insuranceadvisory

Operating Costs

admin — Mon, 04 Oct 2010 16:58:58 +0000

All loans incur an origination cost and ongoing processing costs. Origination and processing costs include direct costs related to the loan, such as any legal fees and costs relating to the credit appraisal process, and indirect costs such as management and administrative overhead, marketing expenditure and use of shared data-center facilities. The problem of how best to allocate overheads and indirect costs to specific transactions, or even business units, is not unique to banks. There are plenty of books on management accounting that address these issues at great length. For our purposes we will assume these costs are given.

Funding Costs

admin — Sun, 26 Sep 2010 16:57:32 +0000

Loan departments at banks do not get their funding directly from external sources but instead request the required funding from the bank’s treasury department. Treasury will quote a rate that it will charge for the funds provided. The term of the loan will also affect pricing. In general terms the longer the term of the loan the higher the rate that banks will require. Many loans are priced against yields from equivalent bonds on the yield curve. Banks are exposed to the risk that borrowers may repay their loans early. This prepayment risk may be priced in a number of ways.
Short-term loans are inherently lower risk. Banks with shorter-term exposure can reduce that exposure at an early stage of a company showing symptoms of financial distress.

MICRO-LEVEL FACTORS AffECTING PRICING

admin — Tue, 21 Sep 2010 16:57:21 +0000

In addition to external factors beyond the bank’s control loan pricing will be affected by inputs from other groups within the bank and by specific factors concerning a particular loan. The funding costs will depend on the bank’s deposit taking effectiveness and on the spread that
treasury takes. From the lending department’s perspective this is a given cost. Operating costs will depend on the productivity of back-office and cost allocation methods (for example, how head office overheads are treated). The lending department is also likely to have a target return on capital employed and to have capital allocated to it. This will usually be both at a business unit level and for specific loans. The level of likely credit losses must also be considered. Pricing has to take these factors into account.

The Art of Charting

admin — Sat, 04 Jul 2009 10:26:28 +0000

Technical analysis has much in common with the major principles at work in ﬂow analysis. Both focus on behavioural patterns within ﬁnancial markets. Both claim that market behaviour can indeed impact future prices. In addition, both reﬂect a belief that markets must move and traders must trade irrespective of whether or not there are changes in economic fundamentals. In this sense, if ﬂow and technical analysis did not exist, they would have to be invented. Demand will eventually result in supply!
In these few posts, we take a look at the core ideas behind the fascinating and controversial ﬁeld of technical analysis, its origins, how it works and its main analytical building blocks. For those looking to study this ﬁeld in more depth, I provide useful references in the footnotes. Whereas ﬂow analysis focuses on price trends that are created by order ﬂow, technical analysis focuses on price patterns within those trends. Technical analysis remains a controversial subject for many people. Despite such controversy, its origins are rooted in mathematics and it has been around in one form or another for a very long time indeed.

Risk Reversals

admin — Fri, 03 Jul 2009 10:19:08 +0000

In addition to ﬂow indicators, there are also sentiment indicators. These do not reﬂect ﬂows directly going through the currency market, but more indirectly by representing the market’s bias towards exchange rates. A very useful indicator of market sentiment or “skew” is the option risk reversal. This is the premium or discount of the implied volatility of a same delta currency call over the put. For instance, a dollar–Polish zloty three-month risk reversal may be 3 vols, which means that the implied volatility on the 25 delta three-month US dollar call costs 3 vols more than the 25 delta dollar put against the Polish zloty.
Now let’s have a look at the risk reversals for the major exchange rates and the US dollar–zloty exchange rate. Given that it provides risk reversals across tenors, this produces in effect a risk reversal “curve”. How do we interpret this information? Clearly, the best way of doing so is by comparing current to historic levels. In this case, one should compare the current levels of option risk reversals as expressed by the results to a historic measure of risk reversals for those same currency pairs.
Options are priced off forwards and through this option risk reversals are priced off interest rate differentials. How do we price interest rate differentials? A key determinant for both the level and trend of interest rates is the current account. A current account surplus results in greatly increased liquidity, which in turn pushes interest rates lower. Equally, a current account deﬁcit is an important factor in pushing interest rates higher. From this, we can say that term currencies with current account surpluses usually have the risk reversal in their favour. Thus, the dollar–Swiss franc exchange rate risk reversal should usually be in favour of Swiss franc calls. In other words, Swiss franc calls should be more expensive than Swiss franc puts. Equally, the same should usually be the case for dollar–yen risk reversals. If at any one time they are not, then this may represent a proﬁtable trading or hedging opportunity.

The Euro-Zone Portfolio Flow Report

admin — Thu, 02 Jul 2009 10:18:21 +0000

The Euro-zone capital ﬂows report for September 20015 shows that the Euro-zone, which had been recording monthly capital outﬂows (combined direct and portfolio investment) from 1999 through the ﬁrst half of 2001 started to record capital inﬂows in the second half of 2001 and in September of that year saw the second highest monthly inﬂow since the establishment of the Euro in January 1999. This was also the fourth consecutive net inﬂow. Comparing the ﬁrst nine months of 2001 to 2000, the total net outﬂow fell to EUR51.3 billion from EUR87.5 billion, an important reason for the Euro’s more stable performance. Within this overall ﬂow picture, net ﬁxed income inﬂows rose substantially to EUR16.6 billion in September, a ﬁve-fold increase from the previous month’s small inﬂow. Indeed, for the ﬁrst time since the inception of the Euro in January 1999, the assets side of total portfolio investment (Euro-zone-based investors) switched to net inﬂows in September 2001.
Finally, equity ﬂows recorded a net inﬂow for the ﬁfth straight month in September rising to more than double August’s level at EUR28.3 billion. All of this helps to support a picture of an improving ﬂow story for the Euro in the second half of 2001. This does not deﬁnitively suggest on its own that the Euro should appreciate against its major currency counterparts. It does appear to suggest however that the Euro should at the least be more stable — and this is more or less what happened, excluding the speciﬁc volatility caused by the tragic events of September 11.

The US Treasury TIC (Treasury International Centre) Report

admin — Wed, 01 Jul 2009 10:17:46 +0000

The second way we can approach this general issue of ﬂow analysis is to look at the speciﬁc capital ﬂows going into equity and ﬁxed income markets. Here the availability and quality of the data vary widely. For instance, there are data reports focusing on what amounts of money are going into mutual funds. From this, we can of course break those mutual funds down into investment types — equity or ﬁxed income, the destination of the investment and so forth.
Why these ﬂows move over shorter periods of time depends as much on market psychology as economic fundamentals — but how does market psychology work? Moreover, why does a market that is impacted by some political and economic factors at one time then completely ignore them at another? To a large extent, the answer must lie in the very structure of the global currency market. While many people focus — rightly or wrongly — on hedge funds as being dominant currency market players, on any given day the vast majority of transactions are between banks, or “interbank” in market jargon. Hence, bank spot and forward dealers are by a long way the largest single player in the currency market. No one model has been able to forecast exchange rates accurately, because no one model has been able to predict accurately the sum of their intentions, behaviour or feelings towards the market. Yet, while that is the case there are some generalizations we can make about market behaviour given its participants. Firstly, traders have to trade in order to make a living. Hence, even in the absence of market-moving news or economic data, these traders still have to trade. This is of course linked in with the increasing use of technical analysis. As more people use this and more people watch certain levels, so those levels become more important. Needless to say, a break of those levels, one way or the other, thus leads to herding activity.
There is another aspect to market psychology and it is that markets, just as economies, also trade in cycles. This is not necessarily to say that the two cycles occur over the same time period. Obviously, this is a subject that will be covered more fully in this series of posts, but to summarize brieﬂy the longer a cycle continues, the more self-fulﬁlling it becomes. Speculative elements are increasingly attracted by what appears to be a one-way bet. Of necessity, the type of activity that this reﬂects is trend-following. The rule of trends is that they have not ended until they have ended. In other words, until there is clear evidence that the trend is over, the market continues to buy into that trend. However, such ﬁnancial market trends have impact in the real economy. If the trend represents capital inﬂows, then it causes the current account balance to become an increasingly large deﬁcit. Increasing fundamental deterioration is initially ignored, but after an extended period of time two things start to happen — the size of the current account deﬁcit becomes alarming and investors start to get nervous as a result. Real money investors start to pare back their positions, but speculators continue to pile in. Towards the end of a trend, volatility starts to pick up markedly, until such time as an unforeseen catalyst causes the trend to end abruptly and violently. Indeed, the longer the trend has gone on, the more people are in the trend, and thus the more violent the trend reversal. Yet, just as trends are self-fulﬁlling, so are trend reversals, which in turn become new — if opposite trends; so works the market cycle, according to technical rather than economic factors.
Cross-border ﬂows are also driven by fundamental considerations such as:
Portfolio diversiﬁcation
Maximizing total returns
Speciﬁc investor risk tolerance levels
When it comes to investment, these are important incentives and guidelines. Our purpose here is to track not incentives but actions. Thus in our ﬁrst example we look at the US Treasury’s “TIC” report, which examines portfolio ﬂows by non-residents of the US going into the US equity and ﬁxed income markets. As we have seen, as barriers to capital have fallen across the world, so capital ﬂows have become increasingly important in determining exchange rates. The usefulness of this report is in explaining and conﬁrming medium-term ﬂow trends either in favour or against the US dollar in this case.
From this we can tell a lot of useful information. For instance, we can note that total foreign investor inﬂows to the US asset markets rebounded in August to USD37.6 billion, after falling sharply in July to USD26.8 billion from USD39.5 billion in June. There are both negatives and positives from this. On the negative side, this USD37.6 billion was a rebound from a 14-month low in July and also well below the USD48 billion monthly average for the ﬁrst half of the year. On the positive side, this month-on-month increase happened at a time of USD weakness. A major positive swing in favour of US Treasuries was largely behind it, from a total of –USD11.5 billion in July to +USD4.4 billion in August. Agencies, corporates and US stocks all saw modest declines in net inﬂows from non-US accounts.
Looking at the regional breakdown, the largest swing in favour of Treasuries was by European accounts, though the largest absolute buying was by Latin American/Caribbean accounts, which are usually dominated by offshore hedge funds. For the US dollar to trend lower requires that inﬂows to US assets also trend lower, and as of this report those conditions had not been met. Thus, comparing the spot price action in dollar exchange rates to the other data, we see a ﬂow conﬁrmation of what many in the market called the “surprising” resilience of the US dollar. Subsequent TIC reports from the US Treasury conﬁrmed the US dollar strength through early December, despite the accelerated deterioration in US economic fundamentals. The ﬂow picture thus explained the strength of the US dollar where just using the fundamental picture did not.

Short-Term Emerging Market Flow Models

admin — Tue, 30 Jun 2009 10:15:41 +0000

The academic community and ﬁnancial market participants have ﬁnally come around to the idea that tracking capital or order ﬂow in the developed world currencies was an important thing to do. Given the depth and liquidity of developed world markets, this fact may be surprising to some. However, as we have attempted to show above, this is nevertheless the case. Where it is true in the developed world markets that watching ﬂow is an important pursuit in determining the exchange rate path, this is even more the case in the so-called emerging markets. Here, the relationship between individual capital ﬂows and overall market liquidity is much more in favour of individual ﬂows. Liquidity in emerging markets is by deﬁnition substantially less than in the developed world. Thus, individual ﬂows can cause substantial price disruption in emerging markets, whereas they might be more easily absorbed in the developed markets. For this very reason, it is important for currency market participants who are involved in or exposed to emerging market currencies to have a reasonably accurate idea of the prevailing type of ﬂows going through the market. One such is the EMFX Flow model (Robert Lustberg and Callum Henderson, 2001) created to track client ﬂows going through the global dealing rooms of Citigroup in emerging market currencies. The type of information that one can glean from this is the following:
Total ﬂow — The total ﬂow indicator looks at cumulative transactions in the currency concerned against all the major base currencies (such as the Euro, dollar, yen, sterling and Swiss franc) combined. This gives an accurate indication of the client’s base total exposure to that currency.
Short- and medium-term ﬂow indicators — The short-term ﬂow indicator examines ﬂow going through a speciﬁc exchange rate over the period of one month, while the medium- term ﬂow indicator does this over six months.
Client-type ﬂow — It is also useful to look at what types of clients are doing what. For instance, one can see whether or not corporate hedgers are being particularly active in a currency or not, or whether or not there is substantial speculative ﬂow.
The use of such a ﬂow model is to realize ﬂow trends, in some cases conﬁrming through the model what one knows anecdotally, and then make formal trading recommendations on the back of that. Some of the major ﬁnds in 2001 from this work were the following:
Brazilian real — Corporate hedging was the main ﬂow dynamic of the dollar–real exchange rate for much of 2001. Examining the model’s ﬁndings we saw that the consistency of hedging activity, which entailed buying of dollars, and the quality of the types of corporations hedging, strongly suggested the dollar–real exchange rate would continue to appreciate. Equally, during November–December, when these corporations were no longer rolling their hedges it was no coincidence that the dollar–real exchange rate stabilized and retraced lower in favour of the real.
Mexican peso — Through the ﬁrst eight months of 2001, client ﬂows going through the dollar–peso exchange rate were largely in favour of the peso, conﬁrming the anecdotal view that foreign direct investment remained a major supportive factor for the peso, more than offsetting the current account deﬁcit. From October on, however, local corporations as a group turned net buyers. This did not cause an immediate appreciation in the dollar–peso exchange rate, but did put a ﬂoor under it and caused it to appreciate over time.
South African rand — There has been over the past few years much controversy regarding the ﬂows going through the rand. Local market participants in South Africa have largely blamed the offshore market for rand weakness, while the economic community has been at a loss to explain rand weakness given the country’s “strong economic fundamentals”. From the EMFX Flow model, we discovered that the client ﬂow of the bank had an asymmetric relationship with the price action of the dollar–rand exchange rate. That is to say, when clients were net sellers of dollar–rand — which was most of the time — the exchange rate remained largely range bound. On the other hand, during rare periods when clients became net buyers of dollars against rand, the exchange rate exploded higher. From this we can deduce a simple explanation for the rand’s weakness according to ﬂow — locals are responsible for rand weakness.
Such ﬁndings can help greatly, not just in terms of providing trading recommendations for the speculative community, but in helping investors or corporations to plan their hedging strategies. Proprietary FX ﬂow models focus generally on the short-term ﬂow picture. However, there are ﬂow reports that focus on the medium-term structural ﬂows that go through asset markets. These also reﬂect useful information. As examples of such medium-term ﬂow analysis, we now focus on the US Treasury’s “TIC” report and the Euro-zone capital ﬂows report.

The IMM Commitments of Traders Report

admin — Mon, 29 Jun 2009 10:15:11 +0000

Unlike the OTC data that is currently available, there are two major advantages with data from open outcry exchanges — it is available relatively quickly after the trade is made and it is transparent. The rules of the exchange concerned require not only full documentation for each trade, but also the type of account making the trade. The weekly IMM Commitments of Traders report collates trades made in currency futures contracts through the IMM trading pit in Chicago by various types of accounts. For our purposes, the most useful type of account that we are interested in is what the IMM euphemistically calls “non-commercial accounts”. In layman’s terms, this means speculators or accounts that trade currencies on their own with no attached underlying asset.
Granted, the volumes that go through the IMM currency futures’ contracts pale by comparison with the regular interbank market. However, here again, the advantage is that the IMM data is transparent. Moreover, given that the non-commercial account trades represent the activity of the speculative community on the IMM, this can be used as a reﬂection of overall speculative activity in those currencies. Indeed, one can go further and say that precisely because IMM volumes are small relative to the interbank market, a notable speculative position in a currency pair on the IMM may actually be reﬂective of a similar but much larger position in the interbank market. Before going on further, it is probably useful to take a look at an actual IMM Commitments of Traders report and seek to analyse it, just as a currency analyst would for their traders and clients.
As the data shows, this report reﬂects the total long and short open positions that IMM speculators have in these currencies at any one time (in this case as of November 20, 2001). This is very useful information. If a speculative position becomes too large, we know from our work looking at the speculative cycle that it may eventually be reversed. Thus, using this information, traders, investors or corporations can position accordingly to anticipate such a reversal. In addition, it is a relatively simple matter to graph this against the spot exchange rate. If we accept that the speculative community’s open position in IMM currency futures is a rough reﬂection of what it might be in the much larger interbank market, this might well give us a much more useful picture of what are the outstanding positions in the market, and thus the outstanding risk and vulnerability.
From this data, we can extract a variety of speciﬁcally useful information. For a start, we can compare the net speculative position of the week being analysed to the previous one. In addition, we can compare this ﬁgure with multi-year highs and lows. Moreover, if we overlay this data with the actual spot rate, we can see how net changes in the IMM speculative position for each exchange rate correlate with the actual price action. To be sure, the IMM data is not a perfect representation of what goes on in the currency market as a whole, as its volumes are small on a relative basis and IMM-based speculators are not necessarily the same ones that operate in the larger currency market context. That said, the fact that one can use IMM data to generate excess returns suggests that the strong correlation, albeit with a lag, between the IMM data and the actual exchange rate price action does indeed reﬂect a predictive capacity of the data itself. A large number of banks now regularly use the IMM Commitments of Traders report, both as an analytical and a predictive tool for their own trading desks and for their clients. For example, if we look at the available data we see that the speculative community has built up a substantial short yen position (against the US dollar). The base currency for the IMM data is always the dollar, thus if they were short yen futures, that means they were short yen against the dollar. IMM net positions can of course be easily graphed, either on their own or perhaps more usefully against the dollar–yen exchange rate. If we do that, we see that speculators had in fact been substantially long yen futures for October and much of November. This is also useful to know as it suggests that a potentially important trend reversal has just happened. If we consider this as a reﬂection in the overall currency market, we get a picture of speculators having been substantially short dollar–yen (i.e. long yen) and of that speculative short position having been gradually eliminated initially and then increasingly reversed. This actually occurred in line with a move higher in the dollar–yen exchange rate, as one might expect as a result of the buying required to close out those short positions. One thing that can be noticed from this example is conﬁrmation that the IMM speculative position was indeed reﬂective of a much larger outstanding position in the overall currency market. After all, if that were not true, the closing out of the IMM position would have had no effect whatsoever on the price action. You might think this coincidence, but the correlation between changes in IMM speculative positions and short-term moves in the spot exchange rate is too high to be that. While the reversal in the IMM speculative position in the yen may be a notable change and thus may last for some time, there is a further point to be made, namely that the larger the speculative position becomes, the more vulnerable it in turn becomes to reversal and retracement. Indeed, this is entirely in line with the conclusions of our speculative cycle model, which suggests that the longer a currency price trend lasts, the more speculative it becomes and the more vulnerable to a sharp and violent reversal. In line with this, the larger the outstanding speculative position, the more laboured the price action becomes in favour of the prevailing trend. This is not to say the prevailing trend cannot continue for some time. It is to say however that the momentum of that trend will continue to slow as the size of the outstanding position in favour of that trend increases. It is also to say the longer the trend lasts, the more explosive the eventual reversal.
Returning to our IMM example, looking at the dollar–yen exchange rate, the IMM data tells us that speculators were at the time becoming increasingly bullish on the dollar vs. the yen. Here, it helps to add some fundamental explanation to the available ﬂow information. It is a key theme of this blog that analytical disciplines, which focus on the currency market, are best used in combination rather than in isolation. That way they give a much more powerful — and therefore potentially proﬁtable — signal. In this example, the Japanese authorities, in the form of both the Bank of Japan and the Ministry of Finance, had signalled that they were in favour of a weaker yen, in line with the weak Japanese economic picture. The ability of either monetary or ﬁscal policy to be eased further had been all but eliminated. The only lever left for further policy easing was the yen itself. This idea caught on within the speculative community, with the result that speculators closed out their short dollar–yen positions and created an increasingly large long dollar–yen position, as reﬂected by the IMM data. As an analyst or as a currency market practitioner such as a corporation or an investor, one can use this information in the following ways:
Analyst — Review the ﬂow and fundamental economic data to come up with an overall picture of the short-term ﬂow and fundamental dynamics in the dollar–yen exchange rate and thus the ability or not of the prevailing trend to continue.
Trader — As the prevailing trend continues and increases in the dollar–yen exchange rate, position to take advantage of the reversal when it comes.
Investor — Use the combination of ﬂow and fundamental data as a guide in determining yen exposure and hedging policy with regard to that exposure.
Corporation — Use the combination of ﬂow and fundamental data as a guide for short-term hedging policy.
To reinforce the point of the usefulness of this data, let’s quickly look at another example. If we look at the position in Euro futures, we see that the net position as of November was net short −286 contracts. On the face of it this may suggest that there is no directional bias for the Euro–dollar exchange rate near term. However, it is important to note that the speculative community had a net long Euro position in the IMM futures contract for much of August through mid-November. Indeed, the Five-year high for Euro longs was hit on August 28 at 31,666 contracts. Since then, there was a gradual reduction in the speculative long position in Euro futures. In line with this, spot Euro–dollar came under increasing selling pressure. Thus, noting that there was such a large net long Euro position at the end of August, one could have positioned to anticipate a retracement in spot Euro–dollar in anticipation of those positions being closed out. Equally, the fact that this net long Euro position switched to a small net short conversely gave the Euro-dollar exchange rate some support as this overhang of long positions had thus been eliminated.