Author Archives: Antonio Mello

Corporate financial policy deciphered (2)

In the upcoming years, European telecoms need to issue an average of €30 billion in bonds. But financial market instability suggests that even highly credit-worthy companies may have trouble gaining access to funds.

Liquidity risk management once again became a pillar of corporate financial policy following the Lehman collapse in 2008. It involves a continuous exercise of cash control and refinancing plans that goes far beyond the traditional purpose of bridging temporary imbalances between receipts and disbursements.

For the past two and half years we have been living with the ominous threat of a financial market freeze. These concerns were highlighted by the events of the past week, described in a June 24, 2011, Financial Times article by Michael Mackenzie and Nicole Bullock:

Investors are withdrawing cash from money market funds heavily exposed to short-term debt issued by European banks out of fear that a Greek default could spark contagion across the region’s financial sector.

At the same time there is increasing reluctance among US banks to lend to their European counterparts in the past two weeks…

Investors have not forgotten how some money market funds, viewed as cash-like holdings, had short-dated Lehman Brothers debt and lost money after the bank declared bankruptcy in September 2008.

Once banks stop lending to each other out of concern with counterparty risk, money markets shut down and short-term credit to corporations ceases.  When this happens, companies have to support themselves without backup, a situation which can be exacerbated if key customers and critical partners do not meet their obligations.

Companies therefore need their own liquidity sources to be robust enough to carry them through periods of disruption.  They need to ensure capital availability and a tight grip over operating cash flows in different scenarios, selecting for each scenario the appropriate actions that reduce the probability and/or impact of bad events, for a given degree of residual risk tolerance.

Most importantly, companies must correctly simulate their debt refinancing needs, adjust debt maturities to the risks of a market freeze, diversify alternative funding sources, and ensure that the available credit facilities are committed, unrestricted and long term.

Liquidity risk management is necessary for companies to implement their strategic goals and avoid costly business interruptions.  It is often said in finance that “cash is king”. It certainly is so when cash is the difference between success and failure, life and death.  When equity financing is not viable and good assets sell below their full value, companies should remember: long live the king.

Corporate financial policy deciphered (1)

At a recent TMT conference I attended, a speaker from Moody’s characterized the target capital structure of investment-grade Telecom operators as a Net Debt-to-Ebitda ratio of between 2.0x and 3.0x.[1]

To remain within the target interval, firms need to balance their investments and payout policies with cash available from operations.  A ratio above 3.0x negatively affects lenders’ attitudes, making debt more restrictive and expensive. A ratio below 2.0x raises shareholders’ concerns that cash might be wasted in imprudent acquisitions and value-destroying projects.

As the figure below indicates, companies actively manage their finances in an effort to stay within the designated interval.

By meeting shareholders’ remuneration expectations and their obligations to creditors, firms are able to keep key providers of capital pacified. Additional efforts to achieve the absolute optimal capital structure only translate into unnecessary and costly adjustments. Thus, the fact that firms do not rebalance capital structures frenetically does not mean that firms are inattentive. Rather, the apparent passiveness reveals a lack of concern with some variation as long as the Net Debt-to-Ebitda ratio stays within the target range. But when the ratio approaches the critical limits, firms tend to become sensitive and act to correct deviations. Market conditions then determine whether these corrections happen quickly or slowly.

[1] Moody’s includes operating leases and pension liabilities in gross debt.

The elusive black swan of 2011

The term Black Swan has gained popularity of late, largely due to the enormous success of Hollywood’s recent thriller of the same name. The Black Swans we discuss in this article, however, are more unpopular, involving neither ballet, nor popcorn, nor – most importantly – any synopsis of what we are about to experience. These are rare events with dramatic consequences, and extremly difficult to predict. In this post, we will look at several key indicators of looming financial disaster to determine whether we can predict a would-be Black Swan Event.

Students rarely remember “skewness” after a Statistics course. The measure captures how asymmetric the probability distribution of a random variable is. A left skewed distribution indicates that the tail on the left side is longer than the tail on the right side; even if most outcomes are above the mean, low outcomes can be much larger than high outcomes.

After the stock market crash of October 1987, the Chicago Board of Options Exchange (CBOE) introduced a Skew Index on the S&P 500 that allows investors to gauge tail risk in the stock market, with returns lower than two standard deviations below the mean indicating high lower tail risk. The Skew is calculated from the prices of out-of-the-money put options on the S&P 500.[1] Traders pay attention to the volatility smile of options, which relates the option-implied volatility to the degree of the option’s moneyness. Out-of-the-money options tend to have higher implied volatilities than at-the-money options. As lower tail risk increases, the slope of the left part of the smile steepens, turning the smile into a grimace of apprehension at the prospect of a higher probability of extreme downward moves. Continue reading

The cloud in silver pricing

On Thursday, May 5, commodities markets fell sharply. On that day alone, the DJ-UBS index of commodities prices lost 4.7 per cent. The rout is said to have started in the market for silver, but rapidly spread to a wide range of commodities.

Silver is used for commercial purposes. Recently, however, the metal has been trading predominantly as a speculative asset. A lot of people now associate silver with the role traditionally given to gold as a store of value against the erosion of fiat money. As such, the price of silver, instead of reflecting the value of the stream of income derived from the traditional commercial uses, is driven by changing beliefs about grand macroeconomic events. This is how silver has gone up by more than 70 per cent in just three months, between the end of January and April 29.

Silver prices halted their rapid ascent with an abrupt fall of 28 per cent in the first week of May. Fundamentals can hardly explain such a violent reversal. Searching for an answer, many pointed their fingers at the Exchange, which raised margin requirements on futures positions four times for a total increase of 61 per cent since April 25. Three increases happened in just five trading days. The argument goes like this: many investors, surprised by the repeated large margin increases were unable to quickly arrange financing of the margin and were forced to sell their positions, driving the price down. This selloff may have been aggravated as other investors panicked. Some complain that the Exchange was deliberately, and unfairly, trying to push prices down. Others use the occasion to press the political case in favor of more aggressive use of margin requirements as well as position limits to stop speculators from inflating the price in the first place.

The events of the last couple of weeks in the silver market are a useful opportunity to briefly review the role of margin requirements and what is known about their impact on trading and prices. Continue reading

GNP linked securities? Link to inflation as well.

In an article in the Financial Times this week, Patrick Honohan, Governor of the Central Bank of Ireland, proposes that Irish debt repayments be linked to the country’s growth:

“One dimension which, in my personal view, has not yet received the attention it deserves is the potential for mutually beneficial risk-sharing mechanisms. A variety of financial engineering options could be considered going beyond the plain vanilla bonds currently employed.

A simple version, which could indeed be useful beyond the specific case of Ireland, would, over time, shape the arrangements with European partners in such a way that Ireland pays more if its GNP growth is strong; less and slower if growth remains weak. The aim of such GNP-linked bonds or similar risk-sharing innovations must be to restore, through growth, a favourable dynamic to the sovereign debt ratio, putting its sustainability too, like that of the banks, beyond doubt.”

After a sharp decline in GNP per capita that put Ireland back a decade, Patrick Honohan is worried that the downward cycle of debt overhang and austerity measures will further erode growth and make debt even more burdensome. Continue reading

Swing a Vix con un tango

On February 25, Izabella Kaminska in FT Alphaville blasts the forecasting ability of the Vix futures, a CBOE futures contract that measures the volatility of the S&P 500 stock market index. Since 2009, the Vix futures has remained in contango–meaning that the far out prices exceed the near delivery future prices-and Vix futures repeatedly exaggerated their predictions of the actual volatility.

The first graph below shows the term structure of the Vix futures contracts for several trading dates in 2010 and 2011. The graph indicates that the futures curve has remained in contango.  A closer examination indicates a relationship between the level of volatility and the steepness of the curve: A higher (smaller) level of the spot/near term volatility seems associated with a less (more) pronounced contango.  The second graph shows the same relationship after normalizing the near term futures  price to 100. On July 20, 2010, the near volatility was 28.45 and the far out volatility was 33.2, a 16.7 percent higher. By January 24, 2011, when the near volatility was a much lower 16.15, the far out contract was 26.6, a whopping 64.7 percent difference.

Continue reading

Eli Lilly move upstream

Accelerating costs of drug development and uncertainty surrounding the feasibility of many compounds to reach the marketplace have lead large pharmaceutical companies to resort to independent research organizations for early stage drug development. This helped pharma companies focus on license-proven, later-stage development of compounds with a record of safety and efficacy.

Recently, however, pharma companies have become interested in biotech firms. Roche acquired Genentech in 2009, and Sanofi-Aventis has just agreed to takeover Genzyme.

Eli Lilly also wants to move upstream.  The company is joining forces with venture capitalists to launch three new funds ($750 million) that will finance pre-clinical and early stage clinical tests on molecular technologies by standalone firms in partnership with external researchers. This will help Eli Lilly develop more drugs faster, and give it preferential access to potential successes. Here is the Financial Times piece by Andrew Jack.

Why is Eli Lilly deal clubbing with VCs instead of going it alone? Can’t the company raise $750 million? Presumably Eli Lilly has a limited ability to raise funds. More important, public markets for equity and debt are ill suited to back highly risky ventures. Institutional and retail investors prefer bets they can make sense of, benchmark to the stock market index, and quick returns.

Perhaps the main reason for Eli Lilly’s foray into early stage R&D is that it provides the company first right of refusal after proof of concept. Acquiring licenses and seeking agreements with independent labs after an initial success can be expensive and frustrating, as many pharma companies compete fiercely for a miniscule number of technologies that show real promise at preclinical trials. In this sellers’ market, by retaining preferential treatment Eli Lilly wants to avoid being drawn into aggressive contests that might end into costly failed bids or inflated purchases.

Eli Lilly is redefining its boundaries. On paper it appears to be a smart move for a company that is anxious to rebuild its declining portfolio of patented drugs. But as with every strategy, success will be determined by how well it is executed. Sharing costs and risks is not obvious when Eli Lilly is the only insider, the buyer and user of the fruits of research also funded by other outside investors.

Similarly with the management of partnerships with freewheeling and independent minded external researchers who want to maximize the value of their exit options when Eli Lilly has a right that effectively distorts an otherwise competitive market.

Mario Goes to the FX Market

Nintendo’ management has decided to keep in US$ a significant fraction of its revenues from exports. Nintendo has a large $7.4 billion pile of cash held in foreign currencies (70% of Nintendo’s total cash reserves). See this Wall Street Journal article.

With the sharp rise in the Yen since May 2010, after a crisis in the Eurozone erupted, and recently with the FED stimulating the economy with an aggressive monetary policy, Nintendo has accumulated large currency losses, when most of the other large currencies (Euro, Sterling and $) depreciated against the Yen.

Does it matter?

At first, one would say no. These are merely translation losses, and the competitive position of Nintendo (its ability to sell its products) is not affected by accounting losses. Moreover, Nintendo has expenses in foreign currency, so matching its revenues with operating costs in foreign currency makes sense.

This is not entirely correct, however.

Nintendo has over the past years aggressively shorted the yen to invested in other currencies, and taken advantage of higher yields abroad when compared with almost zero interest rates in Japan. This foreign currency strategy goes by the name of carry-trade, and has been massively employed by both Japanese companies and households since the late 1990s. It yielded very large gains until the eruption of the current financial crisis. Since then, investors and companies in Japan have used this strategy on and off depending on market conditions.

The Japanese Yen, like the Swiss Franc, is a currency of refuge to investors when markets get nervous. In recent years, the correlation between different measures of market volatility (for example, the Vix and iTraxx) and the Yen has been pretty high. When investors become more risk averse and fearful they go long the Yen, and when markets calm down and volatility declines, the Yen tends to lose its value. The point is that a lot of companies and individuals use the Yen to express their fears about deteriorating economic and financial conditions. And there’s plenty of that nowadays.

What this means is that, in addition to matching the currency in which its cash is held with the currency of its cash flows, Nintendo’s management has deliberately made a bet on currencies with the shareholders’ money. And recently, the bet has lost money, as in the past it has made money.

This begs the following question: Should Nintendo’s management use shareholders’ money to bet on currencies, or should it let investors decide by themselves on currency betting?

It is obvious that the majority of Japanese shareholders in Nintendo are upset with Nintendo’s currency losses, as they were presumably quite happy when Nintendo was making profits in the past from its portfolio of foreign currencies. But the management should not be surprised with shareholders’ reaction. Shareholders give the management discretion as to how retained earnings are invested, but voice their disapproval when management decisions go wrong. Betting on currencies is no different from any other investment decision. Except for the fact that Nintendo’s management has no business on betting on currencies. It’s hard to make a case that they have particular skills in doing that.

The other part of the problem relates to executive compensation. More precisely, how currency betting is treated in compensating management. Often times, currency losses and gains are not treated symmetrically in managerial compensation. Because of this, the management might be inclined to take currency bets, if it can persuade shareholders that currency gains are the result of its talent, and therefore should be followed by unexpected higher bonuses, while at the same time currency losses are not penalized with lower bonuses. How the compensation is designed creates the incentives to act so as to maximize the chances of getting the targeted compensation. Moreover, executive compensation is not entirely outside of the management’s control, and can be subtly manipulated by managers. In general, managers are smart operators, and are able to focus the attention of shareholders on operating profits when (financial losses such as currency losses) occur, claiming that these are unpredictable, and therefore not their fault. Shifting shareholders’ attention on different results ex-post is a very common managerial tactic.