Financial Education

Derivative agreements are contracts between two parties, under which at least one of the parties faces a financial obligation to the other. Each counterparty to a contract can be subjected to credit risk, or the possibility that the other party fails to meet its obigation.

In a forward contract, commitments are made at the contract outset but settlement is due at expiration. Consider an agreement under which party A agrees to buy the S&P 500 index from party B for 1,500 in one year. If  the S&P 500 is at 1,400, party A owes party B 100, and party B faces potential credit risk (prior to settlement) and actual credit risk (at the time of settlement.) When the S&P 500 is higher than 1,500 it is party A that is subject to credit risk.

Swap contracts are similar to a series of forward contracts, with interim payments occurring along the way. Each payment exposes one party to credit risk. As each payment is made, the total potential credit risk is reduced.

Option contracts have unilateral credit risk - only the seller is obligated to make a payment, so only the buyer is exposed to credit risk once the initial premium has been paid.

Market risks related to the economy, interest rates, and the state of the market are relatively unimportant when considering investments in distressed securities. There are, however, several types of risks that particularly apply to investments in distressed securities.

Event risk relates to unexpected company-specific or situation-specific events that affect valuation.

Market liquidity risk arises because distressed securities are less liquid, and demand runs in cycles.

J-factor risk relates to the judge presiding over bankruptcy proceedings. The track record in adjudication and restructuring can play a significant role in both the overall outcome and determining the optimum securities in which to invest.

When considering an investment in private equity, investors need to consider a number of factors.

• Can a small investor obtain the diversification needed
• Does the investor have liquidity needs that would prohibit tying up funds for 7-10 years
• Will the investor be able to fund promised commitments to the private equity fund when called for
• What mix of sector, stage and geography is required to provide the best diversification

In addition, selecting managers requires special due diligence considerations:

1. Can the investor and manager evaluate prospects for market success
   • Understanding of the markets, competition and sales prospects
   • Experience and capabilities of management team
   • Management’s commitment - ownership, compensation structure, etc
   • Opinion of customers
   • Identity of current investors - do they have particular expertise that lends confidence to outsiders
2. Operational review
   • Have experts validated the technology
   • Consideration of employment contracts
   • What intellectual property rights have been established
3. Financial and legal review
   • Potential dilution of interest
   • Financial statement (or tax returns, or investor-conducted audit)

The Herfindahl index is a measure of how concentrated an industry is. An industry with few competitors will have a high level of concentration, while many competitors results in low concentration.

The Herfindahl index measures concentration as the sum of the squared market share of each firm in the industry. For example, consider an industry with six competitors, with respective market share of 30%, 20%, 20%, 10%, 10% and 10% the Herfindahl index will be (0.3*0.3) + (0.2*0.2) + (0.2*0.2) + (0.1*0.1) + (0.1*0.1) + (0.1*0.1) = 0.09 + 0.04 + 0.04 + 0.01+0.01 + 0.01 = 0.2.

As a general rule, a Herfindahl index below 0.1 signals low concentration, while a Herfindahl index above 0.18 signals high concentration. Between 0.1 and 0.18 the industry is moderately concentrated.

If all firms in an industry have equal market share, the reciprocal of the Herfindahl index (1/H) will equal the number of firms in the industry. For industry in which firms have unequal share, the reciprocal of the Herfindahl indicates the “equivalent” number of firms. In this example, the six firms in the industry have the same level of concentration as an industry with 1/0.2 = 5 competitors with equal market share.

Compared to the N-firm concentration ratio, the Herfindahl index offers greater discrimination as it includes all firms in the industry and weights the firms according to market share. However, it is not a particularly intuitive measure.

When choosing a fixed income manager, some important points to consider include:

1. Outperformance net of fees is especially difficult for fixed income managers
2. Style analysis can indicate the ways the portfolio construction differs from that of the benchmark. Is the investor happy with these deviations?
3. Selection bets can be determined through return decomposition to identify whether the manager is skilled in credit analysis
4. The investment process should be understood to know the methods used and the drivers of alpha
5. If multiple managers are used, the alpha generated should not be highly correlated with that of other managers

Inventory cycles tend to last two to four years. As business improves, greater confidence in future sales cause management to build inventory in anticipation of those sales. At some point, the sales fall below expectations and the inventories form a glut.

In order to clear inventories, prices are cut and fewer inventories are ordered. Eventually the inventory gets worked down. When sales do finally pick up again, this can sometimes lead to shortages.

Buy and Hold

Investors who use a buy and hold strategy set their initial allocation weights and then do nothing. Such allocations are directly related to the market performance of risky assets, and using them implies that risk tolerance is directly related to wealth and market returns.

Consider a 60/40 split between stocks and the risk-free asset. As the stock market rises (falls), stocks represent a larger (smaller) weight in the portfolio and The risk-free asset provides a floor value. Returns are directly related to market performance in a linear relationship.

When markets are trending, buy and hold methods can perform well because the better performing assets get increasingly larger weights and poor-performing assets have less impact.

Constant-mix

Constant mix rebalancing is a dynamic process that requires rebalancing to the intial target allocation by trading whenever market conditions alter the ideal balance. The strategy ensures that the portfolio’s risk characteristics remain stable over time, consistent with a risk tolerance that varies proportionately to wealth.

Constant-mix strategies can be characterized as contrarian, as they sell the best-performing assets to buy the worst-performing. However, when markets are mean-reverting this will perform better than a buy and hold strategy. The shape of returns is concave - return increases at a decreasing rate in positive markets and decreases at an increasing rate in negative markets.

Constant Proportion

In a constant proportion strategy, the target allocation is a function of cushion, where cushion is the difference between the portfolio value and the floor value, and the allocation to risky assets is the product of the cushion and the proportion (m).  A buy and hold strategy represents a special case in which m = 1. This strategy is consistent with having no risk tolerance if there is no cushion.

If m > 1, the strategy is known as constant proportion portfolio insurance, or CPPI. CPPI strategies buy more stocks when markets are rising and sell stocks as markets fall. The dynamic allocations also affect the floor value, as changing the weight of the risky asset necessitates an opposite-direction change in the floor value.

In strong bull markets, CPPI performs well by continually allocating more to stocks. In strong bear markets, CPPI avoids large losses by rapidly reducing the allocation to stocks. Such returns can be described as having a convex shape as the return increases at an increasing rate when market returns are positive and decreases at a decreasing weight when market returns are negative.

When markets are characterized by frequent reversals, the constant changes in allocation result in high transaction costs that erode performance.

International Accounting Standard (IAS) No. 1, Presentation of Financial Statements, sets out the following general requirements.

Required Financial Statements

A complete set of financial statements includes a balance sheet, an income statement, a statement of changes in shareholders’ equity, a cash flow statement, and notes summarizing significant accounting policies and other explanatory notes.

Fundamental Principles of Preparation

Fair presentation requires faithful representation of the effects of transactions, events and conditions in accordance with the definitions and recognition criteria for assets, liabilities, income and expenses set out in the Framework.

Financial statements are prepared on the basis of the firm being an ongoing entity (going concern). If the firm is being liquidated or will cease business, this must be disclosed.

Financial statements will be prepared on the accrual basis of accounting.

Presentations and classifications should be consistent from one period to the next.

Omissions or misstatements are material if they could influence the economic decisions taken by financial statement users. Material items should be presented separately.

Presentation Requirements

Each material class of similar items is presented separately, as are dissimilar items unless they are immaterial.

Assets and liabilities, or income and expenses, shall not be offset unless specifically required or permitted by an IFRS.

The balance sheet should distinguish between current and non-current assets and liabilities unless a liquidity-based presentation provides more relevant and reliable information.

IAS No. 1 outlines the minimum information that must be presented on each financial statement and in the notes.

All amounts reported in a financial statement should have comparable information for the prior period.