FiNZ Blog

Psychospritual Aspect in Financial Planning

2010-04-29T16:52:00.000-07:00

Displaying the Psycho-spiritual Aspect of Personal Financial Planning: A Suggestion on Key Factors Indicating Prosperity in Qualitative Valuation

Jeffry Merril Liando (2002)

1. Introduction: Psycho-spiritual Aspect as Key Result Area

The psycho-spiritual aspect of personal financial planning inevitable takes place as clients deeply rely on and expect too much of their financial planner’s care. This is fairly seen as the impact of financial planner’s effort to build a strong and ongoing relationship. In this essay, a psycho-spiritual aspect is defined as a view in searching a client’s psycho-spiritual issues relating to valuation of a client’s ongoing peace of mind. Ongoing peace of mind is a remarkable main outcome of the financial planning relationship,[1] therefore this can be taken as a goal in a key result area (KRA) of psycho-spiritual aspect (PSA) for a personal financial planning (PFP) enterprise.[2]

The goal of maintaining client’s ongoing peace of mind in the KRA of PSA can be stated in objectives on which each of them is specified, measurable and possible to result an appropriate outcome in a period of time.[3] All of the outcomes are simultaneously used to achieve the goal. This essay is directed to discuss the concept, method and process of setting the objectives, appraising the PSA based on the money consciousness concept through a method of defining the key factors of prosperity and a process of qualitative valuation in the framework of the PFP process. The objectives are specified by defining the key factors of safer, happier, richer and benevolent, measurable on the critical values decided on a client’s concerns, and possible to achieve with a planner’s recommendations with respect of the financial ratios as the outcomes. All the outcomes are used to prejudge a client’s PSA condition whether prosperous (ongoing peace of mind) or scarce condition in the process of qualitative valuation. If in realisation of planning the valuation indicates prosperous condition, then financial planners achieve the goal of a client’s ongoing peace of mind and a client is recommended to follow a stewardship program.

Financial planners realise their limits in covering the psycho-spiritual aspect although they work closely with a client’s dreams, emotions and hardships.[4] This also regards the rule of competence that ensuring the member of the Financial Planners and Insurance Advisers Association Incorporated (FPIA) in New Zealand to perform services on a competent, efficient and business-like manner and only advise in those areas in which the member has competence.[5] Therefore, in order to display the PSA as a justified strategic form, it is necessary to simulate the whole strategic in the framework of the personal financial planning process. This can be seen in appendix 1, which only describes the goals of each KRA and its objectives concerning the code of ethics and professional conduct of the FPIA Association Incorporated, New Zealand.

2. Money Consciousness as Basic Concept

The basic concept used to interpret the psycho-spiritual aspect is that the money consciousness. A money consciousness is how a person feels, think, and believe about money. This consists of a prosperity consciousness (PC) and a scarcity consciousness (SC). People with a PC know that there is a limitless supply as they will receive and can generate their share more. On the other hand, people with a SC never have enough and are afraid of losing whatever they own. In other words, the PC indicates certainty in finances whereas the PC indicates uncertainty.[6]

Inconsistency in a Client’s Judgement

However, a view in the framework of capitalism-individualism suggests that there are always factors of competitiveness, unequal power and upgrading capacity in people’s mind, which may influence them to wonder whether there is a certain profitably limitless supply of money every time or not.[7] People can have their own judgement based on their record, current status and achievement. Thus, it is possible that one who actually has a PC will feel, think and believe having a SC anyway, or vice versa. Here, the role of financial planners can be to give them appropriate advice using reasonable and prudent judgement based on the fact of diagnosis, which honestly showing their financial condition. Planners then direct them to accept upgraded or downgraded objectives in the recommendation, which financially showing genuineness.

For example, a client feels have failed to upgrade his car $10,000 to a $30,000 car after five years and fears that his colleagues may underestimate him (a SC). By showing his record, he can be judged success (a PC) when brought both his wife and daughter together to Europe attending his son graduation two years ago as he spent $9,000, three times bigger from the budget. Then, he may be recommended to make a new plan to upgrade his car for $20,000 and buying his daughter a $10,000 car for the next five years and encouraged to be proud of his achievement on his son’s education. Another example, five years later he feels success to upgrade for $50,000 car and buy a $10,000 for his daughter and do not fear anything (a PC). By showing his current status, he can be judged failed to control his daughter expenditures costing $10,000 in the current month. As a result, the amount overdraft and credit card is notified over than 30% of call deposits as planned and there will be significant interest loss of 5%.

Money as Energy

From a holistic point of view, money is thought often of as energy that is not a thing to be possessed but an action to transact, transfer and exchange.[8] The psycho-spiritual view of this concept is how human being uses money for purpose and finds satisfaction by not looking at the amount but through assessing the positive things affected when achieving, aligning and balancing the goals. For example, for the same amount of personal income, it can be derived whether from an independent income from salary or a dependent income from income support. Paying for purchases can be considered whether on cash or by credit card. Loans to family member can be decided eventually as a gift. Moreover, there are choices when allocating funds whether for buying lifestyle assets, holiday, travel, saving/investment or charity.

3. Defining the Key Factors of Psycho-spiritual Aspect in Financial Planning

In order to apply the PSA in PFP, using the interpretation of money consciousness and money as energy, financial planner can judge a client’s psycho-spiritual conditions whether prosperous or scarce, using qualitative valuation. Although both conditions can be known based on a client’s judgement, several general factors need to be defined by financial planners when carrying out the PSA in the PFP services. Defining the factors that are significant in judging both conditions, financial planners can then ask a client to determine his or her tolerance in numbers for particular factors. For example, one of particular factor of a prosperous condition is to have appropriate overdraft or credit card facilities. After asked, a client determined that his secured bank overdraft and credit card facilities has to be up to 30% of call deposit account with interest loss level up to 1%.

Money Capacity

Hence, the factors to view psycho-spiritual conditions will be discussed in regard with the rationale of money capacity. Money capacity can be suggested as one’s ability in both action and amount to transact, transfer and exchange in and over lifetime. Relating to the personal financial planning process, a full capacity of money may include all items of balance sheet, income statement, budgeting, portfolio management, risk management, retirement planning and estate planning. For the purpose of defining factors of PSA in the framework PFP, a full capacity consists of a given capacity, a psycho-spiritual capacity, and a disregarded or irrelevant capacity.

Basic Assumption of Given Capacity

As basic assumption, a given capacity of money means a client’s ability to handle all basic expenses, mortgage, all items in risk management and taxations using current account funded by his regularly permanent personal income. This also means a capacity that has to be existed, sustained and stable, therefore as given factors these do not have any effect to the peacefulness and the fearfulness in a client’s mind in financial planning. Every people must cope all their basic living expenses, have and repay the mortgage for housing, cover all the risks they have, such as emergency fund, income protection, security of the home, provision in the event of debt and health cover. It is important to note that covering risk by providing emergency fund relates to maintaining unused capacity of bank overdraft and credit card along with accumulating fund in call deposit account.[9]

The Key Factors Indicating Prosperity from Psycho-spiritual Capacity

A psycho-spiritual capacity can be then defined as a client’s ability to provide money for the purpose of: (1) repaying bank overdraft and credit card without any significant interest loss, being safe as showing accountability to creditors, (2) financing lifestyle assets expenditures and travel and holiday expenses, being happier as realising dreams and enjoying life, (3) rising net worth, being richer as sustaining growth, and (4) giving a portion for charitable funds (or other types of donation), being benevolent as shares grace to others. These four factors, in my opinion, are then the most suitable and reasonable factors to view and judge a psycho-spiritual condition whether prosperous or scarce.

Irrelevant Capacity in Displaying the Psycho-spiritual Aspect

A disregarded or irrelevant capacity, which can be disregarded and is not relevant to concern only when examining a client’s current psycho-spiritual condition, is ability to finance financial assets gaining appropriate returns (as in portfolio management) and to provide appropriate funds or net worth for retirement planning and estate planning. Portfolio management seems like more technical-analytical aspect, moreover this factor is likely refers to examining a financial planner’s competence in advising a client’s portfolio decisions. Retirement planning cannot be chosen as a PSA factor because it depends on how great a client generates net worth before retired. Being prosperous at retirement depends on being prosperous when still productive. Estate planning has been covered by the term of life insurance in the given capacity of risk management.

In conclusion, taking the four factors defined in the psycho-spiritual capacity as the required conditions, a prosperous condition can be judged as a condition on which a client is safe, happier, richer and benevolent. On the other hand, a scarce condition can be judged a client is not having all of the criterions together. The critical values of the factors or criterions are therefore decided based on a client’s concern, worry or desire. However, to portray the PSA in the PFP process using the defined factors above, qualitative valuation is need to employed.

5. Qualitative Valuation in Portraying the Psycho-spiritual Aspect

Financial planning is an art therefore should not be identical between the clients and covers unique requirements and circumstances (the psycho-spiritual aspect) as much as possible to gain from the services provided applying a “modular” planning. Ongoing peace of mind should not be ignored as a main outcome of the financial panning relationship. The key factors determining the successful outcome “are highly dependent upon the planner’s ability to establish empathy and trust with the client and to build a strong and ongoing relationship.”[10] Therefore, a client’s ongoing peace of mind about money can be used as a measure of achievements in establishing empathy and trust along with building a strong and ongoing relationship. However, a client’s current financial condition as caused by his decisions is viewed quantitatively whereas on going peace of mind about money is a qualitative measure.

Overall Process of Qualitative Valuation

The technique of portraying the PSA in the PFP process uses qualitative valuation. At the stage of establishing goals and objectives in the PFP process, qualitative valuation starts through offering a client the four PSA factors as qualitative criterions, i.e. safer, happier, richer and benevolent, and then determining the critical values of each factor using financial ratios. Then, it continues to qualitative assessment, which is carried out mainly at the stage of regular review and monitoring for the purpose of PSA analysis. Quality assessment consists of two steps, first, through financial ratios analysis detecting each factor of qualitative criterions regarding its critical values and concluding a client’s condition as a planner’s prejudgement. Second, through interview observing each factor of qualitative criterions regarding its attitude scales and finding out a client’s judgement of PSA condition. Third, based on early warning signal system, determining the level of critical values of the PSA factors to predict a prosperous condition in the future.

Financial Ratios Representing Key Factors

At the first step of quality assessment, financial ratio analysis is used to evaluate the four PSA factors focusing on bank overdraft and credit card balance, expenses for lifestyle assets, travel and holiday, net worth balance and disbursement in charity donation. This will refer to both cash flow and balance sheet items shown in a client’s financial report and several financial ratios used in financial modelling and analysis.

The first factor is to ensure that a client is able to repay and gain both bank overdraft and credit card without any significant interest loss. This can be interpreted by comparing the total amount of bank overdraft and credit card account to the total amount of call deposits. Moreover, any significant interest loss can be interpreted by comparing the total accrued interest fees payment of bank overdraft and credit card to the total accrued interest incomes receipt of call deposits.

Here, client is asked to determine concerned percentages for both ratios. Client is recommended to avoid using overdraft and credit card to cover all basic living expenses (incl. foods, clothing, accommodation and transportation), mortgage repayment, insurance expenses (incl. health, income, life and house insurance), and taxes. Besides that, client is expected to have willingness to keep an appropriate amount for saving and call deposit accounts along with keeping an unused capacity for overdraft and credit card facilities in the current account. However, this is done after covering other expenses, such as investment cost (on planner’s advice), entertainment expenses and lifestyle assets.

The second factor of condition is to ensure that a client is able to finance lifestyle assets purchase and pay for other expenses (including dinner-out, shopping, holiday, entertainment and overseas travel). The ratio for this is the comparison between actual and budgeted of other expenses plus life style assets expenditure. Here, a client is asked to determine concerned percentages for the actual-budget variance and committed to spend expenses more than or at least equal to those he has planned or dreamed.

The third factor of condition is to accelerate the net worth every time. This can be interpreted by calculating the growth of the net worth every time. Here, a client is asked to determine a desired growth every time. A client has to understand that the growth cannot go down at least it has to be maintained at same level.

The fourth factor of condition is to ensure that a client as a success human being has given a portion of his income by sharing grace in charity or any other donations to others or society. The ratios are suggested as follow, total charity and other donation to total interest income and total church donation and gifts to personal income. This seems like idealistic because a client is unlikely to mention how much they have spent for those. Therefore, this factor can be assessed only with a client’s honest himself.

From diagnosing of these four factors, a financial planner would be able to analyse a client’s PSA condition, as a prejudgement, whether a client is in prosperous or in scarce. A client can be said in prosperous condition if all of the conditions are achieved, whereas a scarce condition is judged if any of those are not achieved.

However, the prejudgement at the first step of valuation may be inconsistent with a judgement, which a client really feels, thinks and believes. This regards the limits of financial planners in applying PSA in PFP. As the ongoing peace of mind can be considered as an expected outcome the financial planning relationship, a prosperous condition should reasonably and prudently be portrayed by a financial planner. Therefore, a planner has to conduct an interview, at the second step of valuation, diagnosing the factors of PSA and analysing qualitative conditions to find a client’s judgement. This can be done through questioner with attitude scaling basis.

As the process occurs during the time of planning relationship, qualitative valuation can continue to the third step, that is an early warning signal system. Using statistical probability methods, a prediction model of a client’s condition in the future is judged by scoring the multiple regression function of the PSA factors. By putting current ratios of PSA factors into the function, the probability of prosperous condition then can be predicted. However, this method is not discussed further in this essay.

Stewardship and Coaching

After undergoing the qualitative valuation of PSA analysis, financial planners will know a client’s condition whether prosperous or scarce condition. If a client’s condition is prosperous, this means that a client has the ongoing peace of mind and thus the planner gets achievement in providing PFP services to him. However, there is a follow-up service relating to whatever the condition is. For prosperous condition, the follow-up service can be a stewardship, and for scarce condition, the follow-up service can be a coaching.

The concept of stewardship is explained as: “implications for the handling of money are especially evident in twentieth-century understanding of stewardship. These implications include exercising fiscal responsibility in the budgeting and spending of one’s money, giving a portion to charitable causes and restraining one’s expenditures on unnecessary consumer goods. Stewardship thus has implications for the normative restraint of economic life.”[11] In the framework of financial planning, this can be interpreted as the fourth factor of PSA discussed above. Here, the role of financial planner is to take responsibility in allocating the surplus of a client’s net worth to charity, other donation, church donation or gifts. Financial planner has capacity to connect a non-profit organization, such as charity foundation, church, mosque or local social organization either on a client’s order or as offered as financial planner’s initiatives. For a qualified client, there would be a yearly program of “public award of successful human being” given by coordinating the event with public media services.

Coaching as a tool of carrying out the PSA in PFP is defined by the International Coaching Association: ”Professional coaching is an ongoing partnership that helps clients produce fulfilling results in their personal and professional lives. Through the process of coaching, clients deepen their learning, improve their performance and enhance their quality of life.”[12] This technique is useful for a client with a scarcity condition as financial planner has capacity to develop a client’s psycho-spiritual condition relating to personal life, work, business and social relationship. For example, introduce a client to personal development program, seminar or prosperity website, or conduct a meeting between clients for the purpose of digging the story one’s success to be shared to others.

7. Conclusion

In conclusion, displaying the psycho-spiritual aspect of financial planning is quite hard and complicated to put into practice. Financial planners may offer this technique as ensuring the financial planning outcome of a client’s peace of mind. However, there is a cost for a client as he or she is helped to understand financially his or her prosperity condition regarding the four key factors as the indicators. Meanwhile, financial planners initially state to take full responsibility in the risk management and portfolio management they offer in the services.

[1] Ed Vos: 2001, p. 42.

[2] The ongoing peace of mind is becoming more important after achieving the material goals the needs to include a comprehensive goal that concluding the psycho-spiritual views of a client’s condition. In conducting a personal financial planning business, the goal of ongoing peace of mind can be put as one of the key strategic factors.

[3] Hunger, J. David: 1996, p. 11. As the goal is too broad, this can be narrowed into the statement of objective in achieving the ongoing peace of mind of client. However, with such accounting financial ratio analysis, this can be quantitatively measured.

[4] Maureen EP Irish, Journal of Financial Planner, April 1999.

[5] Rule 2: Competence, Code of Ethics and Professional Conduct of the FPIA, New Zealand.

[6] As suggested by Joan Sotkin in her article about the framework of holistic approach to financial planning in Prosperity Place.Com, May 2, 2001.

[7] This regards the concept of inequality in the framework of capitalism-individualism explained by Goetz Kluge in Poorcity.Richcity.Org. http://poorcity.richcity.org/entdiff.htm

“ In a system consisting only of unintelligent wealth (E) and intelligent people (A), looking at redestribution in terms of osmosis helps to distinguish between two extreme (as such non-existing) cases and to create a third case:

Merit: If unintelligent wealth cannot move and intelligent people are mobile, distribution determined by people is the result.
Luck: If unintelligent wealth is mobile and intelligent people cannot move, arbitrary distribution to people is the result.
Luck and Merit: If unintelligent wealth as well as intelligent people are mobile, arbitrary distribution and determinable distribution coexist. This is reality.

Capitalism, individualism: For this equivalent society, wealth is a "territory" for which individuals compete by merit. Pure capitalism, a free market and pure individualism are the reference ideologies for this system. In order to describe the extreme side of capitalism we use its socialist caricature: no emphaty between individuals; permanent and "hot" fight between individuals; winner takes all (unfair distribution of all wealth: a part of all individuals own everything); personal advantage only is dominant incentive; trade is war.”

[8] As suggested by Ronnie Kahn in Journal of Financial Planning, Feb, 2001.

[9] Ed Vos, 2001, p. 48.

[10] Ed Vos: 2001, p. 41-42 and p. 60.

[11] Robert Wuthnow, Religion and Economic Life, in “The Handbook of Economic Sociology”, 1994, p. 363.

[12] As suggested by Mell McDonnell in Journal of Financial Planning, October 2000.

Bibliography

Ed Vos, Personal Financial Planning for New Zealanders, 2^nd ed. 2001, Dunmore Press Limited, Palmerston North, New Zealand.

Goez Kluge, Wealth and People: Inequality Measures, What's the difference? © Munich, 1999/03/28. http://poorcity.richcity.org/entdiff.htm

J. David Hunger and Thomas L. Wheelen, Strategic Management, 5^th ed. 1996, Addison-Wesley Publishing Company, Inc, USA.

Joan Sotkin’s, Money. 2000, Prosperity Place, Santa Fe, USA. http://www.prosperityplace.com/excerpts/money.html.

Robert Wuthnow, Religion and Economic Life. In “The Handbook of Economic Sociology”, Neil J. Smelser and Richard Sedberg, editors. 1994, Princeton University Press, New York, USA.

The Code of Ethics and Professional Conduct. 2000, Financial Planners and Insurance Advisers Association Incorporated, New Zealand. http://www.fpia.org.nz.

Journal of Financial Planning:

Catherine Newton, Letting Go: When Planners and Clients Part Ways. Journal of Financial Planning, October 2000 ed. 2001, Financial Planning Association, Denver, USA. http://www.journalfp.net/psychology.cfm.

Maureen E.P. Irish, Psychology and sipirituality: How deep do planners want to go? Journal of Financial Planning, Denver, April 1999. Lecture file.

Mell Mc Donnell, Getting to Know You. Journal of Financial Planning, October 2000 ed. 2001, Financial Planning Association, Denver, USA. http://www.journalfp.net/psychology.cfm.

Ronnie Kahn, Money Consciousness: A Psychospiritual View of Financial Planning. Journal of Financial Planning, February 2001 ed. 2001, Financial Planning Association, Denver, USA. http://www.journalfp.net/psychology.cfm.

APPENDIX 2

The risks of risk management: in the framework of Asset-Liability Management

2010-04-29T16:50:00.000-07:00

The risks of risk management:

in the framework of Asset-Liability Management

Jeffry Merril Liando (2007)

After thirty years of development in Asset-Liability Management (ALM), history has noticed danger rather than reward of it. Started with a simple way of gap management to match gaps between interest sensitive assets and liabilities and between market value of assets and liabilities, it developed to duration model until eventually taking into account the advent of derivatives activities and asset securitisation within the framework of ALM. The latter development seems to be the current issue that puts the implementation of ALM in jeopardy.

Financial institutions have noticeably been the main users of ALM but then corporations have seen the benefit of using it and all unfortunately become the abusers of it. The ALM technique has been interpreted as the way to reshape their balance sheet even by involving separate entities' balance sheet, in this case, using a special vehicle enterprise (SPE). With a fine goal of mitigating risks of interest rate, exchange rate, credit and liquidity, the use of financial risk management in the framework of ALM often comes to a failure. Financial institutions and corporations may potentially face big losses in marked-to-market portfolio value, interest rate and exchange rate, leading to a liquidity problem and insolvency, even the worst case of bankruptcy.

Every time a new context is implemented in ALM, a newer risk issue may arise particularly when synchronising with the other contexts of financial risk. Firstly, repricing gap model may create market value risk and maturity gap model may result to arising of interest rate risk from different cash flow timing. Secondly, potential errors in modelling duration may arise considering factors of embedded options in prepayment risk and liquidity risk and different term structures for different periods. Thirdly, derivatives activities for rebalancing portfolio in duration model may lead to derivatives risk. Fourthly, potential risk of ALM may arise when shifting the goal of derivatives instruments from hedging to speculative profit taking. Fifthly, some ALM tricks with securitisation innovation may lead to securitisation risk.

This essay tries to divide the implementation of ALM in different contexts in accordance with its development to identify the risks of financial risk management. Ideally by the phrase, risk management will not produce risks but eliminate them, however, the tendency of failures and the severity and frequency of losses may be enough to justify the risks of practicing financial risk management. In the sequence of development in ALM, it may come up with a series of risks, as follows: interest rate and market value risks, rate modelling risk, derivatives risk, speculation risk and asset securitisation risk. However, one relevant context is reserved for other discussion outside this essay, that is, credit derivatives risk which is related to derivatives and securitisation risk. This essay particularly addresses how such risks may be produced in the implementation of ALM by presenting several cases of failures in financial risk management, and begins with some contextual frameworks of ALM's concerns and the development of its model in managing liquidity and minimising financial risks.

Nevertheless, the potential failures in ALM can be early identified with a preventive action by the supervisors to monitor the fair value of financial assets and derivatives instruments, the current exposures of interest rate risk and market risk and the net positions of foreign currency. This has been implemented in New Zealand within the environment of financial institutions before the Basel-2 Accord. Moreover, a responsive action to prevent a higher magnitude of losses can be done with such a technical way in the marketplace by manipulating the trading system, as the NYSE and CME use a system called the circuit breakers. This essay would conclude that the preventive and responsive action may early identify the potential risks and assist the abusers to cope with their failures.

ALM in financial institutions and corporations

By a very basic definition, ALM in banking context can be defined as a coordinated management of a bank's balance sheet or portfolio focuses on planning, directing and controlling the levels, changes and mixes of the various on- and off balance sheet accounts which generates the bank's income-expense statement. ALM is approached in three stages: general balance sheet structure, specific balance sheet items and then income-loss production based on policies in spread management, loan quality, generating fee based income, control of non-interest income, tax management and hedging practices.[1] The key point in ALM is management of interest rate risk as the main sources of banks' revenues and expenses.

At the early stage of development, the main goal of ALM is to reduce liquidity risks as the greatest concern in financial institution management by calculating the net of cash flows in different maturity profiles. Then with repricing gap model, interest rate risk is taken into account by calculating the gap between interest sensitive assets and liabilities. Next, ALM considers market value with maturity model by calculating the maturity gap between the weighted-average maturity of assets and liabilities.[2] At this stage, ALM is also known as a gap management.

The next development is to consider cash flow factor in relation to interest rate that is not thought about in gap management, as the interest rate risk is not eliminated completely. ALM method then takes into account duration of assets and liabilities by calculating the average life of the present value of the cash flows. The goal is to match the duration gap as then ALM method came up with the idea of hedging interest rate.[3]

The implementation of ALM at this stage is believed as a way of hedging balance sheet position against the future movement of interest and exchange rates. Hedging position is commonly produced by entering derivatives contracts such as futures, forwards, options and swaps, or by trading derivatives securities such as liquid yield option note, treasury strips, callable and putable bonds and warrants. Here immunisation term is used and related to portfolio rebalancing. Finally, later development in asset securitisation introduced new types of derivatives contracts and securities such as ABSs, MBSs, CDOs, IOs/POs, and credit derivatives such as CDSs, CLNs, TRSs and Synthetic CDOs. These derivatives can cover credit risks directly in the framework of ALM.

As a comprehensive function, ALM synchronises its roles between liquidity management and financial risk management for managing interest rate and exchange rate within a financial institution. In a short-term time frame, it may refer to liquidity management as trading securities to provide sufficient funds for short-term liquidity without any significant losses. In order to meet liquidity requirement, ALM involves with daily transactions in securities trading in the form of short-term money market securities, such as government securities, central bank bills, bank bills, repos and commercial papers. Yet, ALM should be more concerned on managing interest rate and exchange rate risks with hedging positions than taking speculative positions.

Popular liquidity-profitability dilemma and risk-return trade-off have shifted ALM goal from liquidity management to the intention of necessarily taking profit as it is possible.[4] Opportunities created from the price volatility of securities prices can be grabbed for profits by conducting such an active portfolio management. This has also been related to asset securitisation as to consider the benefits of it in managing liquidity and profitability at the same time by generating inflows from portfolio transfer, originator rate spread and service fee. Furthermore, trading derivatives for managing financial risks has blurred the original ALM goal to profit orientation by betting on the economic environment that may be addressed as the potential source of problems in financial risk management.

Seeing the sophistication and usefulness in financial institutions, ALM has been a sought-after tool for corporations and the term is more commonly known as financial risk management. The reason is that ALM framework in the context of corporations still deals with similar risks in their balance sheet structure. In asset side, a corporate has inventory, financial assets and receivables that need to be hedged for the uncertainty of future exposure of interest rate, exchange rate and commodity price, whereas in liability side, there are some financial risks in bonds and loans to be managed. In practice, financial risk management is part of a treasury management of a corporate and deal largely in fixed income securities trading and derivatives activities in order to manage financial risks including interest rate risk, foreign exchange risk and also commodity risk.

Interest rate risk and market value risk

Banks can review their liquidity positions with repricing gap model by remarking the net gap position for maturity less than one year. A negative gap signs a low liquidity position and a positive gap indicates a high liquidity position. A dominant position taken by most banks is normally negative gap for short term as they are funded by shorter maturity liabilities and invest in longer maturity assets, or known as a short-funded position. The basic strategy is that banks usually believe in an upward yield slope of term structure where the short term interest rate is lower than the long term one, thus the interest cost from the shorter maturity liabilities is lower than the interest income from the longer maturity assets.

However, the potential risk arises when the short term interest rate starts to rise and approaching the long term interest rate level as the term structure may shape downward. Here banks need to sell some of the long maturity assets in order to keep the profitability level. In this case, fixed income securities are of course the assets that can be sold immediately to offset the repricing gap for a short term time frame, from a negative gap to a positive gap, and then adding the liquid asset portfolio with more short maturity securities.

For example, a bank considers taking a short-funded position in the short run by keeping a larger proportion in long maturity bonds. If the interest rate is believed to increase in the future, the bank should increase the gap by reducing the proportion of long maturity bonds and adding the proportion of short maturity securities such as Bank Bills, thus the net interest margin does not drop dramatically or otherwise improves. In contrast, if the interest rate is believed to decrease in the future, the bank should do nothing and takes more advantage from the broadening gap as gaining maximum net interest margin.

No one knows the movement of the future interest and some banks believe that the interest rate continues to decrease and keep the larger proportion in long maturity bonds. When the interest rate increases and the long dated bonds are not hedged with derivatives contracts, bonds futures for instance, such banks would get loss, particularly after being sold or marked-to-market. This is as what happened with the National Bank in 1993 and 1994.[5]

In 1993 the National Bank invested around $823 million of government and local authority stock and enjoyed the decreasing interest rate from around 7.5% to around 5.5% during that year. It had marked its book to market and the end of 1993 with $6 million for investment and $817 million for dealing and continues to bet on further decrease in interest rate. Unfortunately the interest rate had been increasing during 1994 and at the end of the year the National Bank was still being in long dated position. Consequently, the value of the $817 million had dropped to $364 million.

Duration model and modelling risk

The series of cash flows until maturity in the portfolio of assets and liabilities imposes the implicit time in each cash flow, which is not considered in the gap model. If an asset with half-yearly time steps matures in two years, it can be said to have a maturity of two years. However, the present value of cash flow in each period corresponds with the implicit time in the episode of every half-yearly time step, for example, the present value at period 2 has one year life and that at period 3 has 1.5 years life. Thus, the average life considering the implicit time episodes can be calculated and is know as duration, which should be less than 2 years of maturity. Financial institutions then can model interest rate risk in the framework of ALM by calculating the duration gap between the weighted-average asset portfolio and liability portfolio and matching the duration gap, or the leverage adjusted duration gap after considering the market value of net worth, to zero. From this stage of development in ALM, duration model has been widely used by banks.

The effectiveness of duration model depends on the effectiveness in modelling it in the framework of ALM. In modelling duration approach, a simulation technique is normally used by the treasury management or Asset-liability Committee (ALCO) of a bank by employing a sophisticated tool of computerised data processing software. The data input includes the individual volume, mix and interest rate of the current position in assets portfolio and liabilities portfolio. The assumptions and parameters used may include the forecasting of future volume, mix and interest rate in different scenarios. The output is to make a projection of future income and to see the effect of interest changes on duration gap. The result of the analysis is expected to base some decisions in taking specific hedging strategy for managing interest rate risk with derivatives activities.

It seems potential errors in modelling duration arises when using assumptions for future volume, mix and interest rate in different scenarios. The factors need to reconsider are the embedded options risk of borrowers and depositors[6] and different types of term structures[7]. The embedded options factor suggests that borrowers would prepay their loans once interest rate decreases and depositors would withdraw their deposits once interest rate increases. Here the volume and mix of asset and liability portfolios may change. The term structure factor suggests that a flat yield curve assumed in duration model does not happen all the time, thus interest sensitivity scenario may change as the interest rate for each maturity moves divergently.

Instead the general factors, Blue and Hedberg (2001)[8] suggest three specific ALM modelling errors, as follows, (1) inaccurate current position, (2) inadequate non-maturity deposit behaviour, and (3) switch option. Inaccurate current position means that a financial institution may incorrectly state pricing information for interest rates of the current position of assets and liabilities that would lead to a miscalculation of net interest income and present value. Inadequate non-maturity deposit behaviour is an error made when a financial institution inputs repricing behaviours and average lives in the absence of contractual data to confirm these estimates which may impact both interest expenses and present values for core deposits, leading to a mistake in the value-at-risk IRR calculations. Switch option is an error in switching the cash flow of option inputted according to the tendency of interest rate movement. The common source of these errors as suggested further, as follows, (1) inaccurate assumptions for option-related risk (ORR), (2) inaccurate credit spreads to treasury securities, and (3) inaccurate points on the treasury curve that calculate resulting average lives, effective durations, cash flow projections, yields, and prices.

Derivatives risk

The result of analysis in the duration model, regardless the potential error risk, is expected to base some decisions in managing interest rate risk with derivatives activities. Direct duration matching with derivatives contracts or securities has been commonly used for producing some hedging positions. However, this may cost much and face a larger risk of losses as derivatives may expose a bigger probability and severity of default than the underlying assets may do.

Futures and swaps are commonly used for hedging interest rate in duration matching and immunisation strategy. With futures, the interest rate movement on the balance sheet can be offset by the price movement of the futures. Increasing interest means decreasing futures price and vice versa, then the loss of net worth on the balance sheet where the asset duration is bigger than the liability duration can be offset with the profit of short selling futures. With swaps, the duration portfolio which is the weighted average of the durations of the assets and the liabilities can be modified with the swap duration which is the difference between the fixed rate duration and the floating rate duration. To increase the portfolio duration, the swaps contract needs to be entered by receiving fixed rate and paying floating rate.

Despite of the usefulness of derivatives activities in risk management, there are some potential risks that should be considered, as Sinkey (2002) interestingly described those risks as IS MORC ILL?[9] This stands for Interaction (covariance), Systemic, Market, Operational, Regulatory, Credit, Intellectual, Liquidty and Legal. The systemic risk focuses on the collapse of the financial system, market risk on price behaviour, operational risk on human and system error, regulatory risk on restrictions, credit risk on the default of counterparty, intellectual risk on inability to understand the instrument, liquidity risk on the inability to buy or sell particular contracts and legal risk on contract documentation, authority and bankruptcy.

The example of interaction (covariance) risk is the case of Long Term Capital Management (LTMC) in 1998 where LTMC bets on government bonds and corporate stocks that the position offset with each other in the portfolio.[10] It held positions in US, European and Japanese government bonds and S&P stocks options without hedged position. When the Russian bonds defaulted followed by high selling of European and Japanese bonds, the demand came to US bonds and then the Treasury yield soared. LTMC finally lost 40% in its value as a result of a divergent movement between its assets in the portfolio.

One case related to futures contract in New Zealand is as follows. In 1990 Westpac lost up to $30 million as guaranteeing Jordan Sandman Futures for trading five-year government stock futures as Stephen Francis, a London-based Kiwi, exposed Westpac and Jordan Sandman Futures to a $1.9 billion risk. As a result, Westpac and JSF found themselves staring at huge short positions in five-year government stock futures when the yield was decreasing. Cases occurred overseas are as follows: in 1994 Procter & Gamble lost $US157 million on leveraged interest rate swaps for US dollars and Deutsche marks written through Bankers Trust on the assumption that U.S. and German interest rates would continue to fall. Cases related to commodity futures by corporations are as follows: Codelco Chile lost $US200 million in 1993 on futures trading of gold, silver and copper and Metallgesellschaft AG German lost $US1.5 billion on oil futures in the same year; in 1996 Sumitomo Corporation lost a very huge amount of $2.8 billion in copper futures trading. Also, in 1994 Orange County California lost $US1.6 billion on a structured notes trading. It seems most derivatives failures occurred in the mid 90s after 15 years invented.[11]

Instead of managing interest rate risk, derivatives risk also arises in managing exchange rate risk. Some instruments used are currency swaps, currency options and currency futures. The impact of the currency derivatives failures may even be worse. This is due to the characteristic of the foreign exchange market as a huge on-line global market connected all over the world in which the magnitude of market supply-demand is impossible for the players to observe. The market is 24 hours and the price volatiles every second. In case of market shock, a financial institution can lose very big money in just a few seconds. The most common mistake a financial institution, or precisely a person, may possibly make is that when she takes a position in a wrong direction against the market for such a long time hoping that the price would come back, which is in fact never coming back.

For example, in the first dealing quote NZD 1 is traded at USD 0.40 (sell) - 0.50 (buy). As expecting the price would go up a trader buys NZD10 at USD 0.50. The price then keeps fluctuating but decreases to 0.35/45 until the second quote. Instead of hedging the position with short selling, she buys again at 0.45 as expecting that the price would start to increase from this level. Using a martingale tricks with a double-cover hedge, she doubles the bet to NZD20 expecting now is the time to offset the previous open position and believes the price to rise. Unfortunately, the price still decreases. At the third quote, the price given by the dealers is 0.30/40 and she is out of deal as waiting the price to go up. At the fourth dealing quote, the price given is 0.35/0.45 and finally decides to lock the position at 0.35 by short selling NZD30. She locks NZD3 loss at 0.50 and NZD2 loss at 0.45 and the price is going down from her open position for months and pays additional fees of transaction and interest.

Prediction of exchange rate movement is hard to model so that the tendency of success in derivatives trading may usually be based on technical analysis although fundamental analysis also contributes to the prediction. Therefore, losses in currency derivatives trading are not such odd cases. In 1993 Showa Sheil Sekiyu KK, a Japanese affiliate of the Royal Dutch/Shell Group, lost $US1.6 billion on currency forward contracts and Nippon Steel lost $US130 million on a currency derivatives.

Speculation risk

Going from the context of derivatives risk, it may suggest that the most significant risk can be related to uncontrolled human behaviours when a trader deliberately changes her objective from hedging to speculation as taking position or trading without authorisation. This may be relevant with the terms of Operational, Intellectual and Legal in â€œIS MORC ILL?â€� before. A trader can be attracted with an opportunity of gaining a huge profit with own strongly believed conception in predicting the future price, which is totally wrong. This may happen once she has the capacity to trade in the system.

The impact to the financial institutions or corporations in the framework of ALM is that the losses on derivatives speculation may lead to interest and currency losses which accumulatively reducing profitability and may cause a liquidity problem as the losses may drain the cash flow level immediately. Moreover, this may cause solvency problem as the market value of capital showing a negative net worth. Sometimes, this cannot be monitored properly as there is a time lag between the exercise time and the reporting time of the portfolio position and financial institutions do not mark its book value to market every time.

One popular story of rogue trader was when Barings Bank lost over $US1 billion in the Singapore futures bourse in 1995 with an unauthorized speculation in futures on Nikkei 225 stock index and Japanese government bonds. The trader, Nick Leeson had accumulated two massive open positions of Nikkei futures and Japanese government bond futures by betting on the recovery of the Japanese stock market. Unfortunately, in January 1995 a powerful earthquake shook Japan dropping the Nikkei 1000 points and brought Barings to even further loss. Lesson has not enough experience and conducted a martingale trick to gain back the money already lost. He also managed to avoid suspicion from senior management for some time.

Asset securitisation risk

Asset securitisation then can be defined as a process of transforming a series of cash flows derived from assets or business revenues of a company into securities in the capital markets that pay interests to the investors. This process needs a special purposed entity (SPE) to be formed to channel the inflows and outflows between the packaged assets or revenues and the securities sold in the capital markets. The SPE normally holds the packaged assets in its liability to be sold in the form of securities to the investors, as paying investors' interest with payments from borrowers' interests or customers' premiums passed from the originators. The SPE pays the packaged assets to the originators with the sale of securities to the investors.

In its development, asset securitization has produced a series of derivatives securities such as ABSs, MBSs, CDOs and IOs/Pos and credit derivatives securities such as CDSs, CLNs, TRSs and Synthetic CDOs. These derivatives can cover credit risks directly in the framework of ALM. The first asset securitisation type introduced in the early 1970s was pass-through securities for residential mortgages such as GNMA, FNMA and FHLMC. Here the mortgage portfolio is completely removed from the originators' asset and the trust passes the principal and interest payments to the investors. Then MBBs introduced, however, is less attractive since the loan and the securities still appear in the originators' off balance sheet. The second wave in the development of asset securitisation was pay-through securities introduced in the early 1980s, which can be viewed a combination between pass-through securities and MBBs. The most common pay-through is CMO in which the originator can structure the payments into different classes to minimise prepayment risk. Then the innovation continues as playing with the tranches with discount effect and prepayment effect. In the late 1980s, securitisation developed in other assets such as automobile loans, credit card receivable, consumer loans, trade receivables, insurance policy loans and junk bonds. In the early 1990s, collateralised debt obligations (CDOs) were introduced to attempt securitisation for commercial and industrial loans.

In the framework of ALM, asset securitisation is a short-cut technique to reshape asset portfolio by removing credit risk. If financial institutions or corporations intentionally remove the bad credits and package them through securitisation process, such banks may face three kinds of risk as follows: (1) downgrading risk arises where an independent rating agency based on its observation, analysis and perception tends to downgrade rating, (2) cost risk arises when a high cost should be paid in the process of securitisation from originating, pooling, guaranteeing, credit enhancing and selling, (3) reputation risk arise when holding a bad reputation from investors' view from securitising bad credits. Meanwhile, the risk faced by investors of the securities would be similar with the risk of lending, such as, default risk, liquidity risk, interest rate risk and additional risk of prepayment for long maturity credits, also transparency risk when the credits condition and situation are beyond investors' visions.

The consequence

Failures in ALM may lead to a liquidity problem as the hedging instruments used in it, such as short-term securities, fixed income securities and derivatives contracts and securities may expose a liquidity risk for immediate cash flow requirement. There is also a possibility that the securities cannot be liquidated immediately or the value at the time of liquidation decreases from the initial value. As funds normally used for meeting deposit withdrawals or loan demands are otherwise used for covering the loss, liquidity problem may arise. Any huge transaction in securities, derivatives or currency trading, even those are exposed in the off-balance sheet accounts, may influence the short-term liquidity condition.

Moreover, failures in ALM may lead to a solvency problem caused by mismatching maturity between assets and liabilities so that the market value of balance sheet shows a negative net worth. The changes in interest rates would affect the market values of assets and liabilities, which the cash flows are discounted at the level of interest rate. Therefore, the changes in market values depend on the changes in interest rate level and the maturities of assets and liabilities.

Early detection

The risks of financial risk management in the framework of ALM can be early detected and identified by monitoring the fair value of financial assets and derivative instruments, the current exposures of interest rate risk and market risk and the net positions of foreign currency. In New Zealand, this can be seen in a bank's general disclosure statement, which is required by the prudential supervision. Therefore, a good prudential supervision can be said to be able to limit the potential risks of risk management by observing and evaluating the current strategy of risk management that can be conducted by general public, and of course including investors. If possible and if the supervisors can afford it, the failures or losses can be rescued.

Disclosure statements consist of a Key Information Summary and a General Disclosure Statement. A Key Information Summary is provided for the non-expert investor and contains key financial information on a bank. A General Disclosure Statement is a larger document and contains a comprehensive range of financial and corporate information, such as comprehensive financial statements, including details on impaired assets and provisioning, the bank's credit rating and changes made to the rating in the two preceding years, the bank's capital adequacy ratios (measured using the standard international capital framework applied by the Reserve Bank), profitability, total assets and growth in assets, information on the number of loans made by the bank and information on the bank's risk management systems.

The objectives of disclosure in prudential supervision summarised by Geof Mortlock (July 1996, p.47) as follows:

They will encourage banks to carefully manage their banking risks. Banks will face sharper incentives to manage their affairs prudently, so as to avoid the need to disclose adverse events to the market.
They provide depositors and others with more relevant and timely information on banks, so as to improve their ability to decide where to bank. This is important as in New Zealand, unlike many other countries, banking supervision does not aim to protect depositors, and there is no deposit insurance. Moreover, bank deposits are not, in any sense, guaranteed by the government or the Reserve Bank. Trading bank deposits have never been government guaranteed.
The disclosure framework is intended to strengthen the duty of bank directors to oversee, and take ultimate responsibility for, the management of banking risks.

In relation to the monitoring of a bank's activity in ALM, in the general disclosure statement the bank has to include the fair value of financial assets and liabilities, maturity profile, repricing schedule, current exposure to derivative instrument and the current exposures to interest rate risk and market risk and the net positions of foreign currency. Specifically, the current exposure to derivatives instruments includes the potential for further exposure should market prices fluctuate significantly, the extent to which revenues of an institution have been derived from derivatives activities and the volatility of derivative-based revenues.

After identifying the risks of financial risk management in ALM through analysis and evaluation to a bank's financial condition, the regulator can conduct further action as assisting the bank to manage the failure. The actions can be in the forms of due and diligent test, technical assistance or restricting the activity in money market and capital market. The regulator may also ask the financial institution to supply regular follow-up action reports during the process of failure management. However, this would need several legal actions and regulation instruments.

Instead of early identification, the role of prudential supervision in limiting the failures in ALM can be seen in how the regulator may actively involve in capital management. It is obvious that the worst impact of ALM failure is insolvency as the result of accumulating losses. By injecting funds to a bank's capital, the regulator can reduce the possibility of a bank failure in overall.

Circuit breakers

If the early identification is such a preventive action, a responsive action to prevent a higher magnitude of losses can be done with such a technical way in the marketplace by manipulating the trading system, as the New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange use a system called the circuit breakers. This may help the losers to avoid further losses from the failures in risk management in the macro context, particularly for securities trading conducted within a very short time period, i.e., intraday trading. Then, the sufficient information needed for future decisions can be gathered effectively and efficiently in the market so that the hypothesis of market efficiency applies properly and prices fully reflect the available information, not the manifestation of market panic or distorted movement.

In the NYSE, the circuit breakers system is an imposed pause in trading that permits buyers and sellers time to assimilate incoming information and make investment choices. Circuit breakers promote investor confidence by giving investors time to make informed choices during periods of high market volatility. The set of rules approved by the US Securities and Exchange Commission are as follows. The securities and futures markets have circuit breakers that provide for brief, coordinated, cross-market trading halts during a severe market decline as measured by a single day decrease in the Dow Jones Industrial Average (DJIA). There are three circuit breaker thresholdsâ€”10%, 20%, and 30%â€”set by the markets at point levels that are calculated at the beginning of each quarter. The formulas for these thresholds are set forth in the New York Stock Exchange (NYSE) Rule 80B.[12]

The Rule 80B is as follows. The halt for a 10% decline would be one hour if it occurred before 2 p.m.; and for 30 minutes if it occurred between 2 and 2:30, but would not halt trading at all after 2:30. The halt for a 20% decline would be two hours if it occurred before 1 p.m.; and between 1 p.m. and 2 p.m. for one hour, and close the market for the rest of the day after 2 p.m. If the market declined by 30%, at any time, trading would be halted for the remainder of the day.[13]

In the CME, the rule would be like this. Trading in the S&P500 futures contract is halted just for a few minutes if the prices move 2.5%, 5%, or 10% from the previous close. Because restrictions on the NYSE effectively shut down trading in this futures contract, there is little need for additional restrictions on the CME.[14]

Conclusion

The main source of the potential risks of risk management in implementing ALM comes from the speculative behaviour of the authorised or unauthorised trader(s) with or without supervision from the treasury management of a financial institution or corporation. A hedging strategy is conducted with an insufficient capacity of capital, low skills in the application of risk management techniques, improper information gathered about the current market condition and interest rate environment and incorrect valuation of the current condition of the assets and liabilities portfolios. However, the level of risks of risk management can be early identified by the supervisors through the requirement of general disclosure statement to be then reviewed by general public and assisted thoroughly by the supervisors. The responsive action with Circuit Breakers in the exchanges may directly and effectively limit the losses in securities trading in a day.

Reference and Bibliography

Blue, Jacquelyn and Jean Hedberg. (2001). Identifying and managing model risk under OCC Bulletin 2000-16 and related agency mandates. Bank Accounting & Finance. Riverwoods: Summer 2001. Vol.14, Iss. 4; pg. 40. from Business Source Prime database.

CME. Circuit Breakers http://www.cme.com/clearing/clr/advntc/clien_NP_0173.html

Davies, Anthony. (1997, Feb 28). Derivatives market continues to boom despite the bad news. The Independent, p. 34. from Newztext Plus database.

Hogan, Warren. (2004). Management of Financial Institutions. Sydney: John Wiley and Sons Australia, Ltd.

Kolman, Joe. LTMC speaks. http://www.derivativesstrategy.com/magazine/archive/1999/0499fea1.asp

Mortlock, Geof. (1996, July). New Financial Disclosures For Financial institutions. NZ Business, p. 47.

National Bank takes a long cold bath in the bond market. (1995, May 19). The Independent, p. 38. from Newztext Plus database.

NYSE. Circuit Breakers http://www.nyse.com/press/circuit_breakers.html

Recent Derivatives Disasters. (1995, June 30). The Independent, p. 16. from Newztext Plus database.

Riordan, Daniel. (1995, June 30). Derivatives: Risk management for risky business? The Independent, p. 13. Newztext Plus database.

Saunders, A. (2000). Risk of financial intermediation: A modern perspective. (3^rd ed.). New York: McGraw-Hill.

Sinkey, J.F., Jr. (2002). Commercial financial institution financial management: In the Financial-Services Industry. (6^th ed.). New York: Macmillan, Inc.

Smithson, Charles W. (1998). Managing financial risk: A guide to derivative products, financial engineering, and value maximization. (3^rd ed.) New York: McGraw-Hill.

The collapse of Barings Bank. http://www.stock-market-crash.net/barings.htm

US Securites and Exchange Commission. Circuit breaker and other market volatility procedures. http://www.sec.gov/answers/circuit.htm

Valentine, Tom and Guy Ford. (1999). Readings in financial institution management: Modern techniques for a global industry. Sydney: Allen & Unwin.

[1] Sinkey, J.F., Jr. (2002), p. 220 completely explains the three stages in ALM

[2] Saunders, A. (2000), p. 122-139 as the summary of repricing model and maturity model.

[3] Saunders, A. (2000), p. 147-149 as the summary of duration model.

[4] Hogan, Warren. (2004), p. 95-100 explains more about the situations of risk-return trade-off in DTIs.

[5] National Bank takes a long cold bath in the bond market. (1995, May 19). The Independent, p. 38.

[6] Saunders, A. (2000), p. 224.

[7] Tannenbaum, C (1999). The decline of duration. In Valentine, Tom and Guy Ford (1999), p. 449-451.

[8] Blue, Jacquelyn and Jean Hedberg. (2001). Identifying and managing model risk under OCC Bulletin 2000-16 and related agency mandates. Bank Accounting & Finance. Riverwoods: Summer 2001. Vol.14, Iss. 4; pg. 40

[9] Sinkey, J.F., Jr. (2002), p. 220 puts a mnemonic interrogatory: IS MORC ILL? from The Group of Thirty Report 1993, where MORC originally stands for Macomb-Oakland Regional Center, a Michigan mental and psychiatric disabilities centre.

[10] Kolman, Joe. (2002). LTMC speaks.

[11] Recent Derivatives Disasters. (1995, June 30). The Independent, p. 16. Newztext Plus database.

[12] US Securites and Exchange Commission. Circuit breaker and other market volatility procedures. http://www.sec.gov/answers/circuit.htm

[13] NYSE. Circuit breakers. http://www.nyse.com/press/circuit_breakers.html

[14] CME. Circuit breakers http://www.cme.com/clearing/clr/advntc/clien_NP_0173.html

The Areas of Conflict between Cost Control, Service Quality, Desire for Growth and Credit Management

2010-04-29T16:49:00.000-07:00

The Areas of Conflict between Cost Control, Service Quality, Desire for Growth and Credit Management in the Framework of Loan Processing

Jeffry Merril Liando (2003)

Lending is the major activity in banking business and the interest thus becomes the primary source of income. Since deposits are assumed already available from the separate operations, new branches are established and new lending officers are hired only for the purpose of expanding loans to satisfy a bank’s desire for growth. However, expanding loans may increase lending cost, which is variable to the number of loans. In order to achieve cost efficiency at an optimum number of loans handled, controlling cost of lending by means of, for example, limiting the time of processing loan may affect service quality. Also, limiting the time of processing loan may cause a bank not applying credit management properly.

Broadly speaking, one of the conflicts comes from the variability of cost concerning the number of loans handled and the time in processing loans. For example, for the same level of growth, a bank has to pay lower cost, put less attention in credit management and process, but serve more accounts. As expanding loans by $1,000, a bank can make either one loan costing $20 includes $10 for one hour origination and servicing plus $10 for one hour analysis and monitoring, or two loans costing $40 includes $20 for two hours origination and servicing plus $20 for two hours analysis and monitoring.

The previous simple illustration shows a broad area of conflict regarding the number of loans handled and the processing time. In the framework of the activities in processing a loan which consists of screening, origination, servicing and monitoring, this essay aims to discuss other specific areas of conflict between the issues of cost control, service quality, desire for growth and credit management. Focusing on cost control and loan process, this essay subsequently tries to find the sources of the conflicts between one subject to other subjects. This essay will suggest relationship lending and loan sales and other relevant concepts in minimizing the conflict. Finally, this essay will conclude that the conflict should be ended up by aligning banks’ goals of cost control and loan growth and customers’ needs of loan received and good service through a good credit management.

Before discussing the areas of conflict, it is relevant to define the issues one by one with respect to the context of lending. The issues of cost control, service quality and desire for growth may have general meanings in bank management and can be interpreted in terms of the other subjects such as cost of funds, marketing and deposit growth rather than in term of lending. Therefore, the interpretation should be related to lending activity. Meanwhile, the issue of credit management can be interpreted straightforward to the subject of lending. After defining all issues, the areas of conflict can be then determined.

As banks normally apply activity-based costing, lending costs are defined according to the activities in loan process consisting of screening, origination, documentation, transaction, maintenance and monitoring. Lending costs can be distinguished into direct cost for the activities of origination, documentation, transaction, maintenance and monitoring; and indirect cost for the activity of screening. As direct cost, in processing a loan, there costs such as origination, servicing (documentation, transaction and maintenance) and monitoring costs normally incurred. Meanwhile as indirect cost, the screening cost generally incurred for several loans or a loan portfolio and appears to be a particular cost regarding the building of credit scoring system.

For all activities, lending costs include the professional cost, the clerical cost, the communication cost and the administration costs. The professional cost is the cost of hiring business development officers, loan officers and loan analyst. The clerical cost is the cost of hiring loan support and servicing staff. The communication cost is the cost of using phone and fax. The administration cost is the cost of using office stationary.

The professional, clerical and communication are counted based on the time used in processing loans whereas the administration cost is counted based on cost allocation. Specifically, the professional cost deals with particular expertise, skills and knowledge and may be charged per term of loan or in hourly basis. The clerical cost is normally charged in hourly basis. Moreover, the personnel costs in wholesale lending incurs per individual loans whereas in retail lending the personnel costs may be treated collectively for several loans.

The major goal of lending cost is actually to cope with information asymmetry, which known as the information cost of lending. This cost mainly incurs as part of monitoring cost as the loan professionals try to gather relevant information about the borrowers and the market as much as they can from many sources. Fulfilling desire for growth, the increase of loans handled would increase the information cost as a bank need more time to get knowledge for new loans. Moreover, coping with information asymmetry, a bank cannot maintain its service quality as the customers will feel bothered when the bank asks so many questions and conducts so many visits. However, a good credit management can be applied properly as increasing the information cost.

As the negative goal of lending activity, there is also a cost of non-performing-loan losses, which is the amount of loans that cannot be repaid. Within the lending environment, it appears that this cost is not relevant to discuss in the issue of cost control as this cost does not really regard the lending activity, has a broad meaning and relates to loan quality. This cost is not discussed further in this essay.

Cost control in lending activity means that a bank try to influence its direct and indirect lending costs to achieve efficiency as still taking great opportunity to produce loans. This can be done by controlling the time or the number of activity in processing loans. This also can be done by combining the transactions needed in servicing loans. The goal of cost control is to produce bigger amount of loans with less lending costs.

Regarding the variability of lending cost, the activity in origination and servicing loans positively correlates with the increase of the number of loans handle. This may affect service quality as there are more services have to be provided. Controlling origination and servicing costs can be done by limiting the time of loan officers originating the loans, limiting the time of staff servicing and administering the loan or limiting the number of activity in processing the loan. Consequently, a bank may reduce its service quality and customers may lose attention in loan processing and have an appropriate service. Due to the lack of time in loan processing, a bank might lose some opportunity to have in-depth analysis about the customers’ condition. Also, a bank does not really catch what sort of following adjustments and services customers want regarding their credit accounts.

Moreover, limiting the communication cost by reducing contact effort with customers may cause a bank losing some important information from the customers. In case of suffering financial burden, the customers often hold information as hiding their real condition so that a bank has to be more active to make contact with them. This regards the agency theory burden. Another example, controlling the transaction cost by means of limiting the time of reconciliation or using improper tools may cause the customers having improper reconciliations as the staffs may create errors in processing their accounts.

Cost control may also affect desire for growth as a bank may have difficulties in setting new loans. Expected to concentrate on existing loans, limiting the time of loan officers and business development officers assessing new prospective businesses may cause a bank losing opportunity to create new loans or attract some new prospective businesses to take their loans. Not trying to establish new branches a bank would lose opportunity to expand its loans for a bigger market.

Conversely, expanding loans as fulfilling a bank’ desire for growth may affect cost control. As the number of loans handled increases, the lending costs would also increase. The loan officers and loan staffs would spend more time in processing and servicing the loans. Banks would spend more on phone and fax and the communication cost would increase.

Controlling the origination and servicing costs may cause a bank not applying credit management properly. Some components of origination and servicing costs relate to credit management. Most of the time given to loan officers is used to assess the creditworthiness of the customers which includes the character, the capacity, the capital, the collateral and the condition before the decision is made. The loan officers hired have to have appropriate skills and knowledge to gather, sort out and analyse information according to the nature of loans. Cost control by limiting the working time of loan officers or hiring a low expertise person may cause an appropriate credit decision which is the source of loan default.

Regarding the agency theory burden, a customer as the agent may hide some relevant information from a bank as its principal and act according its interests over a bank’s interests. By increasing the origination and servicing cost a bank as a principal tries to know its agent or customer better and make sure if its customer follow its interests. Moreover, in the context of conducting a delegated monitoring, a bank needs to put much concern on increasing the screening cost and monitoring cost.

In lending activity, loan screening and monitoring are special. Both need extra time and effort and have to be handled deliberately in conducting the prudence manner in lending activity. The screening cost can be defined as a cost incurred in setting a credit scoring system whereas the monitoring cost is a cost incurred when a bank try to cope with information asymmetry by monitoring the possibilities for default risk. For example, as a bank plans to make several loans in agricultural lending creating a loan portfolio, the screening cost is needed to set a credit scoring system and procedure in selecting the prospective farmers and the monitoring cost is needed to put more attention for the financial performance and business progress of the individual loans.

The major activities related to the screening and monitoring costs is conducting research and development and business survey and applying the techniques in financial performance evaluation and analysis. Both costs deal with the training cost of the professional cost and the subcontracting cost as employing business and finance consultants, chartered accountants, credit rating agencies or financial advisers. To some extent, a bank may also employ the academic researchers in building the credit scoring models. Often, some credit scoring models have trade mark and copyright and a bank have to pay much to purchase the models from the academicians. Specialized lending will need more attention in particular types of business, industries or sectors of the economy whereas diversified lending takes more subjects, which means having higher costs.

Credit management also relate to the screening and monitoring cost. As applying a comprehensive credit management, a bank have to spend more in purchasing a good credit scoring model or have more time and effort in research and development to build a good credit scoring model. Regarding the monitoring cost, a bank will need to spend more information cost as actively gathering relevant information from many sources as much as they can. A bank will also need to pay more for business finance consulting and accounting auditing to assist and monitor its customers instead of providing training to its loan professionals to gain more skills and knowledge.

The goal of service quality is to provide a better service in processing loans by means of fulfilling all customers’ need. There are three general loan types, i.e., commercial and industrial loans, residential mortgage loans and personal or consumer loans. Service quality relates to product marketing as finding what type of loan specialisation or diversification that suits to a bank’s competence. In order to achieve higher service quality, a bank needs to increase the capacity in origination and servicing loans by upgrading its competence.

Maintaining service quality, banks cannot control the lending cost effectively. Considering cost control, service quality can be affected by a decision to concentrate in one competence in lending activity. Banks may concern only on loan origination competence as focusing on the origination cost or concern only on loan servicing as focusing on the servicing cost. As not applying cost control, banks still concern on both loan origination and servicing.

For example, a loan may be originated by bank A but the funding is undertaken by bank B whereas bank C offers to originate and servicing the loan to maintain service quality. Bank A concentrate on loan origination and bank B concentrate on loan servicing. Bank A obviously pays the origination cost and bank B only pays the servicing cost. This example appears to be related to the activity of loan sales and securitization. Regarding the previous example, bank A takes advantage in taking lending fee and bank B adds its loan portfolio as funding the loan fulfilling its desire for growth.

Maintaining service quality may also affect desire for growth as putting too much concern on existing loans may ignore the effort of establishing new loans or the opportunity to take more qualified customers. Here a bank tries to build a good relationship with the existing customers particularly the good ones by offering other types of loans to their account so that the customers do not have to search other opportunity from other banks. For example, in personal lending, a bank may offer an automobile loan to a customer who has an overdraft account instead of finding new customers for such loan. The existing customer gets benefit from this service as he or she does not need to go to other banks or credit unions to get a loan to buy a car. However, the capacity of funds taken from the existing customer may not be as big as the bank could take from new customers. In wholesale lending, this kind of example is more significant and can be related to relationship lending as banks try to build relationship with the existing customers as well as taking opportunity for a bigger capacity of funds from them.

The goal of credit management in lending activity is actually to apply a strict policy to the customers in analysing and processing their loans. In contrast, banks may apply a soft policy in credit management in maintaining service quality to the customers. The conflict obviously arises between credit management and service quality. Moreover, credit management would need costs as banks need longer time in analysing the character, capacity, collateral, capital and condition. However, applying a comprehensive credit management is essential in lending activity.

Fulfilling desire for growth, banks open new branches and hire new loan officers. As it has been mentioned in the beginning, this needs more lending costs. Banks will need more time to analyse and monitor the loans. There is a possibility banks will mismanage the credit if work loading to their loan professionals is too big. As expanding loans has to be followed by finding good borrowers, credit management has to be conducted effectively.

In minimizing the conflicts, a relationship lending can be applied instead of a transaction lending which is a conventional way of lending. Relationship lending is a way in how a bank offers a flexible permanent service of lending in a multiple loan account to a single borrower. In transaction lending, a bank normally undertake a single account from numerous customers and do not concern on continuing the account after the loans are repaid by the individual customers. In relationship lending, banks can undertake multiple accounts from the single borrowers and offer the single borrowers to continue the service after the loans are repaid or offer other services, such as trust services, insurance and cash management. Even though the loans have not been repaid, in relationship lending, banks offer a flexible term and calculation to work out the loans instead of classifying as non-performing loans. In relationship lending, loan origination, servicing and monitoring is combined in a one deeper process. Moreover, relationship lending is suitable for both wholesale and retail banking.

Instead of maintaining a better service quality, relationship lending can reduce direct lending costs particularly the servicing and transaction costs. Banks are still able to fulfil their desire for growth as expanding loans for the existing customers. As building relationship to the existing customers, banks can also apply credit management in a more comprehensive and effective way. Banks already understand with the character, capacity and condition to their customers. Therefore, relationship lending is only applied to the good customers.

Another way in minimizing the conflict is conducting loan sales. A loan sale is a way of lending when a bank sells a loan after originating the loan for a customer. A bank which sells the loan can control the lending costs by undertaking the origination cost and eliminate the servicing and monitoring cost and also does not need much concern on credit management. A bank which buys the loan can fulfil its desire for growth without taking the origination cost. However, a buyer bank has to put much concern on credit management. Service quality can still be maintained, as a correspondent relationship is built between the seller bank and buyer bank. Normally, a loan sale is applied as a small bank buys a loan from a big bank.

In strategic level, the areas of conflict can be minimized by merger and acquisition as a bank can achieve cost efficiency by eliminating branches and expand loans by taking other banks loan. A bank can reduce the lending cost from eliminating branches. A bank can maintain its service quality as expanding the service geographically to a wider area of service. A bank can still apply credit management properly as sharing the competence in loan screening, analysis and monitoring with other banks that already have other kind experience in particular types of loans, which the bank does not have.

The areas of conflict can also be minimized by applying proper management information system and technology in lending activity. With a comprehensive computer database and credit scoring software, a bank can save time in processing loan as well as conducting a good credit management. Even though a bank undertakes so many loans handled as a result of expanding loan, a bank can still maintain service quality for all loan applications loaded.

In conclusion, within the lending environment, the source of conflict regards the situation when a bank tries to control its lending costs, which include the origination, servicing, screening and monitoring cost. Fulfilling its desire for growth, a bank tries to expand loans as well as to find good borrowers. Expanding loans, the lending cost would increase. Finding good borrowers, a strict credit management has to be applied. Also, it appears that maintaining service quality affects a soft credit management and needs more costs. There are ways such as relationship lending, loan sales and merger and acquisition and application of proper management information system and technology in lending activity which can minimize the conflict. However, to achieve all the goals together, a bank has to align its goal in expanding loans and finding good borrowers along with the effort of fulfilling customers’ need of lending and coping with information asymmetry and agency burden.

Reference and Bibliography

Berger, Allen N., & DeYoung, Robert. (1997). Problem loans and cost efficiency in commercial banks. Journal of Banking and Finance Vol. 21, No. 6, June 1997

Elsas, Ralf & Jan Pieter Krahnen. (1998). Is relationship lending special?: Evidence from credit-file data in Germany. Journal of Banking and Finance Vol. 22, No. 10-11, October 1998

Emerson, L. (2000). Writing guidelines for business student. (2^nd ed.). Palmerston North: The Dunmore Press Ltd.

Franklin, Allen & Gale, Douglas. (1999, September). Innovations in financial services relationship and risk sharing. Management Science, Issue 9, p. 1239

Kathe, Raymeon A. (1997: March/April). How to reduce direct lending costs. Bankers Magazine. Vol. 174, Issue 2, p. 70.

Kulkosky, Edward. (1997, January 1). Relationship lending requires proper tools. American Banker Vol. 162, Issue 19, p. 7.

Ongena, Steven. (1999, July). Lending relationship, bank default and economic activity. International Journal of the Economic of Business. Vol. 6, Issue 2, p. 257.

Saunders, A. (2000). Risk of financial intermediation: A modern perspective. (3^rd ed.). McGraw-Hill.

Sinkey, J.F., Jr. (1992). Commercial bank financial management: In the Financial-Services Industry. (4^th ed.). New York: Macmillan, Inc.

Staples, R. (1995, December). Changes in the application of commercial lending principles: Module 2. Department of Finance, Banking and Property, Massey University.

The Globecon Group, Ltd. (1995). Active bank risk management: enhancing investment & credit portfolio performance. Irwin.

Credit Derivatives as Part of Hedge Funds’ Strategy

2010-04-29T16:02:00.001-07:00

Credit Derivatives as Part of Hedge Funds' Strategy

Jeffry Merril Liando (2007)

For the last decade, hedge funds have entered indirect credit markets by speculatively playing with credit derivatives and more recently involved in the origination process. This has given a financial perception of double risk. Hedge funds are exposed to higher risks compared to other investment pools as badly as credit derivatives are seen riskier than other derivatives. The connotation of a hedge fund as a "player" implicitly depicts its aptitude to employ credit derivatives as an alternative asset class in its portfolio strategy and implementation.

The relationship between hedge funds and credit derivatives is symbiotic in the context of financial market as one is the user of the other for a mutual benefit. Hedge funds with their channelling and leveraging capacity are able to trade and play with credit derivatives as accessing credit markets in which they do not have the capability of originating the credits. Credit market for loans or bonds is in fact the biggest available market in capital market in terms of volume, outweighing equity market. Hedge funds may see an opportunity to take a big profit in credit market via credit derivatives as they can speculatively bet on default probability and interest rate movement. Credit derivatives on the other hand can provide lenders with a broader and liquid market for transferring credit risks in order to capture wealthy investors via hedge funds. Credit derivatives market needs hedge funds involvement in making market price as hedge funds can bid or offer a better price than other players such as commercial banks, investment banks, pension funds and insurance companies can do.

To see how hedge funds can play with credit derivatives, it is important to view the market environment as an over-the-counter market for private deals between two parties that agree to set an extended condition on new or existing loans or bonds. Whether as buyers or sellers, the unregulated hedge funds can more flexibly deal with the regulated counterparties and keep the derivatives in a portfolio or as a stand-alone investment without compliance of public disclosure. The appearance of hedge funds in playing credit derivatives can also be represented by private equity funds who can hold the underlying assets. However, hedge funds with a limited capital will have to borrow from banks for meeting sufficient collateral to chase bigger returns from a bigger contract size. The common forms of credit derivatives played by hedge funds are collateralised debt obligation (CDO), credit default swap (CDS), total return swaps (TRS) and synthetic CDO with CDS as the underlying assets.

This essay aims to discuss some forms of credit derivatives played by hedge funds with some examples and referenced evidence that can be gathered from available information and databases. A term of double risk is interpreted by pointing out some risk issues of credit derivatives played by hedge funds. The conclusion to be made is that a combined risk perception between credit derivatives and hedge funds is something that cannot be prevented by financial market community as long as the desire of hedge funds for excess returns and the need of lenders for liquidity in credit market can always be fulfilled. This essay is divided into four sections: hedge funds, credit derivatives, credit derivatives played by hedge funds and conclusion.

1. Hedge Funds

A hedge fund is an investment product like a mutual fund or a pension fund and not necessarily maintaining a hedge position. A hedge fund is an actively managed fund of a tailored investment pool which is organised by an investment advisor who sets up a company under a limited liability partnership to invest money that is privately placed by a group of not more than 499 accredited investors as the partners. Accredited investors mean individuals with net worth more than US$1 million or income more than US$200 thousand. The hedge fund manager or the investment advisor will be compensated by large incentive, normally 15%-25% of the fund's net profit. Because of its nature, hedge funds exempt from 1940 Company Act in order to minimise public disclosures and 1933 Securities Act in order to charge asymmetric performance fees.

Seemingly, it is quite simple to set up a hedge fund on the ground that one has excellent skills and knowledge in portfolio analysis, network relationship building and marketing. As an investment advisor or financial planner she may offer some of her wealthy clients to go to the next step in business relationship as her limited partners under a limited liability partnership. By having an excellent concept of what to hold, buy and sell in the portfolio, she may start to explore some better offers available in the market with counterparties, in the exchanges or over-the-counter, with ordinary securities or derivatives. She may build relationship with some exchanges, investment banks or other financial institutions for some chances in repurchase agreement, fund borrowing and margin facility. The most common trading strategy is by going long and/or short in the stock and/or derivatives exchanges, whether domestic and/or offshore. To avoid higher tax, she may choose some tax havens for the domicile of the funds. She may also need to test first that her managed portfolio is supreme before offering to her clients as they need some kind of proof of a sought-after investment. In practice, many hedge funds nowadays operate under the umbrella of investment banks which are investing in portfolio of hedge funds. All of the above shows some level of freedom in hedge fund transactions compared to ordinary mutual funds.

Unlike mutual funds that usually take long positions, hedge funds have more degree of freedom to take any speculative position for increasing investors' profit and managers' incentives from investment returns above average benchmark returns. Now is popular with the term of seeking alpha. They can go mainly long, mainly short or combination of both. A short position can be done by asking for a margin facility, entering a repurchase agreement.

To pursue a high leverage level, hedge funds are likely to go short and bet on a decreasing price or alternatively borrow directly from major banks to upsize the volume for a bigger chance return. For private equity funds, they can borrow funds for some percent of the equity they are willing to invest through a leveraged buyout (LBO). Creditworthiness of hedge funds could be viewed from the managers' skill to implement a good strategy for a big return. Hedge funds are somehow able to take other financial players as counterparts.

The nature of short position, high leverage and high incentives are similar to those in the first hedge fund set up by Alfred Winslow Jones in 1949. His strategy was a market neutral or hedge strategy by buying undervalued shares with an offset position of short selling overvalued shares. Since his long and short positions were applied to different shares, it was a leverage strategy as he possibly expected a profitable divergent movement of such shares.

A hedge fund is structured as a heterogeneous asset class by employing different approaches, strategies and instruments to explore opportunities to generate abnormal returns. Some hedge funds trade in shares and some do not trade at all but more focus on emerging market debt, fixed income and derivatives. Latter development shows that some hedge funds play in credit derivatives market offsetting positions with fixed income trading and through interest rate swaps.

Classification of hedge funds according to TASS, as follows: convertible arbitrage (between a convertible bond and equity), dedicated short, emerging market funds, equity market neutral (maintaining close balance), event driven (responding corporate event, e.g. merger, LBO), fixed income arbitrage (long/short related bonds), macro (directional movement in financial market and macro economic indicators), long/short equity (with a long bias), managed futures and others (risk arbitrage, statistical arbitrage, derivative arbitrage, distressed securities, fund of hedge funds). In 2004, the largest percentage of asset under management is long/short equity 32% followed by event drive 19%. There is a slight decline from the previous year in macro strategy from 11% to 10% and an increase in others from 8.5% to 10.1%.

Hedge fund industry has been growing rapidly along with investors' desire to enjoy excess returns or alpha. The spirit of seeking alpha becomes the main goal of hedge fund strategy. Assets under management of the hedge fund industry grew from US$456 with number of funds from 3,102 in 1999 to US$973 with 5,782 number of funds in 2004 according HFR database and it is estimated to be more than US$2 trillion at the end of 2006, 30 percent more than a year earlier. The average annual return from 1994 to 2004 for live hedge funds is 14.4% for TASS, 14.3% for HFR and 15.5% for CISDM. TASS, HFR (Hedge Fund Research) and CISDM (Centre for International Securities and Derivatives Markets) are three commercial databases for hedge fund research.

Table-1. Hedge fund returns

However, despite the prospect in generating excess returns hedge funds also experience some failures. This is due to the speculative risk in taking such positions that can offer big returns therefore also big risks. The survivorship bias return in the table-1 shows the average lost return deduction after some collapsed hedge funds. Some failures in the hedge fund businesses gathered from different news sources in the internet are as follows:

Long-Term Capital Management in 1999 lost US$2.3 billion in equity value after its bet on narrowing credit spread after the Asian crisis being hit by Russian default.
Tiger Management in 2000 failed to return US$6 billion in investors' assets after its strategy to go short in overpriced technology stock being hit by the bull market in technology.
Aman Capital in June 2005 lost more than US$100 million from its leveraged credit derivatives strategy.
Marin Capital in June 2005 closed its funds valued at US$1.7 billion after its bet on the outlook for General Motors by buying its bonds, shorting its stock, $500m long equity position and $1bn short mezzanine position being hit by GM junk bonds rate.
Bailey Coates Cromwell Fund in June 2005 dissolved and lost 20% of US$1.3 billion asset due to wrong bets on the movement of US stocks.
Amaranth Advisors in September 2006 lost the total of US$6 billion in two weeks after its bet on an appreciation natural-gas futures post Katrina Hurricane 2005 being hit by the depreciation of the futures.

Hedge fund in credit derivatives

There have been some big changes in market environment after LTCM collapse as more hedge funds have been entering credit derivatives market. From the above facts, it can be noted some failures on credit derivatives, such as LTCM with total return swaps, Aman Capital with leveraged credit derivatives and Marin Capital with synthetic CDO. It seems LTCM has been the pioneer of hedge funds involvement in credit derivatives market and some hedge may have seen the opportunity to gain big returns assuming that their bet would never go wrong like LTCM's bet.

In spite of Warren Buffet's opinion in 2003 that credit derivatives are "financial weapons of mass destruction", players in capital market continue to use credit derivatives for speculating and hedging purposes. The general argument is that credit derivatives provide more liquidity for credit markets other than from financial institution's funding and also provide higher returns than the original securities or assets. Hedge funds with their investors' funds can be seen as the sources of credit liquidity. Here it can be seen that even in a nature of retail funding a hedge fund may access the wholesale credit market due to the advantage of high leverage.

Figure-1. Players of Credit Derivatives

In has previously been mentioned that total assets under management of hedge funds is estimated more than US$2 trillion in 2006. If the involvement of hedge funds is about 30% average between buyers and sellers (see figure-1) and the total market volume of credit derivatives is estimated US$20 trillion in 2006 (see figure-2), it can be projected that US$6 trillion of credit derivatives market is managed by hedge funds. If say 20% of hedge funds or US$400 billion assets played in credit derivatives, this may suggest that there is a 1:15 leverage applied by hedge funds with assumption that the 30% average hedge funds consists of offsetting long and short strategy. If it is assumed that hedge funds overall may have stand-alone strategies as buyers and sellers and the involvement becomes 60%, then it can be projected about US$12 trillion of credit derivatives market is managed by hedge funds with 1:30 leverage in trading. For example, a hedge fund selling a credit default swap (CDS) of a US$15 million loan value for US$1 million premium would have to face maximum US$15 million claim. If selling US$2 million mezzanine notes of a synthetic collateralised debt obligation (CDO) of two CDSs above, a hedge fund would have to face maximum US$30 million claim.

2. Credit Derivatives

The market volume of credit derivatives have shown a figure of exponential growth from 1996 to estimated 2008. From just US$0.2 trillion in 1996, it has been growing gradually to US$2 trillion in 2002 until rapidly jumping to US$5 million in 2004 and estimated to grow exponentially to US$20.2 trillion in 2006 and further to US$33.1 trillion until 2008. The size in 2006 is around 1.5 times annual nominal US GDP. However, this cannot be compared explicitly as there are factors of leverage and multiplier in credit derivatives that may bias the perception of the real volume of credit market and money circulation in the context of macro and monetary economy. The main driving factor of credit derivatives is in fact governments who sponsor the development in the countries that use alternatives of liquid funds available other than those in financial institutions and can be explored outside the countries. Hedge funds all over the world are one of the liquidity providers for credit derivatives market even though some tend to deal with a lot of speculations.

Figure-2. Market volumes credit derivatives (US$ trillion)

Credit derivatives market is a market of financial engineering and technology where the assessments of returns and risks are assigned by a set of complex mathematical formulae and computerised programming software. By modelling the probability of default, interest rate risk and timing risk, portfolio managers may find some ways of hedging by replicating portfolios in different positions.

By definition, a credit derivative is a derivative security that is primarily used to transfer, hedge or manage credit risk and whose payoff is materially affected by credit risk. Credit derivatives are traded over-the-counter (OTC) and privately negotiated. Historically, credit derivatives came up to capital market driven by the development in asset securitisation. Asset or credit securitisation is a process of transforming a series of cash flows derived from debt obligations into securities in the capital markets that pay interests to the investors. This process needs a special purposed entity (SPE) formed to channel the inflows and outflows between the packaged assets and the securities. The SPE normally holds the packaged assets in its liability to be sold in the form of securities to the investors paying investors' interest with payments from borrowers' interests or customers' premiums passed from the originators. The SPE pays the packaged assets to the originators with the sale of securities to the investors.

In its first development, asset securitisation has produced derivatives securities such as asset backed securities (ABS), mortgage backed securities (MBS), collateralised debt (bonds or loans) obligation (CDO), interest only (IO), principal only (PO). Financial innovations in the 90s then drove to the inventions of credit derivatives products such us: total return swap (TRS), single-name credit default swap (CDS), credit linked notes (CLN), first-to-default swap (FDS), CDS on basket of corporate names, CDS on ABS, synthetic CDO, index CDS, option CDS and the latest has been launched is collateralised foreign exchange obligation (CFXO). Some products discussed related to hedge funds will be discussed in the next section are CDO, TRS, CDS and synthetic CDO.

Asset securitisation used by lenders as a short-cut technique to remove credit risk. If lenders intentionally remove the bad credits and package them through securitisation process, they may face three kinds of risk as follows: (1) downgrading risk arises where an independent rating agency based on its observation, analysis and perception tends to downgrade rating, (2) cost risk arises when a high cost should be paid in the process of securitisation from originating, pooling, guaranteeing, credit enhancing and selling, (3) reputation risk arise when holding a bad reputation from investors' view as securitising bad credits. Meanwhile, the risk faced by investors of the securities would be similar to the risk of lending, such as, (1) default risk, (2) liquidity risk, (3) interest rate risk, and additional (4) risk of prepayment for long maturity credits, also (2) transparency risk when the credits condition and situation are beyond investors' visions.

A hedge fund basically does not carry out the origination of a credit unless it acts as a private equity fund who invests in a company in the form of equity. As a private equity fund, it may be exposed to the credit risk from the debt of the company it acquires and the loan it receives from banks when buying the company through a leveraged buyout. Then, it may buy protection for the credit risk of the company. Other hedge funds may then sell protection for the reason that the premium would be expensive; however, they can only evaluate the credit condition based on the rating information.

Simple hypothetical simulation of credit derivatives

To simulate securitisation process and credit derivatives, some hypothetical examples can be described in the forms of personal loans.

Scenario 1: with XXX

Ten students borrow $100 each at $15 interest from AAA. If the ten students pay back all of their debts, AAA willreceive $1000 plus $150 interest, totalling $1150. Knowing that AAA would have the $1150 at the end, he then asks XXX who has many friends to find some people who want to lend AAA some money. XXX finally finds 80 friends with $1 interest for $10 each and 20 friends with $2 interests for $10 each. Friends who choose the $1 interest will be paid first after those taking $2 interest if any of the students default. If not default, AAA would earn $30 (may be shared with XXX) from $150 interest deducted by $120 and the 80 friends would earn $1 each and the 20 friends US$2 each. If 2 students default, AAA would still earn $30 but the 80 friends with $1 interest would have to wait longer to get their $10 back.

Scenario 2: with QQQ

Other way to show a protection motive would be like this. AAA knows that there is a risk of the ten students not paying back the debts. The ten students would pay back the interest, but may not pay back some part of their debts. AAA then finds a special friend QQQ. QQQ asks AAA to pay $100 in advance as promising to cover any loss AAA gets at the end. QQQ may expect that AAA might just get $925 back of $1000 as paying the rest of $75 to AAA. If the ten students just pay $925 back, AAA still gets $1000. However, AAA's $150 income is to be deducted by $100 protection cost from QQQ who has promised to cover the loss, totalling $50. Meanwhile, QQQ would receive $100 from AAA and pays $75 to cover AAA's , earning $25 in total. If the ten students pay back all of the $1000, AAA's earning would be still $50 and QQQ's earning would be $100 without covering any loss. How about if the ten students just pay $700 back of $1000? QQQ may simultaneously buy protection at $50 from GGG who promises to cover the loss until $300. QQQ would earn $50 if default or not default whilst GGG would earn $50 if not default and lose maximum $250 if default.

Scenario 3: with HHH

Another instant way to alter the risk of default can be shown as another friend HHH pays AAA $100 now and $1000 at the end whatever the situation would be as AAA has to pass all of US$1150 at the end. AAA would get an instant profit of US$100 now and HHH would get a profit of US$50 at the end if the ten students do not default. To cover the loss if the ten students default, HHH may buy protection from GGG at US$30 to protect the loss until US$150. HHH would earn US$20 whether default or not and GGG would earn US$30 if not default and lose maximum US$120 if default.

Scenario 4: GGG as a dealer

The last two simulations shows that the price of GGG's protection may vary based on the probability of default of the students' debts over time. To some extent, the premium $50 for $300 is still reasonable. If the default probability decreases, it may apply premiums from $40 for $200 loss, $30 for $150 loss, $20 for $100 loss until $10 for $50 loss. Therefore, it can be set protection prices referred to the value of $1000 students' debts would default from $50 to $10. As a dealer, GGG may trade the protection with some counterparties. One may buy GGG protection for the students' debts at $20 for $100 default and sell it back to GGG at $40 once the students' debts are getting riskier to $200 default, earning $20 in total.

GGG now holds protection $40 for $200 default. Believing that the students' debts would default maximum $100, GGG then may end up buying protection from ZZZ at $20 premium for $100 loss. If not default, GGG would receive $40 from QQQ and pays ZZZ $20, earning $20. If default by $100, GGG's earning is still $20 and ZZZ would face a maximum loss of $80.

3. Credit Derivatives and Hedge Funds

a. (Synthetic) Collateralised Debt Obligation (CDO)

A CDO is a derivative resulted from a securitisation process of a portfolio of loans or bonds which is being sold by a lender or issuer to an SPE who then issues securities in the form of notes collateralised by the portfolio of bonds or loans. A synthetic CDO refers to a portfolio of CDSs.

The notes issued by SPE are structured with different payoffs and prices based on the credit qualities of the underlying portfolio to give investors choices to invest in different risk profiles. By structuring a CDO, SPE can enhance the quality of a portfolio with mainly speculative grade loans or bonds by issuing notes with higher credit qualities. In an arbitrage CDO, the notes are usually priced over the yield of the underlying bonds or loans for SPE to gain. For example if the average yield of the bonds portfolio is LIBOR+5%, the CDO may be priced on average at LIBOR+6%, thus the PV of bonds portfolio is higher than the CDO. By purchasing CDO notes, investors may enjoy the advantage of higher expected return even without having the original assets. Despite there are complicated mathematical techniques for structuring and pricing CDO notes, a simple hypothetical example of an arbitrage CDO can be described as follows.

Structuring an arbitrage CDO and hedge funds' play

The underlying portfolio of $100 bonds matured in 2 years with $10 expected default consists of:

$10 rating C bonds with expected return LIBOR+4%.
$10 rating B bonds with expected return LIBOR+2%.
$30 rating A bonds with expected return LIBOR+1%.
$50 rating A+ bonds with expected return LIBOR+0.5%.

The notes issued in different tranches:

Equity tranche: $10 note unrated at LIBOR+5% p.a.
Mezzanine tranche: $10 note for rating B at LIBOR+3% p.a.
Mezzanine tranche: $30 note for rating A at LIBOR+2% p.a.

Senior tranche: $50 note rating A+ LIBOR+1% p.a.

With this simple structure assuming LIBOR is 4%, SPE may expect the net present value between the bonds portfolio and the CDO's tranches are still positive as the average rate of return of the bonds portfolio is lower the average cost of capital of the CDO tranches.

Buyers of the equity tranche may enjoy the highest return of 9% followed by mezzanine and senior tranches. However in default event of $10, equity tranche buyers may not receive back the $10 investment but senior and mezzanine tranches are still repaid. In default of $4, equity notes receive only $6 of $10 investment. Equity tranche buyers expose to default risk.

Sellers of equity tranche pay 9% or $0.9 but the $10 investment received from buyers would not be repaid if the portfolio defaults by $10. It means that only with $0.9 the sellers can generate $10. Meanwhile, by selling mezzanine and senior tranches at the existing notes' rate, sellers expect the rate will drop so that they can buy back and profit. But they may lose if the rate rises.

The most popular position played by hedge funds is long equity tranche and short mezzanine or senior tranche. The advantage of this position is that hedge funds can enjoy the high return from buying equity tranche by selling mezzanine or senior tranche with smaller cost. For example at LIBOR equal to 4%, a hedge fund receives $0.9 (9%) from long equity and pays $0.6 (6%) for short mezzanine rating B note, earning $0.3. If LIBOR rises to 6%, a hedge fund closes it positions and pays $1.2 for equity and receives $0.8 from mezzanine, costing $0.3. If the proportion of mezzanine tranche is bigger the equity, a hedge fund can profit if LIBOR increases. If the proportion of mezzanine tranche is smaller the equity, a hedge fund can enjoy the spread assuming LIBOR decreases or at least does not move. However, this position is still risky. Marin Capital in June 2005 held $500 million long equity position and $1 billion short mezzanine position betting on General Motors (GM) outlook. When GM was rated down to speculative grade, the equity and mezzanine tranches were repriced downward and Marin ended up with an enormous loss.

How CDO helps private equity's LBO and attracts hedge funds investment can be seen in figure-3 regarding the tranches financing structure of a target company's debt. By investing in equity tranche, private equity funds may enjoy the highest returns while banks and CLO may enjoy higher returns from investing directly to the company. In CLO is the portfolio of CDOs from several private equity's LBO. Hedge funds and mezzanine funds are the way to hedge position in the equity tranche.

Figure-3. Tranches financing structure of private equity's LBO

The first CDO hedge fund was launched by Ferrell Capital Management in 2001 when issued US$50 million of unrated junior notes which were based on the performance of a group of hedge funds. Then JPMorgan structured out hedge fund-of-funds CDOs for Grosvenor Capital Management and Ivy Asset Management. In Europe, Deutsche Bank financed CDO for Prime Edge private equity funds transactions. Credit Suisse First Boston structured out deal for US$500 million hedge fund-of-fund CDO deal for the Bahrain-based Invest Corp. Seemingly, the CDO is structured out of hedge funds of funds, which are normally held by major investment banks.

In May 2007 Merrill Lynch and Credit Agricole Asset Management launched a new type of CDO called the collateralised foreign exchange obligation (CFXO). If the product is successful in market it would be the first CFXO that may be followed naturally by other CFXOs. The underlying portfolio is made up of about 10 foreign exchange pairs combining the currencies of the Group of 10 developed countries with a number of emerging market currencies. The AAA-rated tranche is to pay 80 bps - 100 bps in coupons while the riskiest equity tranche is expected to return about 20 per cent.

b. Credit Default Swap and Total Return Swap

CDS

CDS is basically a derivative showing an agreement as one counterpart agrees to pay some regular protection premium as a percentage of the notional debt held as its asset to the other counterpart who promises to pay any defaulted part of the debt so that its assets are protected from losses. Figures-4 shows Acme Inc. agrees to pay premium to CDS dealer or seller to buy protection of Giant Corp's debt held as its asset. If Giant Corp. suffers a default, Acme Inc. is safe and CDS dealer suffers a loss. If Giant Corp. is fine, Acme Inc. still costs a protection and CDS dealer enjoys a protection payment.

Figure-4. Basic CDS cash flows

Hedge funds as CDS buyers usually purchase CDS to hedge portfolios of the bonds they currently own. Hedge funds also purchase CDS on corporate bonds designed to profit from a widening corporate credit spreads as CDS is cheap when the spread is narrow and expensive when widen. Some buy CDS on sub prime, mortgage backed, fixed-income securities and indexes as a way to profit when borrowers' credit quality falls. Some hedge fund managers also buy CDS on emerging debt to bet on a decline in a country's credit quality.

Hedge funds as CDS sellers like to receive protection income and expect no default in the bonds or loans. Meaning that, they bet on a good hope of bonds or loans to fulfil the obligation. Notwithstanding this intention, the bonds or loans default hedge funds may end up owning the bonds or loans and think the next strategy to recover the defaulted part.

Trading CDS on Sallie Mae's LBO can be related to the process tranche financing in CDO as to protect the tranches portfolio in three ways. First, hedge funds buy CDS before Sallie Mae's LBO at say 40 bps and sell it at say 60 bps after the LBO as the credit quality and risk of Sallie Mae increase. Second, hedge funds buying CDS on Sallie Mae debts expect students' debt would default as receiving default payment. They may be predicted from there not so many jobs for students and not so many bright students. Third, hedge funds selling CDS on Sallie Mae debts expect otherwise and receive protection income.

TRS

TRS is basically a derivative of a netting position between the bonds' fixed payment and the bonds' referenced floating payment. Any yield decrease may increase the bonds value and the receivers or buyers may profit whereas the payers or sellers may lose. Any yield increase may decrease the bonds value and benefit the sellers whereas the buyers may lose.

Figure-5. Basic TRS cash flows

Hedge fund buyers of course expect yield decreases, price increases and spread narrows. For example, a hedge fund pays at LIBOR+2%+$90 and if price increases and spread narrows it would receive at increasing LIBOR+2%+$95. On the other hand, hedge fund sellers should expect yield increases, price decreases and spread widens. Moreover, with small collateral hedge funds can trade for a huge value of bonds. For example, only with $1 million capital hedge funds can trade TRS for a face value of $100 million bond. Using 1:10 leverage hedge funds can upsize the TRS profit to 10 times. The collapse of LTCM may be regarded with TRS transaction. LTCM bet on narrowing spread after the Asian Crisis and then bought TRSs on emerging countries bonds. Unfortunately, Russian bonds then defaulted. Spread widened, yield increased and bond price decreased. Because of too much leverage LTCM lost US$2.3 billion with US$1.6 billion TRSs in the portfolio.

Conclusion

Physical development of the world in every economic sector grows rapidly in every country and can only be executed with funding provided through capital investments, whether foreign or domestic. Credit market as the biggest capital provider after equity market has been developed with financial innovations in financial engineering and technology that can turn an illiquid investment with low return into a liquid investment with high return. Bonds, which are low return investments, become more attractive as liquid high return investments in the form of CDO tranches. Moreover, credit protection can be traded into CDSs that can circulate in the market according to one's perception to the probability of default of such loans or bonds without holding them.

Hedge funds with their channelling and leveraging capacity are able to trade and play with credit derivatives as accessing credit markets in which they do not have the capability of credit origination. Hedge funds may see an opportunity to take a big profit in credit market via credit derivatives as they can speculatively bet on default probability and interest rate movement. Credit derivatives on the other hand can provide lenders a broader and more liquid market for transferring credit risks in order to capture wealthy investors via hedge funds. Credit derivatives market then needs hedge funds involvement in making market as hedge funds can bid or offer a better price than other players such as commercial banks, investment banks, pension funds and insurance companies can do.

The nature of speculation in hedge funds becomes the main issue and even a big issue when it meets the nature of leverage and indirect exposure in credit derivatives. History has noted the failure of credit derivatives played by hedge funds. Then, some people observed and analysed with what have gone wrong and can provide the causes of the failures. However before some failures, any strategy in credit derivatives was seemingly paramount for generating a reasonable big return. And after some failures, some new strategy is developed for anticipation. After all, hedge funds may still have some chances to get a big success in credit derivatives market, however, only for the sought-after players who have high analytical skills and freedoms.

Reference and Bibliography

Banque de France. (2006). Are risk transfer mechanisms sufficiently robust? Financial Stability Review, No. 9, December 2006. http://www.banque-france.fr/gb/publications/telechar/rsf/2006/chroni3_1206.pdf

Barr, Alistair. (2006). Hedge funds' use of credit derivatives a concern. Dow Jones MarketWatch, Oct 30, 2006. http://www.marketwatch.com/News/Story/Story.aspx?guid=%7B00A24926-B281-4B50-B257-F8AE13DFAA5D%7D&source=blq%2Fyhoo&dist=yhoo&siteid=yhoo

Barrett, Ross and John Ewan. (2003). BBA Credit Derivatives Report 2006. British Bankers' Association. From class distribution.

DG. (2002). The fund-of-funds pipeline continues to build. Asset Securitization Report, 1/7/2002, Vol. 2, Issue 1, p7. Database: Business Source Premier

Edwards, Franklin R. (1999). Hedge funds and the collapse of Long-Term Capital Management. Journal of Economic Perspectives, Spring99, Vol. 13 Issue 2, p189-210. From Business Source Primer database.

Fung, William and David Hsieh. (2006). Hedge funds: an industry with its adolescence. Economic Review, 4^th quarter 2006. Federal Reserve Bank of Atlanta. http://www.frbatlanta.org/filelegacydocs/erq406_fung.pdf

KL. (2005). CDS may make workouts trickier. High Yield Report, 9/19/2005, Vol. 16 Issue 35, p1&5. From Business Source Premier database.

Lee, Steve, John Schiavetta and Roger Merritt. (2001). Hedge Funds: a new asset class in structured finance. Asset Securitization Report, 12/10/2001, Vol. 1, Issue 47, p10-11. From Business Source Primer database.

Mitchell, Donna. (2006). Mixed macroeconimic fundamentals keep carry trades popular. High Yield Report, 10/9/2006, Vol. 17 Issue 38, p5. From Business Source Premier database.

O'Leary, Christopher. (2001). The CDO revolution continues as market awaits issue backed by hedge fund debt. Investment Dealers' Digest, 3/5/2001, Vol. 67, Issue 9, p15. From Business Source Primer database.

Polleit, Thorsten. (2007). The dark side of the credit boom. Mises weblog. http://www.mises.org/story/2558#

Schounbucher, PJ. (2003). Credit derivative pricing models. Wiley, p7-9,28-50. From lecture notes.

Smithson, Charles and David Mengle. (2006). The promise of credit derivatives in nonfinancial corporations (and why it's failed to materialize). Journal of Applied Corporate Finance, Fall 2006, Vol. 18 Issue 4 p54-60. From Blackwell database.

Steve Rosenbush . (2007). Little risk, big rewards in buyout deals. Business Week. Top News. April 17, 2007. http://www.businessweek.com/bwdaily/dnflash/content/apr2007/db20070417_348128.htm?chan=top+news_top+news+index_businessweek+exclusives

The Economist. (2007). The alchemist of finance. 17 May 2007, Survey: International banking. http://www.economist.com/surveys/displaystory.cfm?story_id=9141486

The Economist. (2007). Sallie Mae's big day. 21 Apr 2007, p79-80. From class distribution.

Benchmark Issue in CAPM

2010-04-29T15:54:00.001-07:00

Benchmark Issue in CAPM

Jeffry Merril Liando (2007)

Capital Asset Pricing Model (CAPM) has been widely used for finding a suitable required rate of return of a share or portfolio. However, the assumption of using a major share market index as the benchmark becomes an issue. This essay aims to discuss this issue related to the good theoretical assumptions, the problems arising in the CAPM, the distortion in its application, the practice of seeking alpha in responding the distortion and the impact of distortion for the New Zealand context.

CAPM and efficient portfolio

CAPM assumes that a major stock index can be used as a benchmark to determine risk premium and beta for calculating the required rate of return of a stock. The formulae can be shown as follows, Rs = Rf + Beta ( Rm – Rf ), or by noticing the future expectation as this: E(Rs) = Rf + Beta ( E(Rm) – Rf ). To see the relationship between share and market returns, it can be formulated as follows: E(Rs) – Rf = Beta ( E(Rm) – Rf ).

The benchmark index assumed in the CAPM is promoted as the market proxy of the efficient portfolio of risky assets. The benchmark index is then set artificially to be a manifestation of a whole market reflecting the acceptable portfolio chosen by investors within the efficient frontier. Markowitz (1952)[1] suggests that rational investors would choose minimum risk and maximum return in diversification and with any combination of weight the optimal portfolio lies on the efficient frontier.

This is such an excellent portfolio theory so that Sharpe (1964)[2], Lintner (1965)[3] and Mossin (1966)[4] further modelled it to include the risk free rate. As the efficient frontier only includes the portfolio of risky assets, a risk free asset with a zero risk return can be combined with risky assets added to the efficient portfolio and investors can then go beyond the frontier by borrowing and lending at risk free rate. A capital market line that used to linearly predict the market return can be drawn by lining up a point of a portfolio with only risk free rate to the other point that touches the efficient frontier, known as a tangency portfolio. The tangency portfolio explains that investors separate their decisions in investing and financing the investment as suggested by Tobin (1958)[5].

In a sense of linear prediction of an individual share return, CAPM is then modelled with a security market line, in which a share’s rate of return can be predicted given the market return, risk free rate and beta. The line is plotted by the expected rate of return of a share with its beta to the market return. The issue of benchmark index can be seen at this point. If there is a benchmark error, CAPM cannot estimate the correct beta and risk premium properly thus cannot calculated the expected rate of share return correctly.

Benchmark error

Benchmark error using CAPM for evaluating portfolio performance according to Ross (1980,1981)[6] can be seen in two ways when the market index produces an incorrect beta for the share and when it produces incorrect estimation for the market premium optimised to the risk free rate (see figure 1 and 2). The problem is not due to statistical variation but rather to the cause that the market index is not a good predictor of mean/variance efficient portfolio.

Figure-1. Incorrect beta

Figure-2. Incorrect market premium

A further study by Green (1986)[7] shows that benchmark errors are continuous behaviour and different for different indexes, thus, share or portfolio performance is sensitive to the choice of benchmark for the market index. We may now say that as beta assumed equals to one, the expected rate of return should be higher as we choose any benchmark that produces a higher market risk premium, and lower for any benchmark that produces a lower premium.

Benchmark errors are also considered in the context of global investment. Reilly and Akhtar (1995)[8] found that there is a variation of beta when using a domestic index, global index or a diversified global stock and bond portfolio. The beta of domestic equity index is lower than the world equity index and much larger for the diversified global stock and bond portfolio.

Market proxy, beta and risk premium problems

The root of benchmark error was based fundamentally on Roll’s critique (1977)[9] that found that market index is efficient per se, not for the individual shares or portfolios. Ross (1978)[10] also added that market proxy is not ex ante mean-variance efficient and individual preference in portfolio selection may be judged with a different market index and then will be penalised by share’s beta according to the different market index. Roll and Ross (1994)[11] found that the market proxy may be located within 22 bps below the efficient frontier (Figure-3).

Figure-3. Market proxy and efficient frontier

Using the true market proxy of the value weighted portfolios of all US shares, Fama and French (2004)[12] tested CAPM by plotting the annualised monthly return and beta of every stock in NYSE, AMEX and NASDAQ from 1928 to 2003 and to be compared to the returns predicted with CAPM. The result is telling us further problem other than benchmark error and market proxy problem, that is, beta inconsistency.

Figure-3. Beta inconsistency.

Figure-3 shows an inconsistency of beta in CAPM. Low beta shares that are predicted to have low returns are in fact too high whereas high beta shares that are predicted to have high returns are in fact too low, as seemingly the line rotates.

The inconsistency of beta was identified a decade before by Fama and French (1992)[13] as suggested a three-factor model by adding size and book to market ratio (B/M) to CAPM. They concluded that value shares with high dividend yield, high B/M, low P/E tend to have bigger expected return than growth shares with low dividend yield, low B/M, high P/E.

Again using the true market proxy and the three-factor CAPM, Fama and French (2006)[14] tested whether the value premium exists in CAPM pricing. The result is rejecting CAPM pricing for portfolio based on size, B/M and beta as concluding that size and B/M, not beta, reward the expected return. The evidence shows that expected return does not compensate beta variation unrelated with size and B/M for both small stocks and big stocks. We may say that if CAPM is fine a good benchmark index should contain both small stocks and big stocks.

Alpha

Market proxy distortion opens an opportunity to have a better portfolio performance than the market itself which was earlier suggested by Jensen (1969)[15] with alpha as a performance indicator: Alpha = Rs - Rf + Beta ( Rm – Rf). However, one can say that even a passive portfolio can beat the benchmark. Bowden (2000)[16] further argued that alpha relates to market timing and cannot be observed by conventional performance measures and suggested ordered mean difference (OMO) as an alternative measure, which is a function of a running mean of the difference between asset/portfolio and benchmark returns that is ordered by values of the benchmark.

Recently, Fama and French (2006)[17] discussed about a portable alpha as a way to add a portfolio consisting risk free rate and index funds with an additional hedge position that generates alpha. Moreover, an alternative indexing has been suggested by Arnott (2005)[18] in fundamental indexation to solve the distortion in value weighted index with some alternative weighting constraints, such as book value, cash flow, revenues, gross sales, gross dividend and total employment.

New Zealand context

In order to see the impact of benchmark distortion in the New Zealand context, there are some market characteristics need to be considered (Bowden, 2005, p.133-168)[19], as follows, narrow true market proxy, large foreign capitalisation, high dividend yield, high risk free rate, low holding period return and low prospect dominance.

A consensus for share market proxy in NZ is the NZX-50 index that can be seen in every business page and news and the NZX-All for the true market proxy. However, there is a significant proportion of investment taking in the form of farming shares as the grass root of the NZ economy as a whole. For example, a rich Waikato Fonterra farmer may see a comparable investment choice between investing in Fonterra shares and NZX-50 shares, thus she needs a broader efficient frontier for the true market proxy other than just NZX-All. In fact, Fonterra only issues capital notes and none of its capitalisation in the share market.

The top ten capitalisations in the NZX-50 hold around 37.5% of foreign capitalisation. Since beta domestic equity market after influenced by beta foreign equity market may change, then the return of individual shares may be predicted below or above the original security market line.

High dividend yield and low P/E make NZ shares considered as value shares. Value shares may have a higher expected rate of return, thus a higher cost of capital, than growth shares according to the CAPM test by Fama and French (1992). If the CAPM holds, it is likely that the correct benchmark used would be the gross index, not the capital index which is widely used in the other market. A promotion to use the gross index to international investors may attract them to choose NZ equity.

High risk free rate may increase the cost of capital with a condition that there is no false market risk premium estimation in the benchmark. However, if benchmark error deviates to a lower market return then the market risk premium would be narrow and the security market line may rotate.

Low holding period return for NZ shares may be compensated by high risk free rate so that at some period the return of NZ shares is in fact is lower than government bond return. Under CAPM prediction, if NZ benchmark consists mainly of such shares, of course the market risk premium would be negative and the expected share return would be below the risk free rate.

The NZX-50 benchmark is dominated by larger companies with low growth prospect. That is why investors may have the opportunity of seeking alpha and beat the index with some shares like Michael Hill, Fisher and Paykel, Cavalier, Dorchester, etc. If tested with CAPM, there would be a big deviation from the predicted return of such shares.

Conclusion

CAPM assumes a major share market index as the best market proxy for efficient portfolio to predict the required rate of return. Despite the good theory background of mean (return) – variance (risk) efficient portfolio, the linear CAPM prediction using such proxy could be far from the reality of historical returns. As Fama and French (2004, p.44) suggested, “But we also warn students that despite its seductive simplicity, the CAPM’s empirical problems probably invalidate its use in applications”.

References

[1] Markowitz, Harry. (1952). Portfolio selection. Journal of Finance, Mar 1952, Vol. 7 Issue 1, p77-91.

[2] Sharpe, William F. (1964). Capital asset prices: a theory of market equilibrium under conditions of risk. Journal of Finance, Sep 1964, Vol. 19 Issue 3, p425-442.

[3] Lintner, John. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets. Review of Economics & Statistics, Feb 1965, Vol. 47 Issue 1, p13-37.

[4] Mossin, Jan. (1966). Equlibrium in a capital asset market. Econometrica, Oct 1966, Vol. 34 Issue 4, p768-783.

[5] Tobin, James (1958). Liquidity preference as behaviour towards risk. The Review of Economic Studies, Vol. 25, No. 2, p65-86.

[6] Roll, Richard. (1980). Performance evaluation and benchmark errors (I). Journal of Portfolio Management, Summer 1980, Vol. 6 Issue 4, p7-14.

Roll, Richard. (1981). Performance evaluation and benchmark errors (II). Journal of Portfolio Management, Winter 1981, Vol. 7 Issue 2, p17-22.

[7] Green, Richard C. (1986). Benchmark Portfolio Inefficiency and Deviations from the Security Market Line. Journal of Finance, Jun 1986, Vol. 41 Issue 2, p295-312.

[8] Reilly, Frank K and Rashid A Akhtar. (1995). The benchmark error problem with global capital markets. Journal of Portfolio Management, Fall 1995, Vol. 22 Issue 1, p33-50.

[9] Roll, Richard. (1977). A critique of the asset pricing theory's tests: part I: on past and potential testability of the theory. Journal of Financial Economics, Mar 1977, Vol. 4 Issue 2, p129-176.

[10] Ross, Stephen A. (1978). The Current Status of the Capital Asset Pricing Model (CAPM). Journal of Finance, Jun 1978, Vol. 33, Issue 3, p885-901.

[11] Roll, Richard and Stephen A Ross. (1994). On the cross-sectional relation between expected returns and betas. Journal of Finance, Mar 1994, Vol. 49 Issue 1, p101-121.

[12] Fama, Eugene F and Kenneth R French. (2004). The capital asset pricing model: theory and evidence. Journal of Economic Perspectives, Summer 2004, Vol. 18 Issue 3, p25-46.

[13] Fama, Eugene F and Kenneth R French. (1992). The Cross-Section of Expected Stock Returns. By: Journal of Finance, Jun 1992, Vol. 47 Issue 2, p427-465.

[14] Fama, Eugene F and Kenneth R French. (2006). The Value Premium and the CAPM. Journal of Finance, Oct 2006, Vol. 61 Issue 5, p2163-2185.

[15] Jensen, Michael C. (1969). Risk, the pricing of capital assets, and the evaluation of investment portfolios. Journal of Business, Apr 1969, Vol. 42 Issue 2, p167-247.

[16] Bowden, Roger and Jennifer Zhu. (2005). Kiwicap: an introduction to New Zealand capital markets. (2^nd ed.). Wellington: Kiwicap Education.

[17] Fama, Eugene F and Kenneth R French. (2006). Tilted Portfolios, Hedge Funds, and Portable Alpha. Chicago GSB Magazine, Winter 2007.

[18] Arnott, Robert D, Jason Hsu and Philip Moore. (2005). Fundamental Indexation. Financial Analysts Journal, Mar/Apr 2005, Vol. 61 Issue 2, p83-99.

[19] Bowden, Roger and Jennifer Zhu. (2005). Kiwicap: an introduction to New Zealand capital markets. (2^nd ed.). Wellington: Kiwicap Education.

Psychospiritual Aspect in Financial Planning

2009-11-01T23:42:00.000-08:00

Psychospiritual Financial Planning Flowchart >>>
(copyright by Jeff Liando)

Some people believe that money is energy that can give them some power to do anything what they want. They earn money and then spend it for something in some way. All their expenses may include mortgage instalments or rent payments, regular basic living costs, insurance premiums, regular savings, holiday costs and life style assets (car and furniture).

However, according to Maslow, at the highest level of needs hierarchy, people would reach the stage of transcendence. The stage when people are willing to help others finding self-fulfilment and realising their potential. This may be giving money to charity or providing "seed money" or "start-up fund" in venture capital world.

The psychospiritual aspect of financial planning inevitably takes place as clients deeply rely on their financial planners' care and expect too much from them. This is fairly seen as the impact of financial planners' effort to build a strong and ongoing relationship.

We define a psychospiritual aspect as a view in searching a client's psychospiritual issues in relation to valuation of a client's ongoing peace of mind. Ongoing peace of mind is a remarkable main outcome of the financial planning relationship, therefore this can be taken as a main goal in providing this service.

The goal of maintaining a client's ongoing peace of mind can be stated in objectives on which each of them is specified, measurable and possible to result an appropriate outcome in a period of time. All of the outcomes are simultaneously used to achieve the goal.

We propose concept, method and process of setting the objectives, appraising the psychospiritual aspect based on the money consciousness concept through a method of defining the key factors of prosperity and a process of qualitative valuation.

The objectives are specified by defining four key factors, i.e. safer, happier, richer and benevolent. These are measurable on the critical values determined with a client's concerns, and possible to achieve with a planner's recommendations with respect of the financial ratios as the outcomes.

All the outcomes are used to prejudge a client's psychospiritual aspect condition whether prosperous or scarce condition in the process of qualitative valuation.

Next coupon date - IF THEN formula

2008-04-05T12:36:00.000-07:00

This was actually a simple problem in semi-annual coupon bond pricing when I was asked to determine the next coupon/interest date after the settlement date. I just needed to use my common sense to find the date from the maturity date.

If the maturity date is 15-Jul-08 and the coupon is paid semi-annually, then the coupon dates are 15-Jan and 15-Jul (6 month difference) ignoring the year. If the settlement date is 16-Oct-07, then the next date after 16-Oct-07 between 15-Jul and 15-Jan should be 15-Jan-08. It's easy!

However, Excel and Visual Basic never consider my common sense to work just like that. There is always a formula or function need to be developed. Surprisingly, using the arithmetical date formula, I came up with the longest if then formula I've ever made. That's crazy as I couldn't find the simpler one.

Finally, I found this bloody Excel formula:

=IF(AND(B3>DATE(YEAR(B3),MONTH(F3)+6,DAY(F3)),DATE(YEAR(B3),MONTH
(F3)+6,DAY(F3))>DATE(YEAR(B3),MONTH(F3),DAY(F3))),DATE(YEAR(B3)+1,
MONTH(F3),DAY(F3)),IF(AND(B3<DATE(YEAR(B3),MONTH(F3),DAY(F3)),
DATE(YEAR(B3),MONTH(F3),DAY(F3))<DATE(YEAR(B3),MONTH(F3)+6,DAY(F3))),
DATE(YEAR(B3),MONTH(F3),DAY(F3)),DATE(YEAR(B3),MONTH(F3)+6,DAY(F3))))

And this is the easy way of how you look at the formula:

IF(
AND(B3>DATE(YEAR(B3),MONTH(F3)+6,DAY(F3)),
DATE(YEAR(B3),MONTH(F3)+6,DAY(F3))>DATE(YEAR(B3),MONTH(F3),DAY(F3))),

=> if Settlement Date > first Coupon Date > second Coupon Date

DATE(YEAR(B3)+1,MONTH(F3),DAY(F3)),
=> next coupon date

IF(
AND(B3<DATE(YEAR(B3),MONTH(F3),DAY(F3)),
DATE(YEAR(B3),MONTH(F3),DAY(F3))<DATE(YEAR(B3),MONTH(F3)+6,DAY(F3))),

=> if Settlement Date < first Coupon Date < second Coupon Date

DATE(YEAR(B3),MONTH(F3),DAY(F3)),
=> next coupon date

Else,
=> if first Coupon Date < Settlement Date < second Coupon Date

DATE(YEAR(B3),MONTH(F3)+6,DAY(F3))))
=> next coupon date

Bear in mind that 15-Jul-07 is the first coupon date and 15-Jan-08 is the second coupon date and the settlement date 16-Oct-07 is between both dates, therefore the next coupon date is DATE(YEAR(B3),MONTH(F3)+6,DAY(F3)), which is on 15-Jan-08.

If you want to be spoiled by Excel, there is actually a formula already provided: COUPNCD(settlement,maturity,frequency,basis).
I just wanted to be a dumb person who had been trying to figure out this IF THEN formula.

CAPM return and cumulative data matter

2008-04-04T15:58:00.000-07:00

This story began when I wrote about benchmark issue in CAPM. Then, it continued with an Excel model for optimisation of shares or funds portfolio. The main problem defined in the model is to select shares and find the optimised asset allocation in a portfolio with three scenarios:

1. Assumed CAPM can't be applied and historical data is important therefore historical mean (average) return and standard deviation are used to simulate random return normal distribution and calculate Variance Covariance matrix.

2. Assumed CAPM can't be applied and cumulative data is important therefore projected mean (average) return and standard deviation are used to simulate random return normal distribution and calculate Variance Covariance matrix.

3. Assume CAPM can be applied and cumulative data is important therefore projected CAPM return and standard deviation are used to simulate random return normal distribution and calculate Variance Covariance matrix.

Starting by processing 13 NZ shares in the optimisation model with the three scenarios then applying the result of the share selection and the asset allocation into three passive portofolios, after one month holding period I found the return as follows:

Scenario 1 = -8.98%

Scenario 2 = -2.86%

Scenario 3 = +6.06%

I will update after 12 months.

The Parables of Investment

2008-03-31T23:26:00.000-07:00

From an interesting paper:
The parables, premium puzzles, and the CAPM
by Hong-Jen Lin and David C. VanderLinden
(download)
image source

Rate of return, risk free deposit, and equity premium

In Matthew 25: 14-30 (the Parable of the Talents), a master has given his three servants five talents, two talents and one talent of money, respectively. The first earns five more talents, the second earns two more talents, and the third earns nothing since he played it safe and buried all the money in the ground. The master commends the first and the second ‘‘Well done, good and faithful servants’’ (verses 21 and 25) but excoriates the third as a ‘‘wicked, lazy servant’’ (v. 26).

A key principle to this parable is risk-taking. The first two servants were willing to place at risk the endowment given to them, but the third servant was ‘‘afraid.’’ As interpreted by most commentators, the parable is an exhortation to take risks in using one’s gifts for the kingdom of God. Jesus indicates a reward for those willing to take risk, and punishment for the one who was too fearful (risk-averse).

Perhaps, we can also infer how the master evaluates performance of the investments by three servants. Why did the first and second servants receive the same praise and rewards? Both took risk and, while the absolute value of income differed, they both earned the same rate of return. In this case (but not for the Parable of the Ten Minas), the master gave them the same rewards. Proverbs 3:14 (in the Old Testament) also alludes to return: ‘‘for she (wisdom) is more profitable than silver and yields better returns than gold.’’ The concept of return appears in both the Old Testament and the New Testament.

Regarding the third servant, the master criticized, ‘‘you should have put my money on deposit with the bankers, so that I would have received it back with interest’’ (v. 27). Given the comment, we can surmise that the risk-free deposit market existed in Jesus’ era. The third servant is despised because he has earned zero return in investment, under the riskfree rate. Therefore, one can interpret the verse to mean that the master measures performance not just based on the rate of return but on the return rate in excess of the risk-free interest rate. This conforms to the formula of the Sharpe-Lintner CAPM:

ri – rf = Bi ( rm – rf )

where ri is the rate of return for asset i, rf is the risk-free deposit interest rate, and rm is the market return. Bi denotes the systematic risk. Both sides of equation are returns in excess of the risk-free deposit rate. In other words, the measurement of performance of investments is based on the rate of return in excess of the risk-free deposit rate.

A similar concept is found in the Parable of the Ten Minas (Luke 19: 11-23). However, in this parable, each servant is given one mina. The first servant invests it and returns ten minas to his master; the second invest the mina to return five minas; a third servant hides his mina in the ground because he is ‘‘afraid.’’ In the Parable of Ten Minas, the master rewarded the faithful servants by giving them authorities to rule cities; the first over ten cities, the second over five. That is, the ‘‘payoff’’ in the Parable of Ten Minas is much more than that in the Parable of Talents (as is the return), but it is proportional to the returns of each servant. Again, the criticism of the third servant’s inaction is still sharp.

The scripture seems to encourage investors to earn as much as possible. The master criticized the third servant because of his laziness. The laziness is simply caused by his fear of taking risk (v. 25). Therefore, according to the Parable of Talents, Christians are motivated to invest and accumulate wealth to glorify God. It seems that Jesus appreciates people who dare to take risk and grasp profitable opportunities. This is consistent with Solomon’s exhortation to enter into risky trade and ‘‘cast your bread upon the waters, for after many days you will find it again’’ (Ecclesiastes 11: 1). Consistent with Weber’s propositions, it may be that the financial markets have been influenced at least indirectly by these principles. That is, religious teachings can change people’s mindset and then motivate them to invest and to fully utilize the financial resources they have. As a result, financial markets are formed, which increases general wealth. The prosperity of financial markets further inspires researchers in forming financial theories such as the CAPM. A possible relationship among the biblical teachings, financial markets, and financial theories is illustrated in Figure 1.

Avariant of the CAPM is the consumption CAPM, in which investors hold wealth to allow consumption. Thus, the expected return on an asset should be related to how the asset’s returns vary with consumption. Mehra and Prescott (1985) found that the historical equity risk premium (the rate of return on stocks over and above the return on a risk-free rate) was too high for ‘‘reasonable’’ levels of risk aversion. Termed the ‘‘equity premium puzzle,’’ this finding has stirred numerous unsuccessful attempts to explain the puzzle. One possibility is that investors have diverse preferences or beliefs (rather than those of a representative individual as usually assumed). In both the Parable of the Talents and the Ten Minas, one investor either was too risk-averse to invest or had different payoff expectations such that he was unwilling to invest. Perhaps these parables offer an avenue of explanation for the equity premium puzzle.

According to Benartzi and Thaler (1995), when investors are myopic-loss-averse, the return on equity must be large enough to attract them to buy stocks. We can also observe from the Parable of Talents that the third servant is myopic-loss-averse. In other words, the third servant ignores upcoming rewards he might earn. His fear of loss is much more than the joy of gain. Therefore, the equity premium is a must to draw investors like him to invest in risky assets.

One final note on equities is in order. Because the master strongly motivates the servants to invest by authorizing them to rule over cities (i.e. have ownership of productive assets), this kind of teaching could be viewed as encouraging Christian investors to hold equities, as the light shed by Weber (1930).

In the field of corporate finance, equity holders may pass up profitable (i.e. positive net present value) investments when debt holders may get most of the benefits of the projects. That is, equity holders may tend to under invest when they realize that their gains in the new projects are limited (see Grinblatt and Titman, 2002, p. 563). In the Parable of Talents, similarly, the third servant may think that the master will get most of benefits so he is reluctant to invest. Actually, he really under invests: invests into the ground!

To sum up, conceivably these parables could help to explain the equity premium puzzle in asset pricing and the under investment problem in corporate finance. Teachings based on the parables may shape the behavior of people especially when these biblical teachings have already become a part of the system in a country.

Optimising Portolio of ING PPS Funds

2008-03-31T01:14:00.000-07:00

What is ING PPS (Private Portfolio Service) Funds?

Private Portfolio Service is a master trust administered by ING. It has been developed as both a series of unit trusts and a superannuation fund, representing a broad range of asset classes and fund managers.

Private Portfolio Service provides investors with the opportunity to diversify their portfolio, without the need to rebalance different investments across a number of fund managers and products.

Someone definitely has to do a quantitative research on these funds, right? What's the purpose? To find the best and optimised alocation of a portfolio of one's retirement plan or any investment plan.

Based on their daily/monthly historical prices, I calculated the daily/monthly log return of each PPS fund, Ln(P2) - Ln(P1) to show the continously compounded return.

I then calculated the mean and standard deviation of each fund and built the covariance matrix. Next, I calculated the portfolio mean and standard deviation.

Finally, using solver, the optimised allocation is found by assuming risk free rate 7%. Contact me to get the optimised allocation and the spreadsheet, if you're curious or just checking with your own calculation.

Please confirm if these annualised monthly means and standard deviations are close with your calculation for data ending 21 Jan 08.

PPS	mean	stdev
AggBal	7%	0.087
AsianEq	10%	0.159
AusEq	7%	0.126
Bal	5%	0.063
DivTrad	3%	0.041
EuroEq	6%	0.138
GlobOpp	-1%	0.176
InterEq	5%	0.131
InterFix	3%	0.029
Mortg	1%	0.018
NZEq	5%	0.098
NZFixed	0%	0.021
PlatInter	1%	0.101
Prop	6%	0.080

Some notes

Sorry, I didn't use CAPM return in this calculation. No market index benchmark therefore no beta and risk premium to consult. :-)

This is an optimisation of a portfolio of optimised funds as a managed fund is a portfolio which is optimised regularly by its fund managers.

Putting into practice, some clients don't believe in this simulation. This is because the simulation is based on the daily prices and they don't concern this kind of time horizon.

For getting the best point of view, in my opinion, it is best simulated from monthly prices, not daily prices.

Finance Concepts

2008-03-26T18:02:00.000-07:00

Charts, News and Quotes

2008-03-26T17:58:00.000-07:00

Yahoo! Finance
Quote for NZT

Excel and Macro Tips

2008-03-26T17:55:00.000-07:00

John Walkenbach's Excel Tips

user tips

developer tips

Allen Wyatt's ExcelTips

Daily Dose of Excel

Top 10 Indonesian Managed Funds (Reksa Dana)

2008-03-13T23:30:00.000-07:00

"Reksa Dana or Reksadana" is an Indonesian term for managed funds. The total number of managed funds in Indonesia is 475. It's amazing! And, the highest real return is around 70%!! Seeing the high return of Indonesia market, who cares about standard deviation...

Fixed Income	168
Shares	58
Mixed	111
Money market	32
Protected	103
Index	1
Listed	2
TOTAL	475

TOP Performers as of 29 March 2008 (in %)

SHARES funds	(Rp)	30 days	1 year	1 year real
Makinta Mantap	3.713,76	-16.76	66.27	62.19
Fortis Ekuitas	9.005,18	-12.42	57.97	51.83
Pratama Saham	2.118,94	-13.2	52.08	50.57
Fortis Infrastruktur Plus	1.557,37	-11.64	54.2	49.29
Optima Saham	1.578,07	-8.16	53.57	48.3
Bahana Dana Prima	8.163,82	-12.05	51.93	47.44
Schroder Dana Istimewa	2.677,91	-8.53	46.77	46.04
Danareksa Mawar	4.715,90	-11.8	47.52	45.33
Mandiri Investa Atraktif	2.757,80	-13.65	46.86	45.21
Reksa Dana Dana Ekuitas Prima	2.320,73	-11.58	53.53	43.7

MIXED funds	(Rp)	30 days	1 year	1 year real
Prospera Balance	2.788,39	-11.37	59.5	53.25
Bahana Dana Infrastruktur	4.997,78	-11.91	56.33	51.71
Fortis Pesona	11.610,89	-11.24	50.22	46.87
TRIM Syariah Berimbang	1.441,77	-9.95	43.37	43.37
Mandiri Investa Syariah Berimbang	2.136,52	-4.25	44.52	41.65
Reksadana Mega Dana Syariah	1.533,92	-6.92	42.78	39.95
Star Balanced	1.778,10	-6.06	42.03	39.9
Danareksa Anggrek Fleksibel	1.895,27	-8.04	44.53	39.62
Schroder Dana Prestasi	12.447,40	-10.69	41.64	38.49
Mega Dana Campuran	1.538,57	-8.55	40.61	37.15

Which Market do you prefer?

2008-03-13T23:29:00.000-07:00

"IHSG" is the Jakarta Market. Isn't it way too high? The mean and also the stdev.

"NZXall" is the the good one I think. It has a considerably high mean and low stdev.

US Recessions and the MSCI World Index

2008-03-13T23:28:00.000-07:00

Recent market talks are around the fears of recession in the US. Although finance is often considered as sort of an exact science, it however cannot avoid the influence of the state of anxiousness by market players and investors. That is why a behavioral finance matters and needs to be neutralised by showing the real facts in the financial markets and a good sense to answer if a US recession is really going to bring down the entire world financial market in the long term.

Periods of US recession and the definition

The state of US recession period is officially announced by the National Bureau of Economic Research (NBER). Since 1970 there have been 5 states of recession in the US, as follows :
• November 1973 to March 1975
• January 1980 to July 1980
• July 1981 to November 1982
• July 1990 to March 1991
• March 2001 to November 2001

The NBER defines that
“A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades.”

The informal recession definition is a decline in the Gross Domestic Product (GDP) for two or more consecutive quarters.

Relationship between recession and stock market decline

There is a confusing logic in relationship between recession and stock market decline: does a recession cause a bearish market or the other way around? The exact answer is that the recession comes first and the bearish market after. In a recession, analysts would see the value of companies is declining therefore the stock prices may fall. However, some classic strategy suggests that investment in the consumables sector may be a recession-proof investment since people still buy those products, recession or not.

If the recession comes first and the bearish market after, how can we explain the states of US recession in July 1990 to March 1991 that came 3 years after the 87 crash? Many analysts argue that the Crash was mainly caused by a programmed trading system and psychology factor that beyond the economic factor of an exact finance. The “quants” (quantitative traders) who developed a computerised trading system that automatically created a sequence of selling positions might had been to blame, or it could had been the investors who were psychology weak and then fell into selling positions.

How strong is US recession influence on global market?

Another question to answer: does US recession strongly influence the global financial market, particularly Australia and NZ markets? It may not be. Asian countries like Japan, China, South Korea and others have been the dominant trading partners for Australia and therefore NZ for the last decade competing trading flows with the US. This recent economic decoupling theory may explain how US recession may be absorbed by growth in the competing countries (Asia) as maintaining trading flows with the third trading counterparts (Australia/NZ).

Some simple examples: the US recession may not affect New Zealanders to stop buying stuff from the Warehouse stores, but Americans to visit their Walmart stores. New Zealanders are not going to disconnect their Telecom line at home because of the US recession.

The recent subprime trouble in the US economy may be likely to influence ASX and NZX in terms of market psychology rather than concluding a good excuse and common sense that Australian and NZ companies should decline in value because of it. The fundamental assessment of companies’ value seems to be flawed in the short term.

Unfortunately, the recent January big drop in Asian and European markets is however breaking the belief of the decoupling theory. Investors and market players are then more aware of the true impact of US recession on the global financial market.

Market randomness over recession period

It seems some finance and economics theories try to explain and justify the prediction of world’s share market trend in the future. However, contradictions, unpleasant facts and non-economic factors may affect one’s prediction and there is only one underlying theory that can explain all this, i.e. randomness and stochastic.

Therefore, it is important to show some historical fact to see the ex post impact of US recession to the world financial market by taking a closer look at the historical data of popular benchmark of the world financial market, the MSCI World Index. The goal is to conclude that randomness in the share markets may be likely to drive the prices up in the long term regardless recession.

The conclusion of this can be easily understood by paying attention to the following chart, which show the period of US recession and the MSCI World Index. The fact is, in the time frames of 10-15 years the US recessions seems to have been driving the ex post movement of the world share market up. Therefore, recession is not a measure of uncertainty in stock market. Or, is it just because the market randomness factor always win over the recession factor?

1977 to 1987: two recessions and 280% return

A decade before the stock market crash of 1988, and despite the two recession periods were defined in 1980 and 1982, the MSCI had been dramatically increased by 280% return.

1987 to 1997: one recession and 135% return

After all, the MSCI index still increased by 135% despite the 1991 US recession was occurred.

1997 to 2007: one recession and 92% return

Regardless the Technology Crash 2000-2002 and the “War on Terror”, and despite the 2002 US recession, the MSCI index still increased by 92%.

The best example of the MSCI Index Fund managed in NZ is AMP Investments' World Index Fund (WiNZ)

Glossary of UK Pension terms

2008-02-20T23:10:00.000-08:00

Annuity
If you have any form of personal or money purchase pension you have to buy an annuity before age 75. An annuity is an income paid to you for life by an insurance company in return for your pension pot. Once you have bought an annuity you cannot usually change your mind and switch to a different one at a later stage. Nor can you get your money back if you die the day after buying one because annuities work by a system of cross subsidy - those who die early subsidise those who live to a ripe old age. The advantage is that they will pay you an income no matter how long you live.

Approved New Zealand Superannuation Fund
Registered superannuation schemes that are subject to the New Zealand Superannuation Schemes Act 1989 and Securities Act 1978.

AVC (Additional voluntary contributions scheme)
You can supplement your pension contributions to build up an even larger retirement fund. AVC's attract tax relief on the premiums, but the final benefits are taxed as income. AVC's are better for basic rate taxpayers and Peps are better for higher rate taxpayers as a way of supplementing pension income. Employees are allowed to save up to 15% of your taxable earnings into a pension plan. When you retire the company is not allowed to pay out a cash lump sum.

Final salary or defined benefit schemes
This gives the employee a fraction of their salary on retirement for each year they have worked.

HMRC
HM Revenue & Customs www.hmrc.gov.uk

Investment trust pensions
These are pooled equity investments allowing you to pay pension contributions and enjoy the tax advantages.

ISA (Individual savings accounts)
Individual Savings Accounts (ISAs) were introduced on 6th April 1999 which replaced PEPs and TESSAs. ISAs are not an investment in their own right. They are a tax-free wrapper in which you can shelter investments. People over the age of 18 living in the UK can invest a maximum of £7,000 per year in each tax year. 16 and 17 year olds can invest up to £3,000 in a mini cash ISA.

Investment may be made in two components: equities and cash. There are strict limits on how much you can put in each component, and the limits depend in part on whether you use a 'maxi ISA' or a number of mini ISAs.
Until 5th April 2004 ISAs benefited from a 10% tax credit on UK equities. Stock and share investments which can be held in an ISA include unit trusts, open ended investment companies (OEICs), investment trusts, ordinary shares, preference shares and fixed interest corporate bonds.

PEPs in existence at 6th April 1999 may continue to be held outside an ISA with the same tax advantages. TESSAs in existence at 6th April 1999 are allowed to run their full five year term.

Income from ISA investments is tax free and you don't have to report it on your tax return. Capital gains are also exempt from CGT.

Lifetime Allowance
A standard lifetime allowance is the maximum amount of pension savings that can benefit from tax relief. This figure rises over time and the proposed amounts are as follows:
2007 - £1.6 million
2008 - £1.65 million
2009 - £1.75 million
2010 - £1.8 million

The standard lifetime allowance is based on the approximate amount of money that would be needed to purchase a pension equal to the maximum HM Revenue & Customs (HMRC) would permit under the tax regime. Funds in excess of the lifetime allowance are felt to have benefited the individual unduly from pension scheme tax advantages and therefore a tax charge is made. Funds taken in excess of this will likely be taxed at 55%.

Money-Purchase or defined benefit schemes
This is where the employee and employer have contributed a set percentage of the employee's salary into the scheme. At retirement an annuity is paid out.

PEPS (Personal Equity Plans)
It is no longer possible to start a new PEP or add to an older one. Personal Equity Plans (PEPS) are investments that are totally tax exempt, both on the capital and income side.

PIE (Portfolio Investment Entity)
The QROPS funds we recommend for your UK Pension Transfer are PIE approved investments. From October 2007 taxation of New Zealand managed funds was changed to PIE. Capital gains on New Zealand and Australian (some exceptions) equities are exempt and income is taxed at the investors marginal tax rate. From April 2008 maximum tax is 30% even for a 39% tax payer. International investments are taxed under the Fair Dividend Rate method (FDR) tax at the investors marginal tax rate on the opening value plus 5% growth.

QROPS (Qualifying Recognised Overseas Pension Scheme)
HMRC require any pension transfers to go into a QROPS registered scheme. If this is done incorrectly you will be subject to a 55% withdrawal tax.

SIPPS (Self-invested personal pensions)
SIPPS offer greater flexibility than ordinary personal and occupational pensions. You can have many types of investment in them, including British and foreign stocks, unit trusts, investment trusts, managed life funds, unit linked funds and commercial property. They have the same tax relief as ordinary personal pensions.

SERPS (State Earnings Related Pension Schemes)
Part of the National Insurance contributions goes towards your SERP which is paid out on top of your state pension when you retire.

TESSA ( Tax Exempt Special Savings Account)
These lasted for five years and you were allowed to invest up to £9,000 over the life of each account. You got all your interest tax-free and once your five years were up you could either take your money or put your money into a new TESSA account (and continue to receive tax-free interest). The last day you could open one was 5 April 1999, so there aren't any TESSAs in existence any more. But you were allowed to roll a TESSA that matured between 6 April 1999 and 5 April 2004 into what is known as a TESSA-Only ISA (or TOISA for short) so that you could continue to receive tax-free interest.

FAQ: UK Pension Transfer

2008-02-20T23:07:00.000-08:00

For an explanation of terms frequently used please refer to the Glossary page.

What criteria is required to transfer my UK Pension?
You have to have permanently emigrated to New Zealand with no intentions of returning to the U.K. You must have either have been granted permanent residency or have submitted an application.
Should I transfer my UK pension fund to New Zealand?
For many UK ex patriots your pension fund will be the second biggest "investment" after your home.
Refer to "Reasons to transfer my UK Pension".
Do I have to have a super scheme in NZ to transfer my UK pension into?
Yes. If you decide to transfer your UK pension funds, UK regulations require that they must be transferred to an approved or registered superannuation scheme in New Zealand.
Should I transfer my UK pension fund to NZ, even if I think I may return to the UK to retire?
No. Once you have made the transfer to a NZ pension you cannot transfer back to your UK pension plan as if nothing had happened, you have given up all your rights to your UK pension.
Who handles my money and how safe is it? All transfers are paid directly by your UK Pension fund into the New Zealand HMRC QROPS Approved superannuation fund. We do not use a trust account or handle your money.
How long does it take to transfer my UK Pension?
Each pension transfer is different as each individual has different circumstances. The rule of thumb is that a normal transfer will take between 3 to 4 months (the shortest 6 weeks and the longest 12 months). Generally the delay is the UK pension provider arranging transfer papers and confirming transfer figures.
What are the main benefits to transferring my UK pension to New Zealand?
- Enables you to keep track of your pension plan and gain more control of your funds without affecting their earning power. You won't need to be concerned whether the fund is merging, closing or going out of existence.
- You no longer need worry about exchange rate fluctuations affecting your pension payouts.
- You will not be paying bank fees for each transfer (may be as a high as £18 per transfer)
- You will have more information and control on the companies holding your retirement savings.
- Easier to access your money in retirement.
- If you die with a UK pension scheme your spouse can get up to 2/3 of the pension you would have received. If you both die your pension dies with you, however, If you both die leaving qualifying dependent children , your UK pension could continue for as long as you fulfill the schemes eligibility criteria. With New Zealand superannuation plans all of your remaining investment becomes part of your estate and is passed on to your children, heirs.
What are the tax issues that need to be considered?
- Under the new FDR rules introduced in New Zealand in April 2007 your UK pension is exempt tax.
- If you retain your UK pension and it pays a regular benefit this is deemed income and you will need to pay tax on it in New Zealand.
- If your funds are transferred to a NZ approved superannuation plan under current legislation you are not taxed when you withdraw funds.
Can I get my UK pension paid directly into my bank account?
No, it is a requirement of the UK legislation that the money can only be paid into an approved New Zealand superannuation plan.
Do you charge a fee for your pension transfer service?
Emphatically YES, because you need impartial advice on such a complex and important issue. If it is in your best interests to retain the status quo we want to be able to say so, but receive remuneration for the time and experience involved in assisting you to reach that decision. Should you ultimately transfer your benefits to New Zealand we will, at your request offset our charges against any initial commission received, with any excess being reinvested. Or reinvest all the initial commission and charge you separately. We do not charge a fee and take initial commission. Contact Alison Renfrew at Alison@LYFORDS.co.nz .
Why don't I just transfer the pension myself?
You can transfer the pension yourself, but the process is complex, and can be very frustrating and confusing. Do you have the necessary understanding of your actions and how they might impact on your future financial security? If you get it wrong it could cost you thousands of pounds. Our UK Pension Transfer service will save you time, money and stress.
I have already started to draw income from my UK pension can I still transfer the lump sum?
No, once your pension is being paid out as regular income you can no longer transfer what would have been a lump sum.
Will I be eligible for New Zealand Government superannuation payments?
To be eligible for New Zealand Superannuation you need to be aged 65 or over and a legal resident of New Zealand, having lived here for ten years since age 20. Five of those years have to be since you turned age 50. Contact Work and Income Support on 0800 552 002 or at www.winz.govt.nz. For current after tax rates of New Zealand Superannuation click here.
Should I transfer my UK pension to a NZ Superannuation plan before I leave the UK?
No, you need to be a permanent resident in New Zealand before your UK pension plan can be transferred. We recommend waiting until you are living and working in New Zealand before you make any sort of decision on this. At present entitlement to New Zealand superannuation is not asset tested. The NZ Government will off-set pension income you are paid by the UK Government against your NZ super entitlement. How much would I get if I qualify for New Zealand superannuation?
Can I withdraw cash from my pension fund once the transfer is complete?
Yes, but this is dependent on restrictions imposed by your UK scheme. It may be possible to take up to 60% in cash, but sometimes the transferring scheme can insist that the whole amount is 'locked in'. This is an area often abused by some New Zealand advisers and getting it wrong could result in penalties being applied. Our recommendation is that your UK pension money was saved for your long term retirement savings so keep to this plan and put it aside for your retirement savings. Besides if the UK Government gets to hear that this facility is being abused it may rescind the regulations permitting it!
UK Pension Simplification Rules 2006 - How will they affect your Pension Transfer?
On the 6th April 2006 the new "pension simplification" regulations came into effect in the UK.
Under these rules every overseas pension fund that wants to accept transfers from the UK must be approved as a "Qualifying Recognised Overseas Pension Scheme" (or QROPS). All QROPS will have to report back to HMRC any payment made to a member in respect of the amount that was transferred from the UK. This will include the date, amount and "nature of the benefit" and the current address of the member.

Note: HMRC will apply a 40% tax on the transfer value if the UK pension is transferred to a non QROPS.

The new regulations state that the earliest retirement age (the earliest age at which funds can be withdrawn) is to rise to 55 years. In addition the maximum withdrawal in the first year will be limited to 25% of the pension without incurring any tax liability. Anything above this will incur a tax liability of 40%. To be a QROP reporting of all withdrawals is required to be provided to the UK authorities. Additional contributions and/or investment growth are not subject to the UK tax penalties.

Please also refer to the "7 traps of transferring your UK Pension".

UK Pension Transfer Traps

2008-02-20T23:02:00.000-08:00

The 7 Traps to Transferring Your UK Pension Funds

There are very good reasons for transferring your UK Pension to New Zealand. But you will see after reading the section "Comparison between NZ and UK Pensions" that there are some differences.

When transferring your UK pension there are some simple Transfer Traps to avoid.

Pension Transfer Trap One

From 1 April 2006 pensions from the UK must be transferred into a Qualifying Recognised Overseas Pension Scheme (QROPS). If you transfer your pension into a non QROPS scheme you will have to pay UK withdrawal tax of up to 55%. We transfer your UK Pension into HMRC approved QROPS funds.

Pension Transfer Trap Two

If you withdraw money from a QROPS before 6 years are up you may be up for an unauthorised payment charge. This is a UK Tax charge and can be up to 55% of the amount withdrawn. QROPS approved New Zealand superannuation fund managers do not want to loose their QROPS approval status. One of the requirements to continue to be approved is that the NZ scheme must notify the UK authorities of any withdrawals.

There are some exemptions to this which you may qualify for, we can discuss this with you.

Pension Transfer Trap Three

Once you start drawing down on your pension fund in the UK it cannot be transferred to New Zealand. You need to be a permanent resident of New Zealand before you can transfer your UK pension and you must not have started to draw down.

Pension Transfer Trap Four

Delaying your decision because of the exchange rate. If you have concerns about the exchange rate then discuss this with us. We can give you a consensus of the 18 month outlook for the UK/NZ exchange rate. There are many factors impacting the exchange rate. If you are really concerned we can transfer your funds and retain them in UK pounds until you instruct us to transfer into NZ dollars.

Pension Transfer Trap Five

The Savings Trap. After transferring your UK Pension to New Zealand you may want to continue saving. If you save into the scheme you used for the transfer, and you later decide to make a withdrawal within six years, any withdrawal will be treated as withdrawing the UK portion first. You could be liable for the 55% tax charge on the amount withdrawn. Solution save into a separate scheme.

Pension Transfer Trap Six

Being too Conservative. If you are retired we recommend a "balanced" risk/return profile. This is a 50:50 mix of growth (shares, property and future funds) and income (cash, fixed interest). Even at 65 you probably have another 25 years of investing. You need to make sure your investments and retirement income is inflation hedged. If you are younger than 55 a "growth" risk/return profile may be more suitable. We will discuss this with you.

Pension Transfer Trap Seven

Not reviewing your investments. We believe its important to keep track of your investments and review asset allocations to ensure your risk/return profile stays within its limits. We will provide six monthly reports and an annual review.

Taxation Issues UK Pension Transfers

2008-02-20T22:58:00.000-08:00

Taxation Issues UK Pension Transfers to NZ

Under current tax legislation in New Zealand (NZ) all earnings from Superannuation funds are taxed at 33%. All benefits/withdrawals are tax free.

Generally there is no tax payable when a UK pension fund is transferred into a New Zealand approved superannuation fund - refer to FIF exemptions below.

If your UK pension fund is employment or self employment related and you only made contributions to it before you became a resident of New Zealand, then you will be exempt from Foreign Investment Fund (FIF) Regulations.

If you acquired an interest in a UK pension fund which was NOT employment or self employment related before you become a resident in New Zealand you will be exempt from the FIF regime for the rest of the income year in which you first become resident, and for the next three income years.

After this exemption period has expired, you are then required to declare your interest in your UK pension fund to the New Zealand Inland Revenue. Income tax will then be levied on any gains the fund makes each year.

There is a possibility that should you leave your pension fund in the UK and at retirement take the Tax Free Cash sum, this may be subject to tax in NZ, even though you have left your funds in the UK. New Zealander's are taxed on their world-wide income.

So the tax advantages to transfer are:

You simplify your tax calculations
You remove the tax and exchange rate uncertainties
You pay no tax on the proceeds from the New Zealand superannuation plan.

UK Pension Simplification Rules 2006 - How will they affect your Pension Transfer?

On the 6th April 2006 the new "pension simplification" regulations came into effect in the UK.

Under these rules every overseas pension fund that wants to accept transfers from the UK must be approved as a "Qualifying Recognised Overseas Pension Scheme" (or QROPS). All QROPS will have to report back to HMRC any payment made to a member in respect of the amount that was transferred from the UK. This will include the date, amount and "nature of the benefit" and the current address of the member.

Note: HMRC will apply a 40% tax on the transfer value if the UK pension is transferred to a non QROPS.

The new regulations state that the earliest retirement age (the earliest age at which funds can be withdrawn) is to rise to 55 years. In addition the maximum withdrawal in the first year will be limited to 25% of the pension without incurring any tax liability. Anything above this will incur a tax liability of 40%. To be a QROPS reporting of all withdrawals is required to be provided to the UK authorities. Additional contributions and/or investment growth are not subject to the UK tax penalties.

NZ Taxation Rule Changes April 2006

After 1 April 2006 new migrants and returning New Zealanders who have not been tax-resident for at least ten years will be exempted from tax for four years on foreign income such as dividends, interest, royalties and rental income.

The ten year requirement is designed to ensure that New Zealand residents do not leave the country just to become eligible for the exemption.

The changes are part of the Taxation (Depreciation, Payment Dates Alignment, FBT and Miscellaneous Provisions) Bill.

Taxation Rules

Taxation Changes NZ: April 2007

Before Immigrating to NZ

2008-02-20T22:55:00.000-08:00

Here are some suggestions if you haven't already immigrated.

Set up a Family Trust before you immigrate
In the UK for the 2007/2008 tax year, the Inheritance Tax Rate is 0% on the first £300,000 (the "nil-rate band), and 40% on the rest of the value, at death, of an individual's tax estate. The nil rate band rises annually; tax is only payable on the value of an estate above the nil rate band. In the 2007 budget report the Chancellor announced that the nil rate band is to rise to £350,000 by 2010. This is to take into account the sharp rise in house prices in the United Kingdom over the previous few years.

In New Zealand individuals are taxed on Gifts over $27,000 per year, but there are no death duties. If you set up a Family Trust after you immigrate to New Zealand it is a slow process to transfer your assets across and forgive the debt.

Contact LYFORDS and we can put you in contact with an Independent New Zealand Trustee company experienced in setting up Family Trusts and what Estate Planning considerations you should take before you immigrate to New Zealand.

For a description of how Discretionary Family Trusts could benefit you, please refer to our main web site www.lyfords.co.nz.

Schooling
Education Review Office - the Government department which reports publicly on the quality of education in all New Zealand schools and early childhood centres.

Estate Planning
In the UK an Enduring Power of Attorney (EPA) will cost around £80-700 and it will have to be registered through the courts. This is not the case in New Zealand and an EPA costs approximately $80.

You should consider who will be the Guardians of your children, Executors of your estate in New Zealand.

We can arranged for a reputable Trustee company to set up your, EPA, Wills and Family Trust before you leave the UK which would comply with UK and New Zealand laws.

Comparison between UK and NZ Pensions

2008-02-20T22:53:00.000-08:00

With a UK Pension

You can receive a lump sum when you reach your pensionable age. This is limited to 25% of the value of your pension fund, or for occupational pension schemes based upon a formula involving salary and service. This latter formula is being done away with in respect of service from April 2006, under the UK Government's Simplification Programme.
If you die with a UK pension scheme your spouse can get up to 2/3 of the pension you would have received. If you both die your pension dies with you, however, If you both die leaving qualifying dependent children , your UK pension could continue for as long as you fulfill the schemes eligibility criteria. With New Zealand superannuation plans all of your remaining investment becomes part of your estate and is passed on to your children, heirs.
Your payments from your UK pension funds will be affected by exchange rates and bank transfer charges.
New Zealand Inland Revenue assesses worldwide income as taxable income even if your investments are invested in tax havens. You may receive a tax credit for any income tax already deducted in the UK.

With a NZ Pension

At age 65 you will receive a state pension (New Zealand Superannuation) if you have lived in New Zealand for a total of 10 years since you turned 20 and a total of 5 years since you turned age 50. Any UK state pension will be offset against (deducted from) your New Zealand superannuation entitlement.
You can draw down on your investments usually from age 60 (depending on the requirements of the Trustees) and this is not regarded as assessable income for tax purposes. You can set your own income level.
Your personal superannuation savings (not the Government's New Zealand Superannuation) are part of your estate on death.

Considerations and Requirements UK Pension Transfer

2008-02-20T22:52:00.000-08:00

Have you Considered?

Does my plan contain valuable options?
Does my plan guarantee predictable benefits at retirement, regardless of the future movement of UK interest rates and investment returns?
If I take my benefits as a transfer value now, what rate of return would my Superannuation need to achieve in order to replicate the benefits I have given up?
What percentage of my overall retirement provision is tied up in my UK pensions?
What are the death benefits available from the arrangement, should I die: before normal retirement date? after normal retirement date?
What are the costs associated in making an informed decision?
Where is my pension fund invested in the UK? If I keep it there does it continue to meet with my attitude to investment risk?
What is the current strength of the insurance company it is invested with? Do they still exist?
What are the ongoing charges, if any, of my pension arrangement?
How well or badly has my chosen fund(s) performed against its peers?

Requirements

To transfer any UK Pension Benefits to New Zealand, the following requirements must be met:

Permanent departure from the UK with no intention of returning to work or retire;
Employment or self-employment in New Zealand;
New Zealand residency for tax purposes;
No part of the UK Benefit commenced paying a pension;
Payment directly from the UK scheme to an HMRC, QROPS approved New Zealand superannuation fund.

Some reasons for transferring your UK Pension to NZ

2008-02-20T22:25:00.000-08:00

We believe that the reasons for transferring your UK pension to New Zealand far out-weigh leaving it with your UK pension's administrator.

No Tax: When you transfer your UK pension to New Zealand you will be able to take the full benefit of your pension at age 60 tax free. If the funds remain in the UK, any pension income stream will be assessable as income and taxed at the marginal income tax rates.
Control: Enables you to keep track of your pension plan and gain more control of your funds without affecting their earning power. You won't need to be concerned whether the fund is merging, closing or going out of existence, issues that are not uncommon to UK pension schemes.
Flexibility: In New Zealand, there is no requirement to purchase a life pension/annuity. You will be able to draw your benefits as a retirement income (allocated pension), as a lump sum or as a combination of both.
From April 2006 simplification rules came into effect allowing transfer of UK Pensions to HMRC, QROPS approved schemes in New Zealand. At the moment the UK Government is allowing pension transfers, but how long will this continue? The Australian Government does not allow pension transfers out of Australia unless you are on a temporary work permit.
You may be able to transfer your British pension to New Zealand and access up to 40% of the value immediately. This will be dependent on the specific requirements of your UK Pension plan.
You no longer need worry about exchange rate fluctuations affecting your pension payouts.
You will not be paying bank fees for each transfer (may be as a high as £18 per transfer)
You will have more information and control on the companies holding your retirement savings.
Easier to access your money in retirement.
If you die with a UK pension scheme your spouse can get up to 2/3 of the pension you would have received. If you both die your pension dies with you, however, If you both die leaving qualifying dependent children , your UK pension could continue for as long as you fulfill the schemes eligibility criteria. With New Zealand superannuation plans all of your remaining investment becomes part of your estate and is passed on to your children, heirs.

We have experience in handling the transfer of British pensions to New Zealand, if it is appropriate. We liaise directly with your UK pension schemes. Please note that not all schemes can be transferred. The transfer will need to be into an HMRC approved QROPS registered New Zealand superannuation fund.

If the funds are transferred to a non registered fund in New Zealand a UK tax of 55% could be imposed on the funds being transferred.

If you have started to take a pension from your scheme this can not be transferred.

The UK State Pension cannot be transferred.

UK Pension Transfer to NZ

2008-02-18T05:30:00.000-08:00

UK Pension Transfer to New Zealand

It is important to seek good, experienced advice. To transfer UK Pensions to NZ Lyfords uses HMRC, QROPS approved funds. This avoids the risk of potentially being taxed up to 55% on the transfer value of your UK Pension.

Use our specialist knowledge to make an informed decision on whether to transfer your UK Pension ("superannuation") - UK Pension Transfer to NZ- to a New Zealand superannuation ("pension") fund.

In the UK, Pension plans are only lightly taxed while saving for retirement, but the income received is assessable for taxation.

In New Zealand (NZ) superannuation funds are taxed along the way and the capital at maturity is tax free and generally not locked in.

You may be able to transfer your UK Pension to New Zealand and access up to 40% of the value immediately.

Fact Finder Form

Reasons for Transferring

Pension Transfer - - enables you to keep track of your pension plan and gain more control of your funds without affecting their earning power. You won't need to be concerned whether the fund is merging, closing or going out of existence.

From April 2006 simplification rules came into effect in the UK enabling a much wider range of permitted investment.

Click here to read more .....

What You Need to Know

Does my Pension plan contain valuable options?

Does my Pension plan guarantee predictable benefits at retirement, regardless of the future movement of UK interest rates and investment returns?

Click here to read more .....

Credit Card, Mortgage and Retirement Calculators

2008-02-18T05:08:00.000-08:00

KiwiSaver Decision

2008-02-18T05:01:00.000-08:00

NZ Investment Advisers and Market Participants Regulations 2008

2008-02-11T12:33:00.000-08:00

A Noisy Market Siren

2008-01-03T03:08:00.000-08:00

The idea is to automatically activate a noisy siren from a sound file when opening the excel file as the market index value drops to, or is below, the minimum expected value. The market index value is refreshed every 30 minutes.

Eg. the index value alert is 4,300. If the market index value is below 4,300, the noisy siren will be automatically activated.

I first set a WebQuery for the market index latest price with automatic refresh every 30 minutes. Then, apply VBA macro to call a sound file.

I modified the VBA codes taken from ExcelTip.com and J-Walk.com as follows:

Public Declare Function sndPlaySound Lib "winmm.dll" _
Alias "sndPlaySoundA" (ByVal lpszSoundName As String, _
ByVal uFlags As Long) As Long
-------------------
Sub PlayWavFile(WavFileName As String, Wait As Boolean)

If Dir(WavFileName) = "" Then Exit Sub
If Wait Then
sndPlaySound WavFileName, 0
Else
sndPlaySound WavFileName, 1
End If

End Sub
-----------------------------
Sub PlaySoundAlert()

For i = 1 To 5

PlayWavFile "c:\WINDOWS\Media\notify.wav", True

Next i

End Sub
-----------------------------
Function Alarm(V)

x = Range("alert")

If V <= x Then

Call PlaySoundAlert

Alarm = True
Exit Function
Else
Alarm = False

End If

End Function

VBA Progress Indicator

2008-01-02T20:14:00.000-08:00

I learn how to create an VBA progress indicator from j-walk blog after surfing around and finally found the simplest one.

And now I can apply it into my portfolio optimisation model, as follows:

Sub optimise()

Dim PctDone As Single

Application.ScreenUpdating = False

nosim = Range("nosim")

For i = 1 To nosim

Application.DisplayStatusBar = True
Application.StatusBar = "Please be patient..."

Range("simulation").Copy
Range("simmeanresult").Cells(71 + i, 1).PasteSpecial Paste:=xlPasteValues

Count = Count + 1
PctDone = Count / nosim

With UserForm1
.FrameProgress.Caption = Format(PctDone, "0%")
.LabelProgress.Width = PctDone * (.FrameProgress.Width - 10)
End With

DoEvents

Next i

Unload UserForm1

Application.StatusBar = False

SolverOk SetCell:=Range("tangency"), MaxMinVal:=1, ValueOf:=0, ByChange:=Range("proweight")
SolverAdd CellRef:=Range("proweight"), Relation:=3, FormulaText:="0"
SolverAdd CellRef:=Range("one"), Relation:=2, FormulaText:="100%"
SolverSolve UserFinish:=True

Application.ScreenUpdating = True

End Sub

Simulating Dow Jones Index in the Future

2008-01-02T19:36:00.000-08:00

Happy New Year 2008. Wishing you a prosperous year of 2008 and years after.

I was again playing with random numbers simulation and found everlasting properous years of Dow Jones Index in the future.

Bear in mind, this is just a rough simulation played to get rid of boredness in the first day of 2008.

The process is as follows:

Gather Dow Jones Index daily prices since 1-Oct-1928 and calculate the mean and standard deviation from the daily log returns.
Using NORMINV(rand(), cumulative mean, cumulative stdev), simulate the daily returns.
Using Price n * (1 + simulated daily return), estimate Price until n equals to 1-Jan-2100.

That's it. Easy. The index is randomly simulated everyday until year 2100. Number of simulations: 24,004.

Can you see the heavenly index level at the end? Such an amazing number, aye? That's why people should be optimistic with the future of finance and investment as glorifying God. Dow Jones Index at 31 Dec 07 is 13,264.82. Is it going to be 3,000,000 in 2100???

Iteration and Circular Reference

2008-01-02T16:38:00.000-08:00

If you can't live without circular references, just turn on the iteration.

cell A + cell B = cell C
while:
cell B = cell C - cell A

In Excel, cell B and cell C are the sources of circular references.
However, to make the calculation work as is, the iteration must be set on as the image below. (Tools>Options)

Then, we all can live with circular references.

Name a Cell

2008-01-02T16:35:00.000-08:00

One of the important tools in the Excel is cell naming. By naming a cell, we can relate the cell name with any formulae we want to make. Furthermore, in creating macros or visual basic codes in Excel, cell naming is very helpful and important particularly in identifying the corresponding cell.

To name a cell, just go to the box 0n the top left side. Write the desired name and press enter.

For example, we want to calculate the return of share prices. With the conventional method, we use formulae =(B2/B3)-1. However, since B2 has been named as "today" and B3 as "lastyear", then the formulae becomes =(today/lastyear)-1.

This handy method is useful in a big spreadsheet when the formulae contains particular parameters that need to be referred frequently. It's also good for easily remembering and quickly referencing the formulae.

Lotto generator

2008-01-01T17:07:00.000-08:00

This lotto generator might not explain how I was so lucky two years ago. At least, randomness may still explain how people could win a lotto.

The process of this lotto generator:

1. Running a set of Monte Carlo simulations for getting 6 numbers from 1 to 40 randomly.
2. Calculating the probability statistics from the simulations.
3. Incorporating the historical statistics since the 1st draw until the latest one.
3. Picking up the highest probability numbers.

House: Borrow, Buy, Sell and Profit

2007-12-19T01:29:00.000-08:00

House price may increase in one or two years and the total cost including the paid instalments, left loan balance and prepayment penalty may be lower than the house price (after agent fee) if sold.

Then, we can profit and start finding another house to buy and wait for another year or two. The key is maintaining a good relationship with the loan provider.

HomePlan.xls

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Portfolio Optimisation (Shares & Funds)

2007-12-19T00:44:00.000-08:00

It's quite a complex portfolio optimisation model which aims to find the optimised fund allocation in a portfolio of Australian and NZ managed funds with future return simulation using MonteCarlo method.

The historical prices are provided by Morningstar NZ and the copyright of this model is belong to Lyfords Ltd which I work with.

The optimisation is done by maximising the tangency portfolio (theta) so that it touches the edge of the efficient portfolio from the constant. There are also additional constraints such as particular conditions for any particular fund allocation. (eg. Thoroughbred Cash Fund = 5% and PPS Int Fixed Interest less than 10%)

If it applies into managed funds instead of shares, this may be an optimisation of a portfolio that may have been optimised (by fund managers) as a managed fund is in fact an optimised portfolio.

The process as follows:

1. Gathering data input: historical monthly fund prices. Calculate the historical monthly mean and stdevation of each asset.

2. Conduct a MonteCarlo simulation for monthly returns through 3 years horizon (36 months) using normal distributed random numbers using the historical montly mean and stdev at random probability.

3. Simulate the whole 3 years random movement. If simulated 10 times, so there are 36 monthly simulations times 10 three-yearly simulations (360). Record the projected mean and stdev.

4. Find the simulated portfolio return and risk using the projected mean and stdev.

5. Find the optimised portoflio expected return and risk.

6. Solve the optimised asset allocation using solver VBA. Apply additional constraints to reoptimise.

7. Calculate the value-at-risk.

Option to use mean or CAPM return is to choose whether CAPM is believed to be effective or not in this optimisation. If mean return is used then beta and risk premium don't matter.

Covariance matrix is also to be projected based on the simulation result.

Option to use historical or projected standard deviation is to choose whether portfolio risk is believed to be accumulated in the simulation result.

To run the Solver VBA.

1. Tools > Add-ins to have the Solver add-in first (in a file called Solver.xla)

2. Then create a reference to the 'Solver.xla' in Visual Basic Editor.
Go to Tools > Macro > Visual Basic Editor, choose Tools > References and check the box for Solver.

If it is missing, just click browse and manually find the "Solver.xla" file wherever it is located in your computer.

[Sorry, it's a premium model]

Live-updated Beta Calculation

2007-11-26T03:44:00.000-08:00

Assume CAPM is applicable and works empirically without any doubt in the theory, we can then calculate a stock Beta dynamically over time as it represents the updated historical stock prices from the latest price. Hence, the stock Beta changes over time.

The process and the VBA coding are similar with the Live-updated Yield posted before.

This spreadsheet consists of 3 worksheets that dynamically calculates the beta of Astra stock returns (ASII.JK) against the Jakarta Composite index returns (^JKSE) as being updated over time by clicking the "Update" buttons. Thus, we can get the latest Beta of Astra stock.

The first worksheet is JKSE sheet that contains the recent updated market prices and the second one is ASII sheet for the recent updated stock prices. In these two sheets, there are two "Update" buttons that allow us to update the recent prices from web query and to record the recent prices into the Beta sheet (third worksheet).

The stock Beta is then calculated by simply finding the slope between the periodical stock (x axis) and market (y axis) returns.

[Sorry, it's a premium spreadsheet]

Comprehensive Financial Planning

2007-11-26T03:05:00.000-08:00

An Excel model to judge your prosperity and set your financial goal and objectives.

[Sorry, it's a premium spreadsheet]

The comprehensive spreadsheet is premium, however, you can download this file: University and Pension Plans.

Uni & Pension Plan...

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Value-at-Risk

2007-11-26T02:43:00.000-08:00

Suppose you hold a portfolio like this.

Astra Int shares (ASII) with market value of IDR1,000,000,000.00
Indonesia Govt bonds (Indo-17) with market value of IDR1,000,000,000.00

Total market value of your portfolio is IDR2,000,000,000.00

You may wonder how much your portfolio value would be tomorrow in the worst-case scenario.

How do we get that value? Such value is known as Value-at-Risk (VaR).

The procedure:
1. Collect historical daily data for Astra share prices and calculate the daily return.
2. Collect historical daily date for Indonesia govt bonds yields, generate index and calculate the daily return.
3. Generate covariance matrix for share return and bond return.
4. Calculate portfolio variance and standard deviation. In Excel, it can be done using MMULT(MMULT(TRANSPOSE(value),covariancematrix),value)
5. Calculate VaR at 99% confidence level as 2.326 multiply by standard deviation.
6. Tomorrow's worst value = Today's value - VaR

From the example, I found tomorrow's worst case value is IDR1,937,346,708.11

[Sorry, it's a premium spreadsheet]

Bond Price, Duration and Convexity

2007-11-26T02:40:00.000-08:00

In Feb 06 I submitted some short of article in Wikipedia about closed form formulas for bond duration and convexity. Below is the clone and hopefully it can be useful for those who may use the formulas for bond analysis modelling in Excel spreadsheets.

As far as I know, these have never been published on the web like this as I experienced some problem in finding them when doing some bond pricing project.

Closed-form formula:
A single arithmetic formula obtained to simplify an infinite sum in a general formula. The general formula of bond duration and bond convexity cannot be said closed-form as there is an infinite sum over the different time periods. Using a closed-form formula, a bond’s duration or convexity can be calculated at any point in its life time.

Bond duration closed-form formula (Richard Klotz):

C = coupon payment per period (half-year)
P = present value (price)
i = discount rate per period (half-year)
a = fraction of a period remaining until next coupon payment
m = number of coupon dates until maturity

Bond convexity closed-form formula (Blake and Orszag):

D = coupon payment per period
P = present value (price)
B = face value
i = discount rate per period (half-year)
a = fraction of a period remaining until next coupon payment
m = number of coupon dates until maturity

[Sorry, it's a premium spreadsheet]

Live-updated Yield

2007-11-26T02:34:00.000-08:00

The purpose of this model is to provide a live-updated spreadsheet by automatically capturing the current data provided by a website via Web Query and then automatically recording the data into a master data sheet through a Bootstrapping method.

So, it's just two clicks away on our spreadsheet to update a time series graph to the current rate, automatically. It's similar when we are running a live-update for our antivirus software.

The Worksheet

[Sorry, it's a premium spreadsheet]

The Sheets

There are three sheets: INDO17, Data and Graph. "INDO17" is a sheet where the web query should go and where the two updating clicks are available. "Data" is a sheet where the bootstrapping process is running. "Graph" is only for visualisation.

Cell Naming

Cell naming is an important method as explained before in the previous post. There are several cells to be named in this worksheet and used for visual basic coding: INDO, INDOrow, INDOwebquery, nodays and updatelatestINDO.

To find which range is referred by a cell name, just go to the box on the top left, scroll the box and click the name. A range or cell will be shown.

INDO: a range as the destination for the updated rate from 2-Mar-06 to 31-Dec-10 in "Data" sheet (B5:B1263).
INDOrow: a cell showing a number of rows from 2-Mar-06 to the latest date has been updated in "Data" sheet (D3).
INDOwebquery: a range as the source of data captured via web query in "INDO17" sheet (A2:D21).
nodays: a cell showing a number of days need to be updated since the last updated date in "INDO17" sheet (M14).
updatelatestINDO: a cell showing the next date needs to be updated in "Data" sheet (G4).

Visual Basic Coding

Web Query Update
This code is for the first button "Update INDO-17 Yield from Web Query". The webpage source used for web query is the INDO-17 yield data provided in the Central Bank of Indonesia website.

The code:

Sub dailyINDO()

Application.OnTime Now + TimeValue("12:00:00"), "updateINDO"

End Sub

Sub updateINDO()

Sheets("INDO17").Activate
Range("a1").Select
Selection.QueryTable.Refresh BackgroundQuery:=True
dailyINDO

End Sub

Recording Data through Bootstrapping
This code is for the second button "Record Yield into Data Sheet". The code is quite complicated. However, if we can follow the logic and as referring to the range names, this is a piece of cake for us.

The code:

Sub recordINDO()

For j = 1 To Range("nodays")
For i = 1 To Range("nodays")

If Sheets("Data").Range("updatelatestINDO") = Range("INDOwebquery").Cells(i, 1) Then
Range("INDOwebquery").Cells(i, 4).Copy

r = Sheets("Data").Range("INDOrow") + 1

Sheets("Data").Range("INDO").Cells(r).PasteSpecial Paste:=xlPasteValues
Calculate
End If

Next i
Next j

Sheets("Data").Select

End Sub

The meaning of the above code is:

For the loops as many as the number of days needs to be updated, Excel will copy each yield in the web query sheet and paste into the data sheet on each corresponding date. Where the corresponding date is found by referring the number of rows from the first date to the latest updated date plus 1 day after.

Piece of cake, aye?

Option for updating screen
You may insert this code to disable the visualisation of screen updating. Meaning, you can't see the price line moving forward as time moves.

Application.ScreenUpdating = False

The "INDOrow"

It seems the key problem here is to find the number of "INDOrow", a cell showing a number of rows from 2-Mar-06 to the latest date has been updated in "Data" sheet (D3).

The way is using a MATCH function to calculate the number of rows from 2-Mar-06 to the latest date as this formulae:
=MATCH("latest date",C5:C498,0)

Where the "latest date" is found by tagging a note in the column C as the latest date using IF formulae: =IF(AND(the next yield=0, the current yield >0),"latest date","").

The "updatelatestINDO"

This is a cell showing the next date needs to be updated in "Data" sheet (G4) that can be found easily using an INDEX function:

=INDEX($A$5:$A$498,INDOrow+1)

Recommendation and Notes

The title is for updating government bond yield, but the application can be also for updating other time series data such as foreign exchange rates or share prices.

I also open for any suggestions particularly for any more simple VBA codes.

Please let 2 days lag from Bank Indonesia website for current rate. It doesn't mean they are lazy to update, they just have a lot of other things to do.

Dynamic Company Valuation

2007-11-26T02:33:00.000-08:00

Since the key parameters in valuation model are mostly influenced by market behaviour, then it is important to update some relevant market data in regular basis to see how they affect the analysis. The relevant market data may include risk-free rate, stock price and market index that are able to indicate changes in value.

This model introduces manipulation of data by automatically changing some market data via the tool of external data import in Excel and some VBA simple codes for refreshing the Web Query. The main goal is to adjust calculation in Beta and WACC in the framework of company valuation and also for Option and Bond analysis.

In projecting financial statement, the historical data of the last two year operation is used to find the assumptions in the form of financial ratios that are normally corresponded to Sales. Then, the average of the last two year ratios can be used as the basic assumptions. Sales Growth ratio can be used as a look-up parameter in sensitivity analysis.

Sensitivity models are used by utilising two important tools in Excel, i.e., Data Tables and Graphs. Both tools are set to show visual changes in value after altering the growth ratio to some levels. This model also introduces sensitivity analysis of changes in financial ratios for the goal of predicting the possibility of bankruptcy. Traditional financial ratio techniques used are for Altman Bankruptcy model and Chesser Loan Surveillance model to be visually compared with the equity value and stock price resulted from the Free Cash Flow valuation.

The key analysis in this model is the Free Cash Flow valuation that has been as the important technique explained in the course and from the text. The method follows the that has been explained in the class using the No-Negative Cash and Debt as the Plugs. Some modification is tried to be applied by using Bonds as the plug, where the Bank Loans is calculated based on the bank loans to bonds ratio. The sum of both is the Long-term Debt.

Using bonds as the plug, the plan is to set of a Bond Portfolio for covering future financing in the projection. Then, the analysis refers to Net Present Value and Portfolio Duration that may anticipate in the future. As a bond issuer, the company should expect the lower value and duration.

[Sorry, it's a premium spreadsheet]

Bond Portfolio Analysis

2007-11-26T02:32:00.000-08:00

Using the closed-form bond formula posted before, this bunch of spreadsheet is produced to value a bond at any point in its life time and do some analyses, as follows:

Portfolio valuation, duration and convexity
Derivatives valuation: FRA, Swap, Futures
Risk governance: Value-at-Risk, Stress Testing and Scenario Analysis
Hedging effectiveness
Liquidity analysis

Remark: this portfolio is a liability/debt portfolio, NOT an asset/investment portfolio.

[Sorry, it's a premium spreadsheet]

WACC Calculation

2007-11-26T02:30:00.000-08:00

This model is to estimate the weighted average cost of capital (WACC) of Mainfreight Limited (MFT), an NZX listed company.

Bear in mind, the debt and equity values should be estimated as the MARKET VALUES.

Some may just estimate the BETA, but in this model I calculated it based on the historical share prices. I used NZX ALL index as the market proxy and 5 year NZ Government Bond as the risk-free rate with risk premium assumed 7%.

WACC Calculation.x...

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Share Valuation

2007-11-26T02:08:00.000-08:00

This model is the share valuation of PT Astra International Tbk using Dividend Discount Model with assumed growth of 40%.

This should be the simplest way to value a share. By calculating the cost of equity as the discount factor, the projection of dividend cash flow is discounted to get the estimated value.

Seems similar with growth annuity valuation?

ShareValue.xls

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Value-at-Risk

2007-11-02T21:57:00.000-07:00

AstraWatch: week 29 Oct 07

2007-11-02T20:43:00.000-07:00

PT Astra International Tbk (ASII)

Live-updated Value
Growth 16.00%
BETA 1.298713447
WACC 21.35%
Equity value (in IDR ,000,000,000) 42,757.86
Value per share (in IDR) 10,561.79

last trade
ASII 22,500.00
JKSE 2,638.21
INDO-17 6.086

Astra share value using Dividend Discount Model

2007-09-19T03:51:00.000-07:00

Share valuation of PT Astra International Tbk using Dividend Discount Model.

Last dividend: 290
Dividend growth: 40.00% assumed
Discount rate: 42.13% cost of equity

Estimated share price = Last dividend (1 + dividend growth) / (discount rate - dividend growth)

Estimated share price = 19,047.38

AstraWatch: week 24 Aug 07

2007-08-26T00:28:00.000-07:00

PT Astra International Tbk (ASII)

Live-updated Value

Growth 16.00%
BETA 1.303462794
WACC 19.76%
Equity value (in IDR ,000,000,000) 68,188.12
Value per share (in IDR) 16,843.41

last trade

ASII 17,300.00
JKSE 2,143.11
INDO-17 6.887

AstraWatch: week 17 Jul 07

2007-07-19T22:41:00.000-07:00

PT Astra International Tbk (ASII)

Assumed Growth 24%.
Still undervalue. Strong buy.

Live-updated Value

Growth 24.00%
BETA 1.374012174
WACC 25.33%
Equity value (in IDR ,000,000,000) 93,234.68
Value per share (in IDR) 23,030.26

last trade

ASII 18,600.00
JKSE 2,333.68
INDO-17 6.329

AstraWatch: week 20 Apr 07

2007-04-19T17:50:00.000-07:00

PT Astra International Tbk (ASII)

Live-updated Value
Growth 15.00%
BETA 1.39372807
WACC 19.53%
Equity value (in IDR ,000,000,000) 56,714.69
Value per share (in IDR) 14,009.32

last trade
ASII 14,300.00
JKSE 1,918.35
INDO-17 6.036

Astra net income decreased, so growth assumption changed

2007-03-01T14:32:00.000-08:00

From the 2006 Financial Statement, PT. Astra International net income decreased from Rp5,457 bil to Rp3,712 bil. This is contributed by the decrease in sales growth in 2006 by -10.08%, while the growth in 2005 is 37.41%. The average growth between 2005 and 2006 is 13.67%.

It is good because Astra becomes more rational in determining growth in business. The 37.41% growth in 2005 can be considered as too much and theoritically in FCF valuation, high growth can drop the value referring the sensitivity analysis.

Therefore, Astra valuation in this blog needs to change the growth assumption to 15%.

Live-updated Value
Growth= 15.00%
BETA= 1.411115248
WACC= 19.56%
Equity value (in IDR ,000,000,000) = 56,282.57
Value per share (in IDR) = 13,902.58

last trade
ASII= 14,950.00
JKSE = 1,794.36
INDO-17= 6.073%

Astra Watch: Week 12 Feb 07

2007-02-18T20:39:00.000-08:00

PT Astra International Tbk. (ASII)

Growth: 19.00%
BETA: 1.411115248
WACC: 27.22%
Equity value (in IDR ,000,000,000): 50,862.09
Value per share (in IDR) : 12,563.64

last trade
ASII: 14,950.00
JKSE: 1,794.36
INDO-17: 6.073%

AstraWatch: Week - 19 Jan 07

2007-01-18T03:38:00.000-08:00

PT Astra International Tbk. (ASII)

Growth= 19.00%
BETA= 1.439090216
WACC= 27.35%
Equity value (in IDR ,000,000,000)= 49,937.87
Value per share (in IDR) = 12,335.35

last trade
ASII= 15,600.00
JKSE = 1,730.47
INDO-17= 6.026%

Injecting Capital Fund by cash

2007-01-15T20:01:00.000-08:00

From the previous example, it is shown that the initial capital injection was made by simply recording journal of term loan and equity transfers to bank saving, to be then spent for purchasing fixed assets. The bank balance then is:
Electronic Clearing Account ($ 75,000)
KiwiBank Saving Account $ 100,000
Bank balance $ 25,000

The owner is now thinking to add some more fund to the bank account by cash. However, he wants to consider that his fund injection is to be recorded as a banking receipt to the company.

To record this:
go to Banking > Receive Money

Then fill in the form like this:

Some notes to this form:
1. Deposit to account: KiwiBank Saving
2. The payor is Jeffry Liando as personal
3. Account is for KBF equity as to be injected as capital

The transaction journal is similar with the previous direct method (recording journal):

The updated balance sheet as of Jan 2007:

Balance Sheet Report

2007-01-15T19:43:00.000-08:00

To see the balance sheet report as of Dec 2006:
go to Report (bottom menu) > Accounts
choose Standard Balance Sheet > click Customise
and choose the period of December

And the report will be like this after clicking Display:

FiNZ Blog

Psychospritual Aspect in Financial Planning

2. Money Consciousness as Basic Concept

Inconsistency in a Client’s Judgement

Money as Energy

3. Defining the Key Factors of Psycho-spiritual Aspect in Financial Planning

Money Capacity

Basic Assumption of Given Capacity

The Key Factors Indicating Prosperity from Psycho-spiritual Capacity

Irrelevant Capacity in Displaying the Psycho-spiritual Aspect

Overall Process of Qualitative Valuation

Financial Ratios Representing Key Factors

Stewardship and Coaching

[7] This regards the concept of inequality in the framework of capitalism-individualism explained by Goetz Kluge in Poorcity.Richcity.Org. http://poorcity.richcity.org/entdiff.htm

Bibliography

The risks of risk management: in the framework of Asset-Liability Management

The Areas of Conflict between Cost Control, Service Quality, Desire for Growth and Credit Management

Credit Derivatives as Part of Hedge Funds’ Strategy

Benchmark Issue in CAPM

Psychospiritual Aspect in Financial Planning

Next coupon date - IF THEN formula

CAPM return and cumulative data matter

The Parables of Investment

Optimising Portolio of ING PPS Funds

Finance Concepts

financial concepts

Charts, News and Quotes

nz finance news

global finance news

Excel and Macro Tips

Top 10 Indonesian Managed Funds (Reksa Dana)

Which Market do you prefer?

US Recessions and the MSCI World Index

Glossary of UK Pension terms

FAQ: UK Pension Transfer

UK Pension Transfer Traps

The 7 Traps to Transferring Your UK Pension Funds

Pension Transfer Trap One

Pension Transfer Trap Two

Pension Transfer Trap Three

Pension Transfer Trap Four

Pension Transfer Trap Five

Pension Transfer Trap Six

Pension Transfer Trap Seven

Taxation Issues UK Pension Transfers

Taxation Issues UK Pension Transfers to NZ

UK Pension Simplification Rules 2006 - How will they affect your Pension Transfer?

NZ Taxation Rule Changes April 2006

Taxation Rules

Before Immigrating to NZ

Comparison between UK and NZ Pensions

With a UK Pension

With a NZ Pension

Considerations and Requirements UK Pension Transfer

Have you Considered?

Requirements

Some reasons for transferring your UK Pension to NZ

UK Pension Transfer to NZ

Credit Card, Mortgage and Retirement Calculators

KiwiSaver Decision

NZ Investment Advisers and Market Participants Regulations 2008

A Noisy Market Siren

VBA Progress Indicator

Simulating Dow Jones Index in the Future

Iteration and Circular Reference

Name a Cell

Lotto generator

House: Borrow, Buy, Sell and Profit

Portfolio Optimisation (Shares & Funds)

Live-updated Beta Calculation

Comprehensive Financial Planning

Value-at-Risk

Bond Price, Duration and Convexity

Live-updated Yield

Dynamic Company Valuation

Bond Portfolio Analysis

WACC Calculation

Share Valuation

Value-at-Risk

AstraWatch: week 29 Oct 07