AIM Common Topics
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Correlation of commodities to capital market assets.
Capital market assets are driven by interest rate in an economy. You will always see a
treasury have a yield very similar to the interest rate in the economy (ignoring risk of
government to pay debt) Let’s assume we are talking about the US t-bills.
The theory is that as interest rates are low, commodity prices should rise. Thus there is
positive correlation between treasuries and commodities. Here are a few reasons why
behind this theory:
- Higher interest rates tend to lead to supply increases in such commodities; they make it
more appealing for miners to pull that stuff out of the ground today instead of tomorrow.
- They also lower the desire for producers to carry inventories of such commodities
- They goad speculators into moving out of spot commodity contracts and into something
with a better yield ... such as Treasuries.
However this is when you ignore all the other factors that influence t-bonds and
commodities. Commodities main drivers are the supply and demand of the things. If oil were
to start drastically decreasing in supply and we found we had a huge shortage, it wouldn’t
matter what the interest rate was or the price of a t-bill, that price would be hitting the roof.
Additionally capital market assets can change for many other reasons not just the interest
rate. Inflation for example (although inflation is correlated to the interest rate). And more
importantly the ability of the government to pay back its debts. For example Spain and
Greece, these capital market assets have huge yields and a very low price despite the rate
set by the ECB.
Therefore there may be correlation when ignoring all other factors, but these are not the
main drivers for either of the asset classes therefore this correlation is only minimal.
AIM Common Topics
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Role and functions of an international commodity exchange. (Using 1 example)
An international commodity exchange is centre where buyers and sellers cane come to
invest in commodities by using futures contracts, options on futures and other derivative
products. Some other commodity exchanges will also allow the trade of physical
commodities. The role of the commodity exchange is to seek prices by linking different
warehouses throughout the country and this allows volume to represent a more accurate
price.
Commodity exchanges were created from the fact that they could be more efficient than
seeking buyers or sellers and also a way of lowering transaction costs for both parties. One
of the factors that led to the creation of the Chicago board of trade, over a century ago was
that farmers coming to Chicago at times found no buyers and had to dump cereals unsold in
Lake Michigan.
CBOT (Chicago Board of Trade) is a commodity exchange established in 1848. It trades in
both agricultural and financial contracts. Originally only agricultural commodities such as
wheat, corn and soybeans were trades however CBOT now offers options and futures on a
wide range of products including gold, silver, energy and even Treasury Bonds.
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Calculating price of MBB (Mortgage backed bond)
MBBpv= SumOf t=1 to N ( CPt/(1+r)^t + (CPn+1 + P)/(1+r)^n+1 )
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Understanding a secondary mortgage market and investment into MBB’s
A secondary mortgage market is the buying and selling of mortgages after a mortgage has
been initiated between a business/individual with a bank. The bank enrolled in securitization
of mortgages by packaging parts of different types of mortgage and selling them to
investment funds, hedge funds mutual funds and more.
The bank will package different loans together to create an asset called a mortgage backed
security (MBS). It divides this combination of loans into a trench system starting from triple
A to low grade securities.
Investors seek to find the highest possible return for their mortgage backed security whilst
homeowners and borrowers seek to find the cheapest interest rate. This therefore creates
an efficient market whereby the mortgage rate is determined by the secondary mortgage
market.
Many things affect the mortgage rates. The rate of inflation, the yield on the risk free rate
and the rates set by the Central Bank of the country/continent.
AIM Common Topics
MBB (Mortgage Backed Bond)
A mortgage backed bond is a security which is compiled of different mortgages and its
payment is in coupon payments much like that of a traditional bond.
When investing in mortgage backed bonds, you may do so with a view on the market. If you
feel like the yield of the risk free and bond yields are too high at the moment or maybe you
feel like inflation is going to fall, you may see that now is a good time to invest in Mortgage
Backed Bonds. The price should appreciate as other investments become less attractive and
the time value of money hindering the coupon payments becomes smaller. Thus leading to
profit.
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Example of a Long/Short strategy
This strategy is an equity technique to invest in stocks whilst trying to eradicate the natural
exposure to the market. It involves simultaneously buying stock you believe will appreciate
and selling stocks you believe will depreciate.
Here is a working example:
Suppose you have desire a two stock portfolio.
Stock A: beta 0.5, expect a 8% increase in value p.a. , price = $10
Stock B: beta 1, expect a 15% decrease in value p.a. , price = $10
Traditionally in a long only asset management fund, the only option would be to invest in
stock A. However with this you are exposed to market risk. If the stock is doing well in profit,
growth and revenue terms and a recession happens you would lose substantial amounts
despite still buying an undervalued stock. With this strategy things are different.
In this instance you would look to buy stock A and sell stock B. At the same time, if you want
no exposure to the market you would look to neutralise beta. This would occur with having 0
net beta.
Therefore to do this you would buy one stock of stock B and sell two stocks of Stock A. (This
is because it has half the market exposure thus double the amount of shares).
In the ideal situation you would want stock A to increase and B to decrease. However this is
only likely to happen if the market gives no returns over the year.
Let’s suppose the economy suffers a recession and loses 50% of its value.
In this case you would expect Stock B to lose more than A as this is was overvalued to start
with therefore it loses 65%. Stock A fares better by losing only 30% as it was undervalued to
start.
With these returns, traditional stock funds would have lost lots of value. However in this
case it does not matter that the market has fallen.
Return: stock A (Long) $-6 , stock B (Short) +$6.50 Net profit = $0.50
AIM Common Topics
Therefore in this case you would have made positive returns on your trade even though the
market lost 50% of its value!
In other cases you may take a long-bias (Equity markets typically create wealth). This would
involve adjusting your portfolio to have a small but positive beta. You would therefore have
more weighted beta stock long than short.
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Convertible arbitrage
Convertible arbitrage is the simultaneous purchase of convertible securities and short sale of
the same issuer’s stock.
A convertible bond is a normal bond with the advantage of converting it into shares at a
later point @ a specified price now. Essentially it is a bond with an option. This is therefore
the way it is priced.
It is a relative value strategy, therefore you only have exposure to the difference in the
prices and nothing more.
Ratios:
Conversion ratio: # of share in exchange for the bond
Conversion price: Convertible bond price/# of shares(“conversion ratio”)
This is the price of each share bought.
Investment value: Sum of (Coupon payments/(1+k)^t) + (Principal/(1+k)^t)
Investment value premium: (Spot price-Investment Value)/Investment value
This shows the value of the CB over and above the bond.
Therefore representing how equity sensitive the bond is.
Setting up a convertible arbitrage trade:
Reasons: Convertible bonds are normally under-priced, due to its non-investible grade, low
liquidity, small issue number. This therefore opens up an opportunity to profit from this
price inefficiency without the market or share specific risk.
Buy the convertible bond and delta hedge by selling the underlying share price. Overtime
the market should realise this inefficiency in price and it will be revalued. This is the time to
take off the trade.
The amount of stocks that should be shorted per convertible bond bought should be equal
the value of delta. (Delta hedging)
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Analyse 2 commodities (1 Agricultural and 1 metal)
AIM Common Topics
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Systematic and unsystematic risks of a hedge fund
There are two types of way to make money being an investment fund. The first way is by
taking systematic risk on (beta). This is piggy-backing the wealth creators in the mechanism
of buying stocks.
The second way is unsystematic risks. (Alpha). This is by using strategies to make returns
that are not correlated and are not as a result of buying stocks. This return variable is
generally referred to as the extra return that the manager has added to portfolio by his skill.
Hedge funds tend to seeks alpha returns. They seek all kinds of strategies and techniques
that will give alpha returns. Hedge funds will also invest in stocks, but the way they do this
tends to be more advanced and can include part-hedging to get exposure to more specific
variables as opposed to just ‘the market’ exposure.
Hedge funds tend to be less correlated with the market for this reason, therefore they are a
good way to diversify your portfolio. They expand the efficient frontier.
Sources of alpha return:
Liquidity risk, Commodity risk, currencies, value vs growth, economic growth, spreads etc…
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REIT’S (Adv&D-Adv, Adv. of LSE, asset requirements, income requirements and
stock/ownership requirements)
Advantages of REIT’s
Not subject to double taxation
Limited Liability to Shareholders
Allows investors liquidity and diversification for minimal outlay
Disadvantages of REIT’s
Income is portfolio Income
Tax losses do not pass through to its shareholders
REIT’s must meet substantial operating restrictions
Asset Requirements
>75% of REIT assets must consist of real estate, cash and government securities
<5% may consist of assets by one issuer
<10% of securities that are issued by a single issuer
<20% of assets can consist of stocks in taxable REIT subsidiaries
AIM Common Topics
Income Requirements
>95% of gross income must be derived from dividends, interest, rents or gains from sale of
assets
> 75% of gross income must come from rents, coupon payments from mortgage bonds
<30% of gross income can be derived from the sale of assets held for less than 6 months or
real property held for 4 months
>90% of REIT taxable income must be distributed to shareholders
Stock Ownership Requirements
Be taxable as a corporation
Be managed by a board of directors
Have shares that are fully transferable
Share must be held by a minimum of 100 peoples
No more than 50% of REIT shares may be held by 5 or fewer individuals
Advantages to using the London Stock Exchange
For companies
Tax efficient structure
Access to new investors
Acquisition Currency
For investors
Tax transparent
Regular high yields
Access to property for minimal outlay
Low/controlled gearing
Portfolio diversification
Liquidity
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Trading v Long term investing
Long term Investing
Long term investing is what it says on the tin. It is the allocation of funds with the view of
holding the asset for a very long time-frame. Warren Buffett is the pioneer of long-term
investing having 98% of his wealth in Berkshire Hathaway stock.
Long term investing is very often in stocks as opposed to any other asset. This is because
they are the wealth creators in society and have outperformed any other asset when looking
at long-term historical averages.
AIM Common Topics
Long term investors are very keen to use in-depth qualitative analysis and quantitative
analysis. The main thing when analysing stocks for a long term investment, is to see whether
they can increase profits in the years to come and remain or build upon some form of
competitive advantage in their industry. Quality of growth and financial stability is also a key
thing to ensure is in order as in the long-term, many uncertain market conditions will hit the
business such as recessions and industry declines, thus the business must be in the best
shape to deal with these setbacks.
Bonds are also an instrument that is used in long-term investment, this is more low risk and
tends to be used when stocks are overvalued or there is expected change in the interest
rate.
Trading
Trading is a very different kettle of fish than long-term investing and requires a different way
of thinking. Trading tends to be taking advantage of a changing environment in which asset
prices are going to change accordingly or taking advantage of price inefficiencies. All asset
classes can be traded and changing environments means that all different asset-classes will
have volatility which is required in order to profit from short term trading.
As a short-term trader, psychology plays a key part in the performance. Many traders can
get startled by the fast pace with the changes in prices and can let emotions play a part in
their trading decisions. Along with this sticking to a key plan is essential when trading.
The 3M’s are also important in trading: Mind, Money Management and Method. Mind is to
keep disciplined and stick to your plan. Many traders will have a fantastic trading plan but
will not execute it with discipline as they are managed by their emotions and not their
rational head. Money management is very key. The first goal for any trader is survival. A
trader needs to manage his money well and not take big risks through the form of underdiversification, rushing a trading plan, leverage, trading with little knowledge etc…
Method too is also important as without sufficient trading ideas, you are going to be blindly
betting.
Technical analysis is also much more common in trading as opposed to long term investing.
This is because in the long term, prices of assets are going to move with very high correlation
with earnings, output and much more macro factors. Where-as in the short term, it tends to
move in trends.
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Evaluate qualities of a fund manager. (MPT) Prospects of people with the 3 types of risk
profile.
Risk averse should outperform risk-loving and risk-neutral due to the invention of the global
minimum variance portfolio.
This is because the minimum-variance portfolio will offer the best risk-reward ratio out of
the whole of the efficient frontier. This will outperform other portfolios composed by people
who are risk neutral or risk loving.
AIM Common Topics
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Relationship between the spot and forward commodity markets.
The relationship between spot and forward prices in commodities markets is all to do with
the current cost of carry and the current convenience yield. The relationship is solely a no
arbitrage relationship (No arbitrage trade is worth doing) and is nothing to do with
expectations of future prices of the underlying assets.
The formula for futures in commodity markets is as follows.
F=So*e^(r+u-y)
r= Risk-free rate
u= Storage costs
y=convenience yield
The convenience yield is the premium that would be charged to borrow a commodity in
order to short sell. This premium comes from the fact that holders of commodities are more
in the game of consuming the asset as opposed to just holding it for investment purposes.
They may use this commodity as an input to their primary product/service.
(Example: Oil producers holding crude oil in order to produce and sell petroleum and diesel.)
Therefore if you have a convenience yield that is larger than the cost of carry (cost to hold
the spot until the maturity of the future) then you will have a downward sloping futures
curve, this is normal in commodity markets. This is called normal backwardation. When the
cost of carry increases or the convenience yield lowers (Normally when oil prices fall) you
may fall into a state of contango, this is when futures prices are higher than spot prices.
Note: There is an additional reason that goes into normal backwardation. This is whereby
there is always a constant selling pressure on futures prices as holders of spot that are using
it for consumption are selling futures to hedge. This is most evident by businesses like gold
miners.
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Frontier markets. Adv. & D-Adv., difference between them and other markets
Frontier Markets
These are in some of the newer countries to start to experience high economic growth.
These include: Vietnam, Nigeria, Ghana, Kenya, Qatar etc…
These markets will be expected to make high returns as they start to experience high
economic growth, mainly due to liberalisation of markets, however these returns should be
balanced with poor liquidity, poor sophistication with their stock markets and different legal
environment which can be expensive to find out about.
AIM Common Topics
Emerging Markets
These markets have less stock market sophistication that developed countries however they
have more than frontier markets. These are likely to offer good returns but not as good as
frontier markets. This is because much of their growth has already come and are starting the
lengthy transition to a developed economy.
The returns may be lower however their liquidity is much better.
Evaluation:
Overall there is a clear trade-off between liquidity and return. If you are a very long term
investor, poor liquidity may not be a big problem, especially if you are a smaller fund.
However if you are a large fund and/or have more short term views then emerging markets
may be more suited, as large orders could be very hard to get out of should something go
wrong.
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Dow Theory.
This is the theory that the market has three types of movement.
Primary movement
Secondary movement
Daily movements
Primary:
This is the main trend prevailing in the underlying asset. This is the way that fundamental
analysis is pointing and over a long period of time the price slowly moves in this direction.
There may be times of the price going in the opposite direction but over the whole time this
is the primary move. It is normally more than a year.
Secondary:
This is the trend over a few weeks or a month or two. This happens because of a change in
attitude but not enough to change the overall view. For example GDP growth is now
expected to lower than originally thought. (Primary trend is that growth is still high, however
the secondary move occurs because it is just not going to be as high)
Daily:
These are generally thought to be random changes in the stock price and no analysis of
these can be made. This is mainly because you can’t infer anything from random flows of
orders coming in over the course of one day. Random walk.
AIM Common Topics
Example of all in play:
Primary: The currency in country A is appreciating because their exchange rate is increasing
for macro-economic reasons and is expected to keep on raising for the next 5 years.
Secondary: The currency starts to depreciate for a number of weeks, this occurs because the
expectations of the rate of unsustainable growth in the economy slow down and interest
rates are not expected to rise as rapidly anymore, however they are still expected to keep
rising.
Daily: The daily price is down today because there was a number of large sales because a
few investors were profit taking. The daily price was up yesterday for different reasons.
However we can’t use this to aid us in our investments.
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3 Price/Volume techniques
Moving Averages
Moving averages are a figure that should the average price of that asset over the last
amount of days. The two main ones used are the 200 day and the 50 day.
These are used to see a change in sentiment.
For example; should the 50 day cross the 200 day, you may infer that this is significant in
suggesting that the trend is reversing.
You could then trade in the belief that a new trend has started
Support/Resistance Levels
Support and resistance are essentially prices that seem to be price ceilings and price floors.
The chances are slim that the price will cross them. The price of the particular asset will
seem to trade within a range.
These occur for a number of reasons, but mainly are sentimental for some significant reason
or another. For example it took the FTSE 100 15 years to surpass a resistance level of around
6950. This was the highest ever value and came on the 31st of December 1999. (The last day
of the millennia). The prices “bounced” off this level hundreds of times.
A way to use this technique would be if you were bullish an asset and you would wait for the
price to get close to the support level. Therefore you know there is a slim chance it will fall
further, therefore you put in a buy order with a high chance it will increase in value or stay
the same. This done multiple times should increase your chance of gains.
AIM Common Topics
Relative Strength
Relative strength is essentially a comparison between the performance of a stock and the
performance of the market. This is therefore called the relative strength ratio: Stock
return/Index return. If this ratio increases you may believe it to be overbought, therefore
you may wish to sell, if the ratio falls then you may believe it is oversold and buy.
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Fundamental v Technical Analysis
Fundamental and technical analysis are the two main and contrasting forms of investment
analysis used by traders and investors.
Technical Analysis:
This is the technique whereby traders use only price and volume data to analyse whether
assets are under/overpriced. Chartists have the idea that prices move in trends determined
by the changing mind set of the market participants for a number of reasons. The art of
technical analysis is to identify trends at an early stage and hold the trade until you realise
using technical techniques that the trend is over.
Technical analysis have two main types of technique and these are usually used together to
make up a technical trading plan.
Prices and volume:
Dow theory (3 Types of trend)
Support and resistance lines
Moving averages
Relative strength
Technical indicators:
Breadth indicators:
Volume
Diffusion index
New highs and lows
Sentiment indicators:
Short-interest ratio
Above/below the 50&200 day moving averages
Block uptick-downtick ratio
AIM Common Topics
Fundamental Analysis
Fundamental analysis is the technique by traders/investors by analysing the real reasons
behind why an asset should change value over a period of time. They use certain techniques
to analyse what they think the price should be and then buy if the price is lower than what
their research estimates.
Warren Buffet: “It’s better to be approximately right as opposed to precisely wrong”
Fundamental analysts in stocks will use the financial statements as their main source of
information when analysing a stock. They seek to find the following things:
Earnings per share
Price to earnings ratio
Margins
Revenues
Profits
Etc…
Fundamental analysts seek different types of stocks for investment and tend to channel their
expertise in a type of stock they are looking for:
Growth investing
These are the firms that are in a growth stage of the business cycle and show above average
growth. These shares tend to be more expensive as future profits are expected to be much
higher.
Value Investing
This is the technique of finding undervalued stocks with low P/E ratios compared to what
they estimate they should be. They tend to look for good companies in bad scenarios,
therefore predicting the strength of the company will get through the hard time.
This is the strategy started by Benjamin Graham and adopted by Warren Buffett.
AIM Common Topics
Do they go together or are they opposing strategies?
In theory these two types of strategy can actually go together. The theory is that traders can
use fundamental analysis to get a good view of the long term future direction of the asset
and then use technical analysis to ensure that they are not buying/selling whilst the trend is
going against them.
However in practice this may be much harder. This is because it can take years to develop
great understanding for the different approaches so to be able to master both would be
unrealistic. For example: A fundamental analyst could be spending time worrying about
getting a slightly better price by using technical analysis, however in this time he could be
researching other stocks with great opportunities. Therefore rendering it sub-optimal to use
both.
Additionally a lot of assumptions are opposing:
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Example: Returns are randomly normally distributed v returns are correlated to earnings