Author Archives: John Parsons & Antonio Mello

The Cosmetics of Collateral Transformation

Responding to the new regulatory reforms such as the Dodd-Frank Act in the US, banks are now marketing “collateral transformation” services. A good source for various materials on this issue is Tracey Alloway’s coverage in FT Alphaville.

What are these services? How are they connected to the reforms? Should we be worried?

Collateral transformation is a fancy name for a particular type of loan, as shown in the top three boxes of the figure below. A company/fund trading a standardized derivatives contract cleared by a central counterparty (CCP) must post a margin. Initial margins are posted with cash and government securities; variation margins are posted with cash. Holding cash for the purpose of posting margins exacts an opportunity cost, for it earns less than if invested in less liquid securities. The bank steps in and offers to lend the company/fund the cash for collateral at the CCP, and the company/fund provides less liquid securities it holds in the balance sheet to the bank as collateral. In addition to providing the company/fund with liquidity, the bank structures the arrangement to easily mesh with the mechanics of trading, settlement and so on, so as to minimize the administrative costs to the institutions that are its customers. See this brochure and this article.

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Risk and return in the eye of the beholder

The corporate finance practice team at McKinsey & Co has joined the long line of people looking at the large cash hoard being assembled by corporations and asking “why?”. In an article in the McKinsey Quarterly, they suggest a surprising answer:

One factor that might go unnoticed, however, is the surprisingly strong role of decision biases in the investment decision-making process—a role that revealed itself in a recent McKinsey Global Survey. Most executives, the survey found, believe that their companies are too stingy, especially for investments expensed immediately through the income statement and not capitalized over the longer term. Indeed, about two-thirds of the respondents said that their companies underinvest in product development, and more than half that they underinvest in sales and marketing and in financing start-ups for new products or new markets. Bypassed opportunities aren’t just a missed opportunity for individual companies: the investment dearth hurts whole economies and job creation efforts as well.

The article provides a useful examination of biases in decision making. Many managers would concur that a million dollars lost on a bad investment in the recent past would tighten the finances of a company much more than a million dollars won would relax the constraint. This may be especially so in a period when creditors are deleveraging and equity holders are quite wary about bad news.

The McKinsey piece reminds us that a project is not just the Power Point slides and the numbers in a spreadsheet, but what these are in the eye of the beholder.  But how does that relate to the global picture of corporate cash hoards? It’s one thing to be humble about the quality of decision making and the biases that affect it. It’s an entirely other thing to connect those biases to the very large aggregate economic fluctuations in the global economy, including the cash that companies seem to think it is prudent to husband very carefully right now. When did prudence became a bias?

Central Clearing can economize on collateral

Reforming the financial system involves not only the grand public battles over legislation and rulemaking, but also the substantial trenchwork that falls to staffers in the many agencies responsible for carrying out the mandates. And it is heartening to observe this work advance. One of the many interesting analyses being produced en route is a study by Daniel Heller and Nicholas Vause at the Bank for International Settlements (BIS), the international organization of central banks. The purpose of the report is to produce an estimate of the financial resources that Central Counterparties (CCPs) would need to safely clear interest rate and credit default swaps. Central clearing of derivative trades is one of the major mandates of the Dodd-Frank Financial Reform Act in the U.S. and of comparable reforms in Europe.

In a number of our previous posts, we have emphasized that end-users have much to gain from the central clearing mandate—see here, here, here and here. Central clearing creates the possibility to reduce the total amount of credit risk in the system, lowering the overall costs to the various parties using derivatives, including non-financial companies seeking to hedge their commercial risk. One reflection of how risks can be minimized, depending upon how the mandates are implemented, shows up in Graph 6 of this BIS study, reproduced below.

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Cash & Carry, #4: Other resolutions to the puzzle

We began this series of posts recapping the finding that a currency carry trade investment has historically produced high return relative to the low risk. This finding is not consistent with models in finance that focus on the correlation between an investment’s return and the return on some benchmark stock portfolio. Using these models, and looking at the historical distribution of returns, the carry trade looks like a good bet, even accounting for bad outcomes. Posts #2 and #3 in the series reported on one route of the research effort to explain the puzzle, which attributes the abnormal return to the “peso problem”. But other researchers have been pursuing different routes. To wrap up this series, we’ll quickly mention some of this work.

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Cash & Carry, #3: the Price of “Peso” Risk

In our previous post in this series, we highlighted a line of research by Burnside et al. that explains the profitability of the carry trade as a “peso” problem. That is, the historical data doesn’t completely reflect all of the bad outcomes that may arise. The as yet unobserved bad outcomes are known as “peso events”. The historical profitability of the carry trade, isn’t the complete story. It’s a biased sample. The few bad outcomes not yet observed resolve the puzzle. Investors are worried about these “peso events” and price the currencies accordingly.

In this post we want to delve a bit more into this issue of how investors may be pricing “peso events.”

There are two different aspects to pricing “peso events.” First, we must assess the probability of an extreme negative event. Second, we must assess the discount we want to apply to that negative event. This second aspect is what we want to focus on.

In finance all dollars are not created equal. Cash received in states when the investor otherwise has plenty cash is not worth as much as cash received in states when the investor otherwise is short cash.

The standard models for pricing risk – such as the CAPM, the Fama-French and the Carhart factor models, among others – are based on what is called a linear stochastic discount factor across all states. They assume a linear relationship between the discount factor and some underlying risk factor. In the CAPM, that would mean a linear relationship between the discount factor and the payoff on the market portfolio. But there isn’t any natural presumption in favor of linearity in the discount factor.

The argument made by Burnside et al. is that the discount factor is not linear. Instead, a very high discount factor is applied to the as yet unobserved “peso events.” And this very high discount factor is essential in making sense of the historic profitability of the carry trade strategy.

In order to make the argument more accessible, we have constructed a simple numerical example:

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Cash & Carry, #2: Pesos and Steamrollers

In a previous post, we reported on the evidence that the carry trade strategy – investing in currencies with high interest rates and borrowing in currencies with low interest rates – earns high returns with low risk. In this post we describe in more detail some of what is known about the risk and return tradeoff on a carry trade investment. Our focus is on the risk and the cost of risk.

The returns to the carry trade, like the returns on a number of other trading strategies, are sometimes characterized by the phrase “They take the stairs up, but the elevator down.” That is, the profits accumulate gradually, but once in a while there arises a very, very large loss. The figure below, taken from a recently published paper by Burnside, Eichenbaum, Kleschelski and Rebelo (here is the free working paper version), shows the distribution of returns to a carry trade strategy between 1987 and 2009. The shaded bars are the observed sample. The black line is a normal distribution with the same mean and standard deviation as the sample.

What you can see in the figure is that the sample has a fatter left tail than the normal distribution, as highlighted by the red circle. Those few bad returns are the events at issue. They are very bad, and although few, they occur much more often than is predicted by the normal distribution. And these few extreme events matter to the total return of the strategy: Harvard’s Jeffrey Frankel noted that “In one week of 1998 (October 4-10), the yen rose 16% against the dollar, thereby suddenly reversing years of profitable carry trade from the low-interest-rate yen into the higher-paying dollar.”[1]

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Cash & Carry, #1: Where to Park?

Holding cash is a key risk management tool, and corporations are holding more cash than ever. Where should the corporate treasury park that cash? In which currency should these balances be held–US dollars, Euros, Yen, Swiss Francs, Australian Dollars or what? The choice of the currency denomination of cash investments is the flip side of the problem of selecting the currency denomination of debt. Modern capital markets confront corporate treasury with a broad array of opportunities for borrowing and investing in various currencies.

Assuming the expected returns in all currencies are fairly priced for risk (i.e., Uncovered Interest Rate Parity holds), the answer will depend on the multinational structure of the company’s business and its exposure to fluctuations in the different currencies. Some companies will be better off stashing cash in dollar denominated securities because they anticipate future net cash outflows denominated in dollars, while others will be better off stashing cash in Euro denominated securities and others in Yen, and so on. Many companies will have an optimal mix of cash stashed in a variety of currencies. We’ll call the company’s optimal mix under the assumption of Uncovered Interest Rate Parity the company’s Benchmark currency portfolio.

Other factors will matter, too, such as international tax rules, concerns about capital controls and so on.

But what about that big assumption we made up front? What if expected returns in all currencies are not fairly priced for risk, so that Uncovered Interest Rate Parity does not hold? What if investments in certain currencies are generating big profits, while investments in other currencies are generating losses?

It is well documented that a speculative portfolio built by purchasing high interest rate currencies and selling low interest rates currencies—the carry trade portfolio—has been very profitable over many years.The figure below, taken from a recently published paper by Burnside, Eichenbaum, Kleschelski and Rebelo (here is the free working paper version), shows the cumulative return to an investment in the carry trade portfolio between 1976 and 2009 as compared against the cumulative return to an investment in US stocks and the return to an investment in US Treasury Bills.

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Central clearing lowers end-user costs

One of the most controversial aspects of the financial reform in the US and Europe is the mandate that many derivatives trades will have to be cleared in central counterparty clearinghouses (CCPs). CCPs stand behind the losses in the event that a trader defaults.  To protect the clearinghouse against trader defaults, users of derivative contracts processed in CCPs will need to post margins.

But margins are expensive; they require traders to have spare cash or unused credit capacity; and margins need to be explicitly accounted for. Opponents of clearing have directed their criticisms at these points, complaining that margins crowd out other corporate investment. They also argue that margins have negative implications at a more macro level: variation margins can trigger panics; and out of concentrating risk, CCPs will become dangerous dens of systemic risk. Altogether, clearing under the proposed rules won’t change things for the better, they argue.

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The M-M Proposition of Hedging

Students of corporate finance are familiar with the Modigliani-Miller irrelevance propositions. Proposition 1 says that the value of a firm is determined by the firm’s cash flow from assets and is independent from its capital structure. The Proposition is often presented to demonstrate the irrelevance of choosing between debt and equity, but the underlying logic is more general than that. The Proposition applies to any choice in the set of contracts used to finance the firm. These include hedges, for hedges are implemented with financial contracts that change the balance sheet of the firm. So, what we call the M-M Proposition of Hedging is simply a corollary to the original M-M Proposition 1.

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The Collateral Debate Inches Forward

Last week, the Coalition for Derivative End Users filed a new comment letter with bank regulators on the rulemaking for the Dodd-Frank reform of the OTC derivatives markets. The Coalition has taken a lead role in lobbying to expand the end-user exemptions on clearing and margins. One interesting thing about the letter is how it betrays progress in the intellectual debate on the cost of margins.

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