carry high premiums in this role.

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hen stated that in a highly competitive and performance driven environment, traders are prone to weaknesses such as the fear of trading risks, stresses from drawdowns and the reluctance in getting out of losing positions early.

S.A.C’s former star psychiatrist, Ari Kiev, helped counsel S.A.C’s traders in overcoming these weaknesses and improving their trading successes.

The hedge fund business has changed. The roaring bull markets of the 90’s and early 2000’s made it possible for many players to beat the market consistently. The credit crisis has however wiped out the losers, who were unable reverse their misplaced bets and adapt strategies to overcome the falling markets. Now, the reversing markets will see the existing titans prevail by consistently adopting new techniques to dominate the changing markets. With over 30 years of trading success, Steve Cohen will continue to be one of the top investment managers in the street. “I want to keep the firm growing. I have no interest in retiring. I have nothing else to do. I don’t want to go play golf.” 

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F

OLOUR

Typesetter Steve

ount Handler Emily

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PROOF

December 09

Size (dxw)

48x210 mm

mage quality

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High

important but its people are even more important because those technology advantages are not durable.

What do you think of the case of Sergey Aleynikov, the former Goldman Sachs programmer, who is accused of having stolen Goldman’s code?

I don’t know the particulars of that case. But every firm loses people and every company knows that will happen. This code might be very valuable at the moment but this doesn’t last for a very long time.

Right now, this code might make some very good profits but in a few months, when the markets have changed, the same programme will probably generate losses. For any company, their technology is very

How did the financial crisis affect Optiver’s business?

Last year was good for us and there has been heavy recruiting. This has to do with the way we do our business.

For the market making side of the business, rather than alpha generating trading, revenue is the number of transactions times half the spread we take, i.e. the difference between bid and offer prices. During the financial crisis, we could take a larger spread because demand for transactions was inelastic which means they had to trade despite larger costs. Overall, our profits rose last year because the increase in spread

...when the markets have changed, the same programme will probably generate losses

surpassed the decrease in transactions caused by the environment.

What is your personal role in your company?

I am trading German and American sovereign debt options. I focus on those two because liquidity is concentrated in those markets and products.

The fact that currency pegs and Basel regulations force liquidity towards US Treasuries create one part of the liquidity concentration. Within the EU, Germany’s dominance within the economic framework has meant that Euro debt gets liquidity concentrated there.

High frequency firms are often accused of manipulating markets. What do you think about that?

I completely disagree because this would be very difficult for any HFT strategy at any firm. So long as you put bids and offers into the market, you are prepared to trade on those prices and that makes it a real and transparent event. The presence of

Graduate careers in investment banking Here at Barclays Capital, we’ll help you fulfil your highest ambitions in the most unexpected ways. For instance, we think the best way for you to get to the top is to learn from the people who are already there. That’s why our senior managers are intrinsically involved in training our graduates – and why you can look forward to extraordinary insights and top-floor views from day one.

It’s time to raise your expectations. Visit our website to find out more. barcap.com/expectexcellence

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/The Analyst

rivatives trading through exchanges, means millions of euros or dollars allow billions worth of traded products.

EXPECT TO GO PLACES YOU NEVER EXPECTED.

ate started

Media

the Analyst

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Expect Excellence

Expect Excellence Issued by Barclays Bank PLC, authorised and regulated by the Financial Services Authority and a member of the London Stock Exchange, Barclays Capital is the investment banking division of Barclays Bank PLC, which undertakes US securities business in the name of its wholly-owned subsidiary Barclays Capital Inc., a FINRA and SIPC member. © 2009 Barclays Bank PLC. All rights reserved. Barclays and Barclays Capital are trademarks of Barclays Bank PLC and its affiliates.

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gets a trade does not allow for favours or secret deals like a broker market.

Do you think the 21st century is going to be golden age of algorithm and electronic traders?

Yes, I think so. I might even say that recent years have shown that algo trading already plays a very important role in financial markets. Investment Banks like UBS, Credit Suisse, Goldman etc. and Hedge Funds like Renaissance Technologies or Citadel do not only gain enormous profits with it but those HFT profits already contribute a large part to total profits. If you look at James Simmons, the man behind Renaissance Technologies, he has become the person with the largest compensation in finance ever for years in a row (2.8 billion dollars in 2008). I think this shows the direction where we are going.

What kind of talent does Optiver search for?

We are searching for smart, enthusiastic people. Mathematics and analytical skills are very important in our business but talent does not only means skills. You can learn the essential mathematical skills required to do your job in only a few months.

What is really important, is that you show that you have the energy and motivation to thrive in this job. 

Y

ou may be applying to more banks than you care to remember, but if you want to be successful in your application to any one of them, you’ll need to speak convincingly about why you’re desperate to work for that particular place above all others.

How can you create a credible impression of conviction?

Flattery.

They may not know it, but what each bank wants to hear is why they are amazing. More precisely, each business area wants to know why they, in particular, are amazing within that amazing bank.

So, how can you find out a few facts to substantiate your belief in the supremacy of your potential employers?

1) Annual and quarterly reports

Point out how the equities business has done well, how it’s a strategic priority. views. Point out how the equities business has done well, how it’s a strategic priority. If you can specify that the equities business has done well compared to competitors, you’ll seem even keener.

2) Conference calls Accompanying each annual and quarterly report, is a conference call or webcast. These are often also useful sources of strategic information – particularly the questions from analysts at the end.

Every quarter banks are obliged to produce a roundup of how well they’re doing – a quarterly report. These are to be found on their websites, under the ‘investor relations,’ or ‘about us’ sections.

The website Seeking Alpha has a transcripts library where you’ll be able to find free scripts for US banks’ conference calls.

Quarterly reports often come in several varieties. There will usually be a press release with some helpful blurb (Eg. ‘We had an excellent quarter in equities trading’), plus a separate financial summary with revenue and income (profit) figures for different

It will please a bank immensely if you’re able to say that you want to work for them because they ranked second in a league table for European ECM activity last quarter, up from fifth in the three months previously.

3) League tables

They may not know it, but what each bank wants to hear is why they are amazing.

SPECIAL REPORT MARKETS

By Sarah Butcher of eFinancialCareers: The Financial Job Marketplace

regions and business areas. The latter will help you determine whether, for example, the equities sales and trading business which you’re been applying to has been doing well. The former may also include some helpful strategic pointers (‘Eg. We plan to grow our equities business next year.’).

You should regurgitate this in inter-

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The presence of high frequency and electronic markets make them transparent and competitive...

How to make Bank X think you want to work for them

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high frequency and electronic markets make them transparent and competitive, we can’t change or manipulate a market because the rest of the market will just prevent you by the virtue of competition. In electronic markets, the order book system that decides who

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Unearthing this information isn’t difficult. Thomson Reuters, an information provider, offers it for free on its website; you simply have to sign in.

If you’re applying to work in sales or trading it may be harder to unearth information about the relative strength of your chosen employer. One place to

If you’re applying to M&A, it will help if you have some awareness of the headline deals that your target has been active in recently glean such things is their own website (banks are prone to boating). If you can’t find anything there, try looking back through their press releases.

4) Deal lists If you’re applying to M&A, it will help if you have some awareness of the headline deals that your target has been active in recently. You can find some of these on the ‘financial advisory’ section of Thomson Reuters’ legal tables, or on the league tables provided for free by companies like mergermarket.

5) Hires There is, naturally, a possibility (particularly if you’re desperate), that the bank you’re applying to isn’t a leader in its area, and has been losing money.

In this case, full frontal flattery is unwise.

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However, if you’re aware that the bank has been hiring people in the area you’re applying to, you can point to its growth potential, its commitment to the business, or the fact that you’d dearly love to work under an experienced person like X. 

The new normal: survey results on how LSE students view the job market in the aftermath of the Bloodshed Tracking the trends Undoubtedly, the most pressing issues in finance recently all surround the historic credit crunch and its aftermath. It swamped international investment banking giants including the Lehman Brothers and was coined as perhaps the most disastrous recession since the Great Depression. Its impacts on the economy and therefore the public were undoubtedly profound and even LSE students – individuals outside the job market can feel its influences.

This is certainly unsurprising particularly because a remarkable number of LSE students are inclined to pursuing financial careers after graduation. Therefore, given that it has already been two years since it emerged and the future starts getting certain, it may well be an interesting time to examine its effects on students. A survey was conducted within the LSE campus and 102 responses were reported throughout. A point based system was adopted and interviewees were able to choose from a scale from 1 (strongly disagree) to 10 (Strongly agree) to show the extent to which they agreed with the statements.

The results were indeed very enlightening.

LSE students’ career preferences 2. The appeal of financial industry to LSE students after the recession 3. The views of LSE students on the recession and the economy This is not without surprise to discover that in general, LSE students did not have significantly extreme opinions on these issues. Although amongst all statements, the range of values was between 5.33 and 8.14, demonstrating that interviewees generally agreed with them, more detailed analysis may depict a slightly different picture. The

The results provided substantial evidence that the global economic crisis did in fact spark certain distrust and doubts amongst future LSE graduates in relation to the prospects of a careers in the financial sector.

The general outlook This student survey revolves around three main aspects: 1. The main factors that influence

median of these data was 6.61 whereas the mean was 6.71, both falling short of the threshold for ‘agreeing’, which was 7, as stated in the questionnaire.

This lack of particularly strong opinion can be attributed to the diversity of LSE students in terms of courses, year discipline, career ambitions and so on. Despite the fact that more detailed analysis which concentrates on the opinions of individual courses and year groups is desirable, given the wide variety of interviewees, conclusions may not be representative in each group. Therefore, in the following discussions, LSE students’ views will be examined as a whole.

Have financial careers become less appealing?

The results provided substantial evi-

What LSE students think of the financial industry?

Above: pre-crisis; below: post-crisis.

e e

s t h . y , d n d e s h e

e

-

7.5

7

6.5

Poten+al gain in personal knowledge and experience Personal interest Promo+on opportuni+es Payment level and bonuses

6

Future prospect of the industry as a whole Job security

5.5

The relatively high rating of job security, however, demonstrates that there are indeed concerns over the vulnerability of the sector to future fluctuations.

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r t s l s d y e

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LSE Students’ Career Preferences

e

relatively high rating of job security, however, demonstrates that there are indeed concerns over the vulnerability of the sector to future fluctuations.

Unfriendly media coverage of their alleged lavishness may well play a role in it by suggesting to graduates that the lesson was not properly learnt yet in spite of its severity. Nevertheless, in light of relevant data, most of the interviewees are still, generally speaking, determined to enter the financial industry upon graduation, as shown by a comparatively salient value of 6.88 when asked that their interests in financial careers changed. This result to a great extent matches our expectations. Hence, we are confident that amongst LSE students, confidence will quite possibly continues to be restored at the appropriate juncture, which is surely beneficial to the financial sector in the medium term.

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o

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POLITICS

Careers

5

dence that the global economic crisis did in fact spark certain distrust and doubts amongst future LSE graduates in relation to the prospects of a career in the financial sector. The majority have conveyed that a financial career would not be preferable particularly in terms of job security and the future prospect of the sector with specific regard to the recession. The former was given the value of 7.04 whilst the lat-

ter, 6.28. This was a reasonable outcome considering that financial companies have been continuously bailed out by governments around the globe and seemingly a number of them have recovered profitability. Even though scepticism is still prevailing amongst the public and media publicity remains negative, they are certainly no serious obstacles for financial firms to rebound in the fullness of time. The

In this area, the results predominately were deemed to agree with our expectations aside from a few exceptions.

Number 8, for instance, was considered surprising for it was contemplated that a higher result would be encountered due to the optimistic statistics on the economy in recent months. The result of number 4 was low compared with others, arguably indicating that on the whole LSE students perceived

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t

does not seem to have altered as analysed above, which will have profound implications to both employers and employees . Moreover, a worth mentioning result is that the replies for questions 6 to 8 range mostly from 5 to 6 which are relatively low compared to those of other statements, clearly showing that although the effects of the recession on the macroeconomy

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that the economic downturn was to a certain extent unavoidable. Indeed, it should be noted that there is also conceivable possibility that due to the sophistication of the causation of the credit crunch in which numerous factors were involved, a number of interviewees found no strong arguments to tell either way.

As for statement 5, people seem to believe that the credit crunch was attributable to the financial sector, as a relatively significant value of 7.58 was assigned to it. In view of the recognition that the reasons behind the economic downturn were complex and debates have yet yielded no widely supported convincing conclusions, this outcome leads to the supposition that media stereotype may well have impacts on interviewees’ judgement on this by no means incontrovertible issue.

In measuring confidence in the survey, this abstract concept is realised in three parameters, namely, the economy as a whole, the labour market conditions, which reflect the impacts of the credit crunch to the real economy (from Wall Street to high streets), and the FTSE, which corresponds to the confidence amongst investors as perceived by our interviewees. From the responses, it can be deduced that LSE students are most confident on the recovery of the economy, followed by the FTSE and, lastly the labour market in the financial arena. We believe that this to a considerable extent reflects the actuality because worries amongst university students on job market performances are most directly linked to their interests. A credible explanation is that LSE students are aware of the significant time lag between the recovery and the subsequent increase of supply in the labour market. One important remark is that despite this foreseeable difficulty, demand for financial career

From the responses, it can be deduced that LSE students are most confident on the recovery of the economy, followed by the FTSE and, lastly the labour market in the financial arena.

Are LSE students confident with the future?

Â

...the psychology of LSE students is essentially not highly pessimistic over the future either. should not be exaggerated as discussed above, it would be misleading to suggest that LSE students are incredibly or indeed overly optimistic about the future of the financial sector. This mixed interpretation is certainly not incomprehensible since the road to full recovery is still conceivably remote and the recent good news has merely marked the start. It is nevertheless encouraging that no values were below 5 thereby showing that the psychology of LSE students is essentially not highly pessimistic over the future either.

Conclusion The results of this survey are unquestionably highly valuable especially in terms of their straightforward but on no account simplistic representation.

Given the anticipated continuing importance of the issues covered in this survey, future further studies on a wider basis and in a longer time span may well allow more sophisticated discussions to take place. This is certainly particularly momentous to the LSE as indeed a sizeable number of LSE students have substantial ambition and interests in finance and any results discovered will indubitably be highly meaningful. 

the Analyst

Credits Founder / Editor-in-Chief Greg Silver Co-founder Johnson Ta Publication Manager Gerthrine Cheo CONTRIBUTORS Vivian Lo* Pekka Honkanen Jérémy Aflalo Leon Beressi* Koh Poh Wei Prithvi Murthy Kaushik Sudharsanam* Nicolò Colombo Edward Chai Richard Opong* Paul Chau Thomas Ng Channy Wong*

47 Dhruv Ghulati Shorena Kalandarishvili Tracy Wu* Benjamin Lim Henry Palmer Andrew Slusser

Carmen Luk

MARKETING Niharika Khanna* Chirag Shah Yaryee Wong

POPULATION RESEARCH Joe Chow* Cher Ying Hong Kwame Marfo Long Haffiz Long Hassan Shiqi Shan Ching Ching Tung Charisse Tsang

CORPORATE INTERVIEW Mary Egundebi* Benjamin Stemper Chan Pui Yan Christine Hemant Thillaisthanam Waqas Adenwala Kunal Shah LAYOUT Edward Chai* Harshil Shah* Phuong Truong Clara Batlle

GRAPHICS & VISUALS Alexandra Oprea* Ugne Greivyte Sin Yee Koh

FINANCE AND ACCOUNTING Dhruv Ghulati* Janara Kangeldieva Joyce Wong * Team Coordinator An LSE SU Finance Society Production.

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