Category Archives: financial policy

The Value in Futures

Today’s Wall Street Journal has a piece by Ian Berry about the possible restructuring of the CME’s rice futures contract. The design of the contract determines how effectively “farmers, elevator operators and beer brewers” can use the contract to do their hedging. The article is about problems that have shown in up in recent times and proposals to fix them. These problems impact how farmers and others manage their operations and investments:

“We are losing rice acres to other crops, and the lack of ability to comfortably hedge is a major reason,” said John Owen, a Louisiana producer who has chaired a committee with the U.S.A. Rice Federation, a trade group, to examine the issue.

Farmers said growing rice becomes too risky if they can’t lock in prices at the start of the season. Most of their expenses come up front, so they need some assurances on what they will get for their crop.

“We need to get our rice farmers back to farming rice,” said John David Frith, a farmer in East Carroll Parish, La., where a vast majority of growers have stopped planting the grain.

Designing the terms of a futures contract is a tough problem. Getting it right is how a market like the CME helps make the economy more productive.

Manufacturers as Banks

EADS, the European aerospace group and owner of the Airbus family of jetliners is busy redesigning its boundaries to become a banker of last resort.

The company recently bought PFW Aerospace, one of its suppliers of specialty pipes and ducts, which became victim of the European credit crunch. With banks sharply deleveraging, even to suppliers of EADS, and with strong sales and orders that will sustain growth for years to come, the company has had to step in on several occasions and provide financial support to its sub-contractors.

EADS’ takeover of suppliers and its role as a financial intermediary are an act of necessity, not of choice. EADS cannot risk delay by suppliers that, for lack of bank credit, don’t meet its timing and quality requirements. Finding replacements and renegotiating contracts would involve huge costs and take years.

For many European corporations, coordinating production through the market has just become too risky. EADS never envisaged it would become a banker to its suppliers nor that it would have to bring some suppliers in-house in order to protect the integrity of its supply chain. Clearly, this is not in EADS’ nature. EADS’ example shows an often forgotten cost of the financial crisis: that firms are the (second best) alternative to the market mechanism. When the credit arteries get clogged it is more efficient to produce in a non-market environment.

Europe’s banking crisis is forcing many firms to redefine their boundaries. It is also sending many others to the graveyard.

A Silver-Linked Dividend Without the Silver Lining

Hecla Mining Co. is copying Newmont’s strategy. It announced last month that its dividend will be linked to the price of silver:

All dividends, including those in the third quarter, would increase or decrease by $0.01 per share for each $5.00 per ounce incremental increase or decrease in the average realized silver price in the preceding quarter.

Here’s the resulting payout diagram:

Data from January 1999 to October 2010 show that, with the brief exception of the summer of 2008, silver prices have never been above $25. Prices above $30 are a phenomenon of the last twelve months. Expecting silver prices to go up in the future, Hecla is giving investors extra leverage…if its prediction comes true.

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A gold-linked dividend in the modern gold rush

Earlier this year, the Newmont Mining Corporation announced that future dividend payouts would be linked to the price of gold. For every $100 increase in the average price received on its sales of gold, the annual dividend would be increased by 20¢ a share. From the Newmont deck:

What does the promise of a gold-linked dividend provide above and beyond what investors in Newmont already had?

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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?

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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Apple’s cash hoard: how much is too much?

There was plenty of press last week when Apple announced it’s 3rd quarter earnings. Much of the attention was on the size of the cash pool Apple has accumulated. Here’s the balance sheet:

 

 

Cash and other liquid securities total $76 billion and represent more than 70% of Apple’s book assets.

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