Ifm volume 6 03 10 2014

IFM Independent Financial Magazine Issue 06 / 03 OCTOBER 2014

05 Equity Swap Trade

06 A Small Wite Lie

08 Dr securitisation and Mr CDO

09 Price vs Value

10 If it challenges you, it challenges you

14 Chinese Revolution

16 Is It Everyday Value?

Contents

IFM 03 October 2014

05 Equity Swap Trade Andy Baker

Derivatives basics in an investment bank.

06 A Small White Lie Pete McCarthy

The truth about the $300tn market.

08 Dr securitisation and Mr CDO Jonathan Taubert Were credit derivatives really to blame for the financial meltdown?

09 Price vs Value Jeremy Kempke DCF, no more!

10 If it challenges you, it challenges you Pete McCarthy If you want it, it yours.

14 Chinese Revolution Alan Konopka

Are capital market restrictions gripping to tight on the Chinese Market.

16 Is It Everyday Value?

Corey Gayle I guess every little doesn’t help.

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Independent Financial Magazine vol.6 30.10.2014

Editors View Greetings fellow financiers!

Welcome to a new semester of IFM’s that promise to be better than ever and should give you an insight into the major trends that move global markets.

It’s been six years since Lehman’s demise but we continue to see legacy issues plaguing developed nations. Yet to fully achieve escape velocity, the US are holding off on a rate rise but Janet Yellen has her foot ready to go on the accelerator. Mario Draghi in comparison has yet to buy a car.

The markets were disappointed with the lack of any serious plan for an ABS program, but I guess the old adage ‘patience pays off ’ will reveal itself in due course.

As for IFM, stay tuned for some blockbuster opinions, some controversial, some correct, but one things for sure, entertainment will be very much order of the day.

Happy reading folks and if you have any questions relating to any article, simply pop an email over to me or Alan and we’ll be happy to help!

Cheers!

Pete

IMPORTANT IFM magazine publishes information and ideas which are of interest to investors and students. It does not provide advice in relation to investments or any other financial matters. Comments published in IFM magazine must not be relied upon by readers when they make their investment decisions. Investors/Students who require advice should consult a properly qualified independent adviser. IFM magazine, its members do not, under any circumstances, accept liability for losses suffered by readers as a result of their investment decisions.

Members of staff of IFM magazine may hold shares in companies mentioned in the magazine. This could create a conflict of interests. Where such a conflict exists it will be disclosed. In keeping with the existing practice, reporters who intend to write about any securities, derivatives or positions with spread betting organisations that they have an interest in should first clear their writing with the editor. If the editor agrees that the reporter can write about the interest, it should be disclosed to readers at the end of the story. Holdings by third parties including families, trusts, self-select pension funds, self select ISAs and PEPs and nominee accounts are included in such interests.

Chief Editor Pete McCarthy

Chief Editor Alan Konopka

Creative Director Sarah Aoki

Andy Baker

Corey Gayle

Jeremy Kempke

Johnathan Taubert

Independent Financial Magazine

Issue 06 Published 03 October 2014 Front Cover #06

Bank of China Tower Hong Kong

Independent Financial Magazine vol.6 03.10.2014

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Capital Markets FINANCIAL MARKETS INDICATORS 03/10/2014

Indices FTSE 100 S&P 500 EURO STOXX 50 Nikkei 225 VIX

Commodities Gold ($/100 oz.)

Copper ($/ Brent Crude ($/barrel)

Level: 6,527.17 1,963.61 3,135.49 15,708.65 14.77 Price:

Quarterly Change: -2.51% 5.28% -1.16% 4.28% 2.50% Quarterly Change:

1195.44 3.0163 91.91

-8.14% 0.54% -13.46%

Rate:

Quarterly Change:

1.5971 1.2517 109.7200 0.7837

-3.67% -8.65% 6.18% -5.18%

Currencies GBP/USD EUR/USD USD/JPY EUR/GBP

Bonds 10Y 10Y 10Y 10Y

Volatility (Std Dev): 15.49% 11.66% 21.08% 18.42%

Yield 03/10/2014 2.39% 0.92% 2.46% 0.51%

UK Gov German Bund US Gov Japan

Economic Indicators Real global GDP (% y/y annualized) Real U.S. GDP (% y/y annualized) CPI inflation (% y/y)* Core CPI inflation (% y/y)* Unemployment rate, period average (%) Fed funds rate, end period (%)

Q4 2013

Q1 2014

Q2 2014

3.5 1.5 1.8 7 0.12

-2.1 1.4 1.7 6.7 0.12

4.2 1.5 1.7 6.2 0.12

2012 3.2 2.3 2.1 2.1 8.1 0.12

2013 2014e 3 3.0-3.5 2.2 2.0-2.5 1.5 2.0-2.5 1.8 2.0-2.5 7.4 6.3 0.12 0.12-0.15

Source: Bank of America

Variance Swaps SPX UKX DAX NKY HIS Source: HSBC & Bloomberg

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6m 0.16 0.158 0.186 0.21 0.19

1Y 0.18 0.171 0.204 0.232 0.209

2Y 0.203 0.19 0.221 0.244 0.23

2015e 4.0-4.5 3.5-4.5 2.0-2.5 2.0-2.5 5.4 1.0-2.0

Equity Swap Trade

Andy Baker

E

ssentially, a swap is a synthetic ‘made up’ product, based on an underling financial asset. The main types of swaps are interest rate and equity swaps. While there are key differences between the two, the same principles and fundamentals apply to both.

The below example shows a client going long on a trade; The two “legs”: Leg 1 - Equity leg - Performance of financial asset Leg 2 – Financing rate - LIBOR Rate + 100bps

With an average of $7.4 trillion per trading day in April 2013 alone , it is clear that the derivative market is vast; facilitating hedging, trading opportunities and yield enhancement.

On the most basic level, the simple swap is a transaction between two parties in which two ‘things’ are ‘swapped’.

Derivatives and swaps in particular have been used much more in today’s trading environment as a financial tool and even more so as a hedging tool to mitigate trading risk, whilst providing tax and leverage benefits to investors. This is due to swaps’ exemption from stamp duty. Banks are mitigating risk from their client trades whilst enhancing their yields compared to traditional equity trades.

The swap itself is broken up into two ‘legs’. A financing rate leg and an equity performance leg - this is the ‘swap’. Swaps are incredibly useful for investors as they can be used to long or short an asset, but additionally investors can benefit through leverage, only paying a small amount on the total value of the trade.

Now, for the easy bit! You may only pay 10% of the upfront total value of the trade as collateral. If the stock increases in value, the performance is passed back to you and you as the investor pay the financing rate over that time period. If you are long, and the price falls, you are liable for the price fall as well as the financing rate.

Within the industry, banks will replicate the client swap trade to create a ‘delta one hedged product’. Any gains by the client are simultaneously made by the bank, mitigating systematic risk. This has made the market for equity swaps a commission based market for banks, and a competitive one at that!

Independent Financial Magazine vol.6 03.10.2014

5

A small white lie

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Pete McCarthy

‘We need to bump it way high, highest amongst all if possible’.

That was the voice of Mr. Min, a Tokyo based RBS employee, the boss of Mr. Danziger, who by the way happened to submit the LIBOR for RBS. If you think that sounds dodgy, you’re not alone.

The London Inter-Bank Offered Rate or ‘LIBOR’ for short is a market driven rate; the rate at which banks borrow from each other to balance their books and fill the gap in short term funding.

One could ask, how did this rate make front-page news? I mean it’s only the basis for around $300 trillion worth of contracts from student loans to mortgages to interest rate swaps.

With such value depending on LIBOR, don’t you think it’s mad that the banks ‘estimate’ method of calculation is NOT based on actual transaction records?

Who said business was a science anyway?

The non- existent Chinese wall between the people who submit the banks rate for that day and the people

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Independent Financial Magazine vol.6 30.10.2014

on the trading desk meant submissions to the British Bankers Association (BBA) were effectively made up and designed to suit the proprietary trading division. One could have been mistaken to think that the rate was a genuine, honest rate. I mean this is banking after all.

It turns out banks like a good boost to the net income figure, which can be found around three quarters of the way down on a P&L account. One might be thinking, because the banks are pretty much the same and will therefore submit fairly similar rates, how could one submission from RBS skew the average rate? After all, the BBA discards the top and bottom four rates and average the eight in the middle.

Well sit tight for a telling statistic.

Lets take a portfolio worth $50 billion of interest rate swaps. RBS submits a rate that is slightly higher and I mean, slightly. The benchmark then rises by 1/5 of a basis point. To strip out the jargon, that’s 0.002%. As a result, RBS nets a cool $250,000. It doesn’t take a degree in finance to realize the benefits of the scheme.

With LIBOR impacting how much you can get on a savings account, what families pay on their mortgage and the returns on corporate debt, one could

be a bit miffed at the banks submitting rates to suit their trading desks. We never thought of bankers as the • but frankly, ambassador of the church, a minimum level of moral standards is not much to ask.

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Various regulators have hailed the LIBOR scandal ‘the biggest fraud of all time’. I tend to agree, yet the fines handed out are simply• dwarfed by the recent MBS fines imposed on Citi. UBS fined $1.5bn, Citi $7bn.

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I’ll leave you with this little transcript.

A UBS banker sent a message to an interdealer broker, with reference to the yen LIBOR (the cost • of borrowing yen in the interbank market), ‘If you do that…I’ll pay you, you know, $50,000, $100,000… whatever you want… I’m a man of my word’.

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The banking system needs a radical culture shift. Post 2008 it appears many • of the banks are indeed making such changes.

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Time will tell however whether the white lie turns out to be indefinite.

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Independent Financial Magazine vol.6 03.10.2014

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Dr securitisation and Mr CDO Johnathan Taubert

I

f you walk down the street and ask someone, what caused the financial crisis of 2008, many will just say, the house prices increased and then fell, and then chaos happened!

But what actually happened behind the scenes, it is obviously clear that this is not the case, it is all to do with supply and demand, back to economics 101, house prices do not just increase and fall on their own.

Securitisation is quite a complex financial concept, which was introduced in the late twentieth century. In simple terms, it is the idea of selling assets, like mortgages and loans. These assets would be collected by that bank and then sold on to the investment bank (IB). The IB would then pool all of the mortgages from various banks to create something called a mortgage back security (MBS). The MBS would later be sold on to investors, which would hopefully make a nice return on the investment.

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So what went wrong? Well, all was good until the banks realised that they needed more mortgages to supply the demand of MBS in the market place. This is when the, now, feared notion of “sub-prime mortgage” was introduced. Indeed, it was not until the late ‘90s that they were created.

The problem was that everyone had a mortgage; house prices went up by 194% between 1996-2006 alone. The issue at hand was that you had “bad” mortgages that were pooled with the “good” mortgages in the MBS. The IBs decided to separate the mortgages that were more likely to default with the ones less likely to default, by putting them into separate tranches within the MBS, already things seem a little dodgy. However, it gets worse, the IB did not stop there; they decided to create something called a collateralised debt obligation (CDO).

So, what is it? Well, the MBS has three tranches, senior (very secure), mezzanine (small chance of default) and the equity tranche (high chance of defaulting). The IB would take the

pool of assets below the senior tranche (AKA junk bonds), from various MBS, and would then put them together, to sell them with extremely high ratings (usually AAA-A) to the investors. How is that possible? The idea behind it is that the assets are diversified and so less risky, plus the benefit for the investor is that they can choose their risk and return strategy depending on the tranche they invest in. The IBs created the investor, the more mortgages were sold, the more MBS and CDOs were made, and the more money was made by the banks, it was brilliant! However, when house prices went south, so did everything else, the concept of diversification just made everything a lot worse, turns out that some of the assets that were pooled were not just from the US but everywhere, we were all affected.

Where are we now? Well, put it this way, Mr CDO should not cause any issues for a while.

Price vs Value Jeremy Kempke

I

t’s no news that the recent financial crisis has shaped today’s financial markets. Before you’re starting to worry whether this is another boring article on “what happened in 07/08” or “how can we prevent a repeat from happening”, I’ll correct you right here – It’s not. The recent crisis has forced central banks to adopt extreme policies, particularly with respect to extremely low interest rates (I promise that’s the last on 07/08).

In the following I will outline a thesis on how the past economic climate has affected current fundamental equity valuations and thus led to higher equity deal volumes (particularly M&A, IPOs and follow on offerings).

Any equity offering makes most sense if equity investors are pushing up the market and you’re able to receive the most amount of money for the least amount of shares issued. Intuition right? So why are we currently in a period of equity markets at all-time highs? There are many theories out there regarding sentiment, risk on/ off modes, valuations and most likely some voodoo magic too. Most of which are subjective and close to impossible to verify of having any actual impact (not saying they don’t).

One that is to some extent objective concerns valuations. However, why would valuations suddenly be higher than 6 years ago?

The primary valuation technique used is the Discounted Cash Flow analysis which predicts future profits and

discounts them back to the present (i.e. if you have £100 now and you can make 5% interest over the next 12 months then your £100 now is worth £105 in the future or vice versa your £105 in the future is worth £100 now. The 5% interest when reversing the process is called “discount rate” or commonly cost of capital and represents the minimum amount an investor is willing to accept.) The Discounted Cash Flow calculation essentially divides future profits by “1 + cost of capital” (If you want to know more about DCF, I advise you to come to the club’s Equity Research meetings every Wednesday). A low cost of capital which has been created through the central banks’ lending at low interest rates allows firms to access funding at a lower cost of capital. Everyone has learned in primary school that dividing by a smaller number returns a higher number and in turn higher valuations.

It is worth noting that this access to cheap funding in combination with some level of economic recovery seemed to have led to increased M&A activity (interestingly enough: cash only transactions are down 66% year on year) despite the target’s price increase on the other hand.

I’m not saying that the above mentioned points are solely responsible for what we have witnessed over the last 8 months but it is certainly something to keep in mind. #Food4Thought Independent Financial Magazine vol.6 03.10.2014

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If it challenges you, it challenges you Pete McCarthy

C

ongratulations to the European team on retaining the Ryder cup for another two years! There really is nothing quite like 24 competitors slugging it out in the highest of pressure cookers, when the whole continent rests on the line.

For me and I suspect I’m not alone in this view, that I feel the Ryder cup is the greatest event in sport. For those of you who play golf or have tried it, will know the complexity of the action, the up and downs in play over a season but most importantly, the emotions one has to put up with over the course of a round. In many ways the discipline shares similarities to trading in the financial markets.

But the booming drives, the flush 3 irons and the clutch putts to halve matches, having the ability to perform amidst a cauldron of pressure is not a coincidence. You see the result every two years but to get to where they are now takes years of work, struggles, 1,000 reasons why they should never play golf again and endless niggles and injuries. When you have a putt to halve a match, when you need it at that precise moment, to see it drop is the best feeling. Even against your friends at your local course, when you absolutely need to pull a shot off and the result is your imagination, you realise how special the game is.

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I guess its similar to scoring a penalty in a cup final or doing endless research on a company and making 20% the following week would possibly compare.

Whether you love golf or think it’s the dullest sport in history, performance is common whatever sport, business or exam situation. The satisfaction of putting in the long hours and then being rewarded at the end, simply makes it all worth it.

There are lessons to be learnt from watching over the weekend.

Graeme McDowell was 4 down to the blockbuster American Jordan Speith, whilst Rory Mclroy flew out the blocks against the gun slinging Rickie Fowler, shooting 6 under thru 6 holes. Some days everything will be in your favour. What separates the true champions is when things are going against you, how you respond will define you.

For me, as much as it was great watching Rory stripe every shot he looked at and his majestic swing is a beauty to behold, I preferred Mcdowell’s comeback. Leading the team out first places a certain responsibility on you to deliver the first blow, but going 4 down early, it would be so easy to just get blown out the water. But he eventually won the match due to the simple idea of

taking it to 3 down, then 2, then 1 and then All- Square. That composure we can all learn from.

One of my favorite quotes, ‘life is 10% what happens to you, 90% how you respond to it’. Over the course of the degree, I’ve had more up and downs than a yoyo, but each time I’ve encountered an obstacle, I don’t let it get the better of me. I hated public speaking. In fact, I was probably the shyest person in the universe. I could never understand how some people just seemed to ooze confidence when presenting in front of an audience.

But recently I spoke to 140 people in a lecture theatre, on my own.

I’m a great believer in a positive attitude. Particularly during exam time, I will never convince myself of any negativity. Those who constantly tell themselves, ‘I’m really stressed’ and then tell their friends, end up on a downward spiral when their mind is occupied on the wrong thing.

Even if I feel like I have a lot to learn, I constantly tell myself, whatever happens, it will be great, it will be great, it will be great. It works 100% of the time, why? I believe it, so it works.

When life throws you into difficult spots remember, you’re there for a reason.

Impossible is nothing.

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Independent Financial Magazine vol.6 03.10.2014

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“Price is what you pay.

Value is what you get.�

Warren Buffett

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“Finance is a craft that can become an art with skill and proper application.�

Michael Milken

Independent Financial Magazine vol.6 03.10.2014

13

Chinese Revolution Alan Konopka

R

ecent developments in Hong Kong might suggest the mind shift not only in political matters, as Umbrella Revolution in HK shows, but also in capital markets.

While participants of the Umbrella Revolution in Hong Kong demands more democratic powers from Beijing, equity capital markets are silently demanding more “capitalistic” powers for investors.

One of the most recent “silent demands” was the stock market listing of the biggest on-line platform for retail and wholesale in China: Alibaba. After heated debates of the best place for equity offering, Jack Ma and the Board of Directors decided to list in New York on NYSE rather than on Hong-Kong Stock Exchange. Such decision was motivated mostly by the dual share classification that the New York Exchange had to offer under the US legislation. Unlike Chinese regulations that offer one vote for each share owned, New York allowed Alibaba to issue shares that carry less or no voting rights.

Under NYSE listing regulations, the

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firm’s chairman, Jack Ma, will control nominations to a majority seats on the board. According to Alibaba’s prospectus, the move will allow the firm to retain its structure and preserve its corporate culture.

Another issue that caused many investors’ headaches was capital flow regulations for foreign investors in and out of Chinese equity markets.

Chinese equities are the world’s worst performing markets since the stock market peak in 2007. This is due to the strict rules imposed on foreign investors. The only foreign investors who have access to Chinese markets were big institutional investors like pension funds. In addition, investors could not buy and sell shares on the same day.

It was also close to impossible to withdraw your capital once the shares have been liquidated. That however comes to an end with the new Hong Kong and Shanghai stock market scheme called “the through-train” that will allow any foreign investor to buy and sell stocks directly listed on Chinese exchanges.

Although there will be restrictions in terms of the limit on capital flow between these two exchanges (300bn yuan annually from HK to Shanghai and 250bn yuan from Shanghai to Hong Kong), there should be no significant disruptions as the quoted figures represent net amounts and does not take into consideration transactions between investors on the same exchange.

Credit Suisse and UBS, two Swiss banks announced that theoretically any of their clients would now be able to invest in China.

Will that cause a significant inflow of capital into Chinese equity markets?

The answer is yes.

Many smaller investors like hedge funds or day traders are still hungry for a piece of Chinese action.

Keep in mind that such a loosening of regulations is just the beginning and many more will be sure to follow.

Boarding the Chinese train early might turn to be one of the best decisions for investors since creation of joint-stock company.

Independent Financial Magazine vol.6 03.10.2014

15

Is It Everyday Value?

Corey Gayle

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n recent weeks Tesco PLC has not been the markets favoured supermarket with general consensus amongst investors and traders being sell. However this is no new phenomenon as for the past year Tesco has experienced around 48-49% decline in the general share price. Some contrarian investors all of a sudden have stamped their feet and seem to think Tesco is a great idea because its ‘cheap’.

I’m afraid I disagree, Tesco can be summarised into three key reasons why not to buy at the moment. Firstly, the accounting scandal whereby there has been a £250 million overstatement in profits, it seems corporate governance was forgotten in search of growth overseas- which also didn’t go too well. However this scandal is potentially the tip of a very large iceberg, outside auditors have been called in and a full FCA investigation has been launched to unearth the unknown. This is a huge risk and could in theory mutilate Tesco’s share price if further discrepancies are uncovered in the accounts within the UK or overseas businesses.

Secondly, Tesco are a victim of falling sales; this has come at the expense of a poorly delivered company strategy to try and grow overseas while

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targeting a different customer base in the UK. Furthermore the decline has materialised through much stronger competition in the form of Aldi, Lidl, Asda and even Sainsbury’s in Tesco’s so called strong hold being the UK where 79% of Tesco sales are generated. In the past 8 years Tesco market share has fallen consecutively year on year from 32% to about 28% today. It may not seem like a lot, but there is no sign of this decline slowing and with Tesco already been so large it’s difficult to grow a company of that size unless it was overseas which so far has been a failure to put it mildly.

Last of all, the one reason maybe a long term investor would be willing to buy and hold Tesco shares would be the impressive yield that could have been received. That was short lived in the next set of interim results Tesco have already announced that the current dividend will be cut by 75%. The reason for this comes from falling sales and profits but an ever growing burden from the groups pension deficit and rental requirements. In the light of such a situation Tesco loses its attraction as an income play.

Aside from the investor’s perspective and more what a trader would look at being technical indicators and price action. The relative strength index

for the last 5 days shows that Tesco is very much in a lasting downtrend as appose to displaying a signal for showing oversold activity (RSI figure currently, 12.89). Further to this Tesco has now approached a new key support level to which if it breaches we can expect further declines in the Tesco share price; the key price level is recently set at its new 52 week low being 177.75p. However if the support level holds you can expect the market to go sideways or back up but I would keep at the front of my mind this would only be a traders play for the short term as the fundamentals hold greater weighting to Tesco’s fate and value.

As an amalgamation of the three negatives and what the trading signals infer it’s fair to say in my opinion Tesco is not ‘everyday value’ but at this moment in time the approach I would adopt would be very much a wait and see. As if no more scandals are revealed in the accounts and with the new CEO reverting back to Tesco’s original success strategy of focusing upon the middle class masses, then this could certainly be an opportunity to buy in the future as you would expect the corporate governance to certainly improve and hopefully sales and profits begin to stabilise or grow slightly.