Archive for May, 2008

Information Content of the Option Volatility Skew

Deep out-of-money options tend to trade with higher implied volatility than near-money options, a phenomenon known as the volatility skew. In the October 2007 Journal of Futures Markets, Doran, Peterson and Tarrant extend this observation to ask whether the implied volatility skew becomes more positive immediately prior to a market spike or more negative immediately prior to a market crash.

They find that at the short end of the term structure, the skew does give information regarding an impending crash. There is less information conveyed from positive skew. Further along the term structure, information content from volatility skew is weak.

Posted on 5th May 2008
Under: Derivatives, Economic Analysis, Investment Returns, Options, Research | No Comments »

Longevity Annuities

Longevity annuities exchange an up-front payment for a stream of payments that will begin some years after retirement. For example, the annuity may be purchased when the investor is 65, but only begin to pay benefits when the investor turns 80. Benefits will continue for the remainder of the investor’s life.

Investment annuity payouts per dollar invested are much higher than immediate annuity payments for several reasons:

  • The lack of payouts in early years allows for greater compounding benefits on investment returns
  • The shorter remaining expected life span after payouts begin allows for each payment to be larger
  • Potential annuitants who die before reaching the target age subsidize returns for those who live longer

In the January/February 2008 Financial Analysts Journal, Scott argues that many investors will benefit from an allocation to longevity annuities, and that the optimal bundle depends upon the percentage of total assets the annuitant is willing to allocate to annuities. The greater the proportion annuitized, the earlier payments should start.

Posted on 4th May 2008
Under: Alternative Assets, Asset Allocation, Investment Returns, Personal Finance, Risk Management | No Comments »

“Best Execution”

Part of the responsibility of any investment manager is to seek the best possible execution for clients. Best execution is the trading strategy that maximizes the value of the client’s portfolio, subject to the investor’s objectives and constraints.

Some characteristics of best execution include:

  • A tie to the investment decision (obtaining the right price or capitalizing on the information)
  • Inability to know what the best execution will be prior to the actual execution, but an ability to measure and analyze the execution afterward
  • A component of complex practices and relationships that are undergoing continuous refinement

To help achieve best execution, firms should establish processes around maximizing the asset value of client portfolios, and establish guidelines for measuring and managing execution. The compliance with these procedures should be documented and disclosed to clients.

Firms should also disclose general information about their trading techniques, venues and agents and also any potential conflicts of interest that may result.

Posted on 4th May 2008
Under: Active Management, Governance, Institutional Investing, Investing in Stocks, Passive Management, Portfolio Management, Risk Management, Trading Execution | No Comments »

Types of Securities Markets

Global securities markets are organized into a number of different structures.

Quote Driven (Dealer) Markets

These markets rely on dealers to provide liquidity by establishing firm prices at which securities can be bought or sold. The dealers will buy securities for inventory at a specified offer price and sell securities from inventory (or short) at a specified ask price. The dealers’ benefit for providing liquidity is the difference between the bid and ask prices (the bid-ask spread).

Dealer bid and ask prices are subject to a limit on the number of shares offered (bid or ask size). In effect, the bid and ask are limit orders placed by the dealer. If multiple dealers are placing orders, it is not necessary for the same dealer to have the best bid and the best ask. Consider the following dealer order book:


Dealer C is offering the best bid for shares at $100.05. Any sell orders will go to dealer C. Dealer D is offering the best ask price at $100.15 and will fill any market buy orders. Although Dealer B is willing to accept the smallest spread, he is not offering the best price at either the bid or the ask and will only fill orders that exceed the bid and ask sizes offered by dealers C and D.

The inside quote is the best bid from any dealer and the best ask by any dealer. The spread for the inside quote will be less than or equal to the smallest bid-ask spread for a given dealer.

Order Driven Markets

In order driven markets, transaction prices are established by  public limit orders and there is no intermediation by designated dealers. The lack of dealers could have different types of impact on order prices:

  • Competition could be higher because there are more public participants than there would be dealers. This is often true of highly liquid securities.
  • Competition could be lower because there are no dealers who are required to fill orders by taking in or drawing down inventory. This can be the case for less liquid securities.

Current trends favor order-driven markets, including:

  • Electronic crossing networks that batch orders together and cross them at a specific time. The fulfillment price will be the price at which the most shares can be traded – all buy orders with prices above the trading price are matched with the sell orders below that trading price. When trading on such networks there is no price discovery – the price at execution is not known until there is execution.
  • Auction markets in which orders compete for execution. Since the orders are visible there is price discovery. Auction markets can be batch markets or continuous auction markets.
  • Automated auctions operate continuously and offer price discovery. Execution is based on a set of rules.

Brokered Markets

The broker is an agent of the buy side trader who collects a commission in exchange for skillful execution of the trade. Particularly when a trade involves blocks of illiquid securities, a broker may be useful for finding a natural counterparty. In some cases the broker may put its own capital at risk and take the other side of the order, hoping to find various parties willing to accept parts of the order at a later time. Brokers may also be useful in providing a reputational screen – offering the trade only to parties that will not try to trade in front of it.

Hybrid Markets

Many markets operate as a combination of the types listed above. For example, the New York Stock Exchange batches orders for market-on-open and market-on-close execution using a batch auction process. During the day, trading is accommodated using a continuous auction process. This consists of both order-driven quotes that do not reach a dealer and dealer-driven quotes offered by the specialists.

Posted on 3rd May 2008
Under: Active Management, Institutional Investing, Investing in Stocks, Portfolio Management, Security Selection, Trading Execution | No Comments »

The Income Statement: Operating versus Non-Operating Components

On the income statement, accounting standards encourage separate treatment of operating and non-operating items. Operating items are those relating to the day-to-day management of the enterprise: sales, cost of sales, selling, general and administrative expense, research and development costs, etc. Often the net of these items is presented as a subtotal, operating income.

Non-operating items include investing and financing activities, which are reported separately from operating income (unless pertaining to a financial services firm, for which such items are operational.) Non operating items include the interest, dividends and profits on investments made in the securities of other companies; interest expense; etc.

Some investments in other companies are made for strategic reasons, such as access to raw materials. In these cases, investors and analysts may wish to classify the investments as operating.

While taxes are a normal operating expense, they are also affected by non-operating items. Often, analysts will adjust operating profit by the tax rate to arrive at NOPAT (net operating profit after tax.)

Posted on 2nd May 2008
Under: Adjusting Reported Financial Statements, Financial Statement Analysis, Fundamental Analysis, Investing in Stocks | No Comments »

Value Weighted Index

A value weighted security index is calculated by summing the market capitalization of each stock in the index. A derivation of a value weighted index is the float weighted index, which uses only the freely trading shares to calculate market capitalization. Today, most capitalization weighted indexes are actually float-weighted.

A major advantage of value weighted indexes is that they automatically adjust for corporate actions such as stock splits. The decline in value per share following a split is exactly offset by the increase in the total shares outstanding. Stocks with higher market capitalization receive relatively more weight in the index.

Posted on 2nd May 2008
Under: Investing in Stocks, Investment Returns, Passive Management, Performance Measurement | No Comments »

The Top Down Approach to Security Selection

The top down approach to security selection is described in Investment Analysis and Portfolio Management (with Thomson ONE – Business School Edition) as a three-step process.

  1. Analysis of alternative economies and securities markets to decide how to allocate investments among countries, and within countries to asset classes such as stocks, bonds or cash.
  2. Analysis of alternative industries, based on the results of the market analysis. Which industries are likely to prosper or do poorly, both globally and on a country by country basis?
  3. Analysis of individual companies and stocks, based on the results of the first two steps. The final objective is to select the best securities in the industries most likely to benefit from economic trends.

Studies have shown significant relationships between a stock’s earnings and aggregate industry or market earnings. Other studies have demonstrated relationships between stock performance and economic data series. Significant portions of total return can be attributed to industry and market effects as well. These findings offer support for the top-down approach to security selection.

Posted on 1st May 2008
Under: Security Selection | No Comments »

Margin Transactions

Investors have the option to invest borrowed money, leveraging the return on their transactions. Brokers provide margin funds for this purpose.

In a margin transaction, the investor posts a portion of the cash needed to buy a security and borrows the rest. The stock or security purchased serves as collateral on the loan.

The Federal Reserve Board determines the margin requirement, or maximum portion of any transaction that can be made using margin. A lower margin requirement permits higher borrowing levels. Currently the margin requirement is 50%, meaning investors can borrow up to half the funds for a transaction.

Using margins exaggerates the return on an investment. For example, buying 100 shares of stock for $100 per share at 50% margin, the investor uses only $5,000 cash. The investor’s cash is also called the “equity” in the transaction.

If the stock rises to $110, the shares are worth $11,000 but the investor would still only owe $5,000 (plus some interest.) The equity has increased to $6,000 – which is a 20% gain even though the stock itself rose only 10%.

Of course, the same phenomenon works in reverse. If the stock falls 10% to $90, there is only $4,000 of equity and the investor loses 20% when the stock has lost just 10%.

Posted on 1st May 2008
Under: Investing in Stocks, Securities Regulation, Security Selection, Trading Execution | No Comments »