Original Link: http://www.imd.ch/research/challenges/upload/TC013_10_PDF-2.pdf

Our Copy: TC013_10_PDF-2.pdf

Back in February 1950, the first Diners Club credit card was unveiled. The Diners Club card, used mainly for travel and entertainment purposes, became the first credit card for widespread use and eventually changed the way consumers make purchases. Sixty years later, what are the state and the future of the credit card industry?

Despite the 2008 downturn being a credit crisis, not much has been said about credit card companies and their role as capital providers to individuals and households. Banks were the culprits, but also the victims of the largest drop in stock market indices in decades. Yet, the stock price performance of credit card companies which are publicly traded (American  Express, Mastercard and Visa) has been impressive. Since April 2008, with the S&P 500 index losing almost 33% on a cumulative basis, all three companies have out-performed the market with respective total returns of -2%, +29%, and -14% respectively (see the graph). The case of Visa is exceptional, as it went public in March 2008, so part of its stellar performance can certainly be attributed to its market debut.

The market performance of credit card companies is not surprising. While the reduction of interest rates resulting from the recession has allowed financial institutions to lower their borrowing costs and therefore to emerge almost harmless from the crisis, individual consumers and households seem to have not enjoyed such a favorable environment. Indeed, Visa's Net Operating Income in fiscal year 2009 was $2.0 billion, up 13% from the previous year. Competitors have not fared so great, but the outside perception is that the easy credit that financial institutions enjoy has not been transferred to households. Not to be forgotten is that credit card companies are typically owned / controlled by large banks. For instance, JP Morgan Chase is the largest shareholder at VISA, and Diners International is a fully owned subsidiary of Citibank.

How do credit card companies operate? Any credit card transaction involves -- in addition to the cardholder and the credit card company -- a merchant (let us say a retail store), the cardholder's bank (also known as the issuer in the industry), and the merchant's bank (the acquirer). A credit card company is only a network of processing services, by which issuersand acquirers transfer payment from the cardholder to the merchant. In the process, merchants pay fees for the payment processing, and cardholders pay interest on their credit card balances.

This is a very profitable business model, but it would be a mistake to assume that credit card companies issue credit cards. Nor do they determine the rates they charge to customers, or the fees that merchants pay to acquirers. Visa, Mastercard and AMEX make money from fees that issuers and acquirers pay. Such a profit generating system translates into an atypical balance sheet structure. Mastercard for instance is a $6.4 billion company (at the end of 2008), of which $4.3 billion are cash and other liquid assets, $700 million are intangibles, and $500 million deferred income taxes. On the right hand side, the company has virtually no debt, and it is financed mostly by current liabilities, and $2.0 billion in equity. Visa is even impressive, with $20 billion in intangibles out of a total size of $32 billion, of which $8 billion are liquid assets.

Who would not want to invest in companies like these? They are swimming in cash, are extremely profitable and can sail through a financial crisis by transferring their interest rate risk to customers, issuers and acquirers. Since its IPO in 2005, the cumulative return on Mastercard stock has been more than 500% (even taking into account the 2008 financial crisis!), which is equivalent to a 38% annual return.

Well, unfortunately if there is something that credit card companies do not need, it is investors. They are rich, do not need to finance heavy capital investments, and their largest owners are banks, which are indeed happy capturing most of their profit. It turns out however that Mastercard did go public, as did Visa in 2008. Their reasons were however non financial. Mastercard had a severe problem of image: in 2004 Forrester had published a survey where hundreds of customers were asked to "indicate your level of trust in ads for the following type
of products." About 69% of respondents said that they completely trusted ads by retail
companies, for instance. However, only 21% said the same for credit card companies, which
ranked the worst in a list that included movies, consumer electronics and autos. Mastercard
solved its problems by going public, earning a great reputation through its aftermarket
performance and... by putting most of the money raised in the IPO in a foundation.

Visa followed suit, essentially after witnessing the amazing performance of the Mastercard stock. But also for its owners to cash out (remember we did have to endure 2008) about $19 billion, Visa had to create an escrow account that would cover litigation (some $3 billion) started against the company by Discover and Amex, among others.

So despite the stated intention of these two companies to use IPO proceeds to create a foundation (Mastercard) or pay for lawyers (Visa), their public offerings were among the most successful of recent years (Visa's is indeed the largest IPO in the US to date). The market,  that is forward looking, cannot be easily fooled.

What would happen though if, as some commentators say, the next financial crisis is a
personal credit crisis? First of all, such a crisis seems now further away than ever. With low interest rates and social pressure, a household credit crisis would be the last event that any government could now afford. Additionally, I hope this article clarifies that it would not be the credit card companies that would suffer the most -- they are cash shielded, do not get directly impacted by the default of the final customer and are owned by banks, which are by far healthier than two years ago.

Following the launch of the first credit card 60 years ago, there is little reason to doubt that it
will continue to thrive and be a part of our every day lives for the decades ahead.

Arturo Bris is Professor of Finance at IMD. He will direct the "News Ideas in Corporate
Finance: Addressing Financing Gaps" stream during Orchestrating Winning Performance
(June 20 - 25, 2010).

He also directs the Advanced Strategic Management program and teaches on the Program for
Executive Development as well as the Strategic Finance and Building on Talent programs. 

 

 

(Thanks for the article, Harry)

Biggest Money in Currencies Is Made Selling Options (Update1)
2009-04-20 02:23:26.609 GMT


    (Updates prices in 14th and 24th paragraphs.)

By Ye Xie and Liz Capo McCormick
    April 20 (Bloomberg) -- This year's most profitable
foreign-exchange trade is signaling increased optimism that the
first global recession since World War II is easing.
    Bets that currency swings will continue falling from record
highs produced profits in each of the past five months for a 32
percent gain, the best performance for that length of time,
according to ABN Amro indexes. The strategy was the only one of
four currency tactics simulated by ABN that made money in the
first quarter.
    Currency fluctuations ebbed as global economies recovered
from the turmoil that followed Russia's 1998 default and the
Sept. 11, 2001, terrorist strikes. Now, the JPMorgan Chase & Co.
benchmark index of investor expectations for currency swings,
known as implied volatility, has fallen to 14.4 percent from its
27 percent October record. The G7 Volatility Index's decline
since mid-January is the steepest three-month drop since its
1992 inception.
    "Big currency moves are behind us," said Maxime Tessier,
chief of foreign exchange at Montreal-based Caisse de Depot et
Placement du Quebec, Canada's biggest pension fund manager, with
C$120 billion ($98.6 billion) in assets. "The volatility spike
has to unwind itself over time. Selling volatility has been the
winning trade so far this year and will continue to work well."

                        Past Experience

    That may be good news for the global economy. Within a week
of the 9/11 attacks, the JPMorgan index jumped to 13 percent
from 11 percent. By April 2002, that gauge of expectations for
U.S. dollar swings over the coming three months versus the yen,
euro, pound, Swiss franc, Australian dollar and Canadian dollar
had fallen to 8 percent as the U.S. recovered from a recession.
    After Russia defaulted on $40 billion of debt in August
1998 during the Asian financial crisis, the index surged to
almost 19 percent in October, from 10 percent in May. It had
fallen by half when the global economy emerged from the meltdown
the next summer.
    Today, investors are becoming more convinced that
unprecedented sums pledged by the world's major economies,
including $12.8 trillion from the U.S., will stem the worst
financial crisis since the Great Depression. The U.S. economy
will grow 0.3 percent in the third quarter, from a year earlier,
according to the median forecast in a Bloomberg survey of 59
analysts. It probably contracted 5 percent in the first quarter
and will shrink 2 percent in the second, the survey shows.

                       'Good Description'

    "FX vol tends to be correlated with the business cycle,
and normally peaks after troughs in growth," Goldman Sachs
Group Inc. strategists led by London-based Thomas Stolper wrote
to clients on April 8. "That appears to be a good description
of the current situation."
    JPMorgan's index remains elevated relative to historic
levels, signaling continued demand for protection. The index,
which usually moves in tandem with actual fluctuations, remains
above 14 percent, a level it has breached only seven times at
closing since its mid-1992 creation.
    Expectations for swings in the U.S. dollar versus the
Canadian dollar over the next two years are about 15 percent,
compared with 14 percent for the next two months, suggesting
investors see currency volatility remaining elevated, Bloomberg
data show.
    "Although volatility levels have peaked, they are still
pricing in significant market uncertainty in the years ahead,"
said Geoffrey Yu, a London-based foreign-exchange strategist at
UBS AG, the world's second-biggest currency trader. "So long as
the banking system is still under stress, people will want
protection. We are far from giving banks a clean bill of health,
which means there will be more nasty shocks along the way."

                     $4 Trillion in Losses

    Since the start of 2007, the world's largest financial
companies have reported loan-related writedowns and losses of
$1.3 trillion, about the size of Russia's economy. Global losses
may total $4 trillion, the International Monetary Fund will
announce on April 20, according to an April 8 report in the
Financial Times.
    RBS Securities Inc. takes a different view. In an April 15
note to clients, it said exchange rates for the euro, yen and
the dollar suggest there is little room for extreme swings
because they are closer to their 10-year averages than any time
since 1997.
    Volatility expectations on three-month euro-dollar options
fell to 14.09 percent today from 25.39 percent in December, the
highest level since Bloomberg started compiling that data in
1998. Tessier predicted it will decline to about 11 percent.

                     'Doing the Opposite'

    "People are still willing to pay a premium for insurance
against disaster, which is keeping implied volatility from
falling too much," said London-based Henrik Pedersen, chief
investment officer at Pareto Investment Management Ltd. "That
is probably why there is value in doing the opposite" by
selling options, said Pedersen, whose firm oversees more than
$46 billion. Traders use implied volatility to set options
prices.
    Goldman Sachs' April 8 analysis concluded that actual
volatility on one-year euro-dollar options, which stood at 15.7
percent on April 14, is higher than the bank's economic model
suggests it should be by 4.7 points. The deviation was the most
since the mid-1970s, Goldman Sachs said.
    Lower volatility typically follows the easing of monetary
policy by 18 to 24 months, said Alan Ruskin, head of
international currency strategy in North America at RBS in
Greenwich, Connecticut, in an April 15 research note. The
Federal Reserve lowered interest rates to a range of zero to
0.25 percent from 5.25 percent 19 months ago, in September 2007,
in an attempt to stave off the recession as the housing market
collapsed.

                     'Reassuring Investors'

    "I would expect volatility to continue to drop," said
Andrew Milligan, the global strategy chief at Standard Life
Investments, which oversees $181 billion in Edinburgh. "We are
still expecting to see a lot of policy statements reassuring
investors that the governments are in charge, and we will see an
upturn in economic activities."
    A so-called short volatility strategy, where investors sell
options that protect buyers against currency swings, gained 32
percent from Nov. 1 through March 31, ABN's Volatility Capture
Style Index shows. That's its best five-month performance since
the index's 1974 start and among the top dozen gains for that
length of time in any of ABN's four currency-trade gauges. The
volatility strategy had lost a record 29 percent in October. Its
12.8 percent drop last year followed smaller drops from 2005 to
2007 -- its first multiyear losing streak.

                     Straddles, Strangles

    Investors typically short volatility by simultaneously
selling the right to buy and to sell a currency at set strike
prices, known as call and put options. When volatility
expectations fall, so does the price of that protection, and the
seller makes money. Such strategies can use identical strike
prices, known as straddles, or different ones, strangles, with
the former being riskier.
    An investor who on Jan. 2 sold $10 million worth of three-
month euro-dollar option strangles with a call price of $1.5135
and a put price of $1.2921 would have reaped a $338,000 profit
at the end of the first quarter as implied volatility fell to
about 18 percent from about 23 percent, Bloomberg data show.
    Momtchil Pojarliev, currency chief at Hermes Pension
Management Ltd. in London, said he has been selling volatility
since October, mainly with short strangles, which he considers
"definitely the winning bet." One of his positions is on the
Canadian dollar versus the U.S. currency. Pajarliev, whose
company oversees about $39 billion, predicted one-year implied
volatility on the pair will drop 3 points to about 12 percent.

                          Carry Trade

    Smaller fluctuations benefit another common currency
strategy, the carry trade, where funds borrowed from countries
with lower interest costs are invested in those with higher
rates, allowing investors to pocket the difference. Low
volatility decreases the chance that sudden moves will wipe out
carry trade profits.
    An increase in carry trades would boost currencies from
higher-interest rate nations, such as the Australian dollar, and
hurt legal tender from economies with lower rates, including the
yen. Over the past two months, the dollar in Australia, where
the central bank benchmark rate is 3 percent, has gained 18
percent to 70.86 yen in Japan, where the corresponding rate is
0.1 percent.
    The Aussie lost 35 percent against the yen last year, when
three-month volatility expectations on the pair more than
tripled to a record 54 percent between January and October. It
is now 27 percent.

                           In Vogue

    Selling option volatility was in vogue after the 2001
recession ended until mid-2007. During that period, increased
transparency by central banks and stable interest rates damped
currency swings. The ABN volatility-strategy index's best year
was 2004, when it gained 26 percent.
    JPMorgan's volatility index for emerging markets rose to a
record 35.8 percent in October, from about 10 percent in August,
as currencies from Brazil's real to Iceland's krona weakened.
    The volatility and currency depreciation caused Taesan LCD
Co., which makes computer screen lights in Pyeongtaek, South
Korea, to collapse in September as its currency derivative bets
went awry. Gruma SAB, Mexico's largest maker of corn flour for
tortillas, reported a 11.1 billion peso ($844 million) loss in
the fourth-quarter, in part from bad currency wagers.
    "People got burned badly last year," said Pojarliev of
Hermes Pension Management. Now, "fear is disappearing. We are
moving towards a normal environment," he said. "We could see
more normal levels in volatility."

For Related News and Information:
Options and Volatility XOPT <GO>
FX Implied Volatility Matrix WVOL <GO>
Volatility Comparison: VOLC <GO>
Currency trade idea tools: FXTI <GO>
Positions and Sentiment: IPSP <GO>
Currency forecasts: FXFC <GO>
Developed-market monitors: DMMV <GO>
Emerging-market monitors: EMMV <GO>

--Editors: Phil Kuntz, Nicholas Reynolds

To contact the reporters on this story:
Ye Xie in New York at +1-212-617-2768 or
yxie6@bloomberg.net;
Liz Capo McCormick in New York at +1-212-617-7416 or
Emccormick7@bloomberg.net.

To contact the editor responsible for this story:
Dave Liedtka at +1-212-617-8988 or
dliedtka@bloomberg.net.

(English) DOC090323174049.pdf 

 

(Japanese, by NSJ Fund Newspaper) DOC090323174059.pdf

 

 

DOC090323172830.pdf

Article alludes to four areas of FX strategy, carry, fundamental discretionary, event driven, and mean reversion.

Talks about a multi-strategy approach to switch to be able to switch to the strategy that is performing well.

http://news.morningstar.com/newsnet/viewnews.aspx?article=/dj/200902230817dowjonesdjonline000237_univ.xml

2-23-09 8:17 AM EST

LONDON (Dow Jones) -- Royal Bank of Scotland Group plans to split in two, slash costs by more than 1 billion pounds ($1.46 billion) and potentially cut up to 20,000 jobs, as nationalized U.K. lender Northern Rock prepares to reverse course and revive its mortgage lending.

RBS (RBS) will announce some of its plans on Thursday as it unveils details of its 2008 loss, which the bank has previously said could be as much as 28 billion pounds -- the biggest in U.K. corporate history.

CEO Stephen Hester will try and ring-fence about 300 billion pounds of unwanted and risky assets -- around a fifth of the balance sheet -- in a new subsidiary, according to a person familiar with the situation.

The division would act as a type of "bad bank" that would allow investors to more easily assign a value to the core operations. The segregated assets could then be either sold off or run down by RBS over the next three to five years.

Among the businesses that could be wound down are the bank's Australian units and its aircraft-leasing business, the person familiar with the situation said.

The bank may exit from as many as half of the 60 countries in which it currently operates, Dow Jones Newswires reported. Cash could also be raised from the sale of some Asian operations acquired in the takeover of ABN Amro.

Former chairman Tom McKillop told a U.K. parliamentary committee earlier this month that the acquisition of ABN Amro had been "a bad mistake" and that the bulk of what it had paid for the business will be written off as goodwill.

The Financial Times reported over the weekend that the restructuring plans could result in job losses for up to 20,000. The person familiar with the matter said the bank, which employs nearly 180,000 people worldwide, is unlikely to reveal an exact number of job cuts on Thursday.

Taken together, the measures should reduce costs by more than 1 billion pounds, which will contribute to the bank's plans to repay about 20 billion pounds of capital injections from the U.K. government, which now owns close to 70% of RBS.

Newly appointed as CEO, Hester is expected to emphasize a renewed focus on the NatWest U.K. retail unit, its insurance business, and some businesses within its U.S. Citizens Bank unit.

Macquarie Research analyst Robert Sage said that, provided the plans can be achieved without a full government takeover, "it seems increasingly plausible that the RBS investment case may at last fine some more robust underpinning."

Trading in RBS showed investors in a buying mood, bidding the shares about 14% in early London action. The wider European banking sector also climbed to start the week amid reports that the U.S. government is in talks over expanding its equity stake in Citigroup Inc. (C).

Northern Rock u-turn

Also in focus Monday were plans by the U.K. government to revive mortgage lending at nationalized bank Northern Rock.

The U.K. had previously been gradually running down Northern Rock's operations, but now officials want the mortgage bank to make as much as 14 billion pounds in additional loans over the next two years, in a bid to help plug a hole in the U.K. lending market.

Chancellor of the Exchequer Alistair Darling told BBC Radio earlier Monday that the plan for Northern Rock is one of a series of measures the government will introduce to help reinvigorate lending.

Another eagerly awaited part of the plan is an insurance program for risky assets.

RBS reportedly wants to put at least 200 billion pounds of assets into the government plan, which would effectively limit banks' losses beyond a pre-agreed level in exchange for an annual percentage payment.

However, the value of the scheme to shareholders will depend on the detail, including how much of any further losses the bank would have to shoulder.

  (END) Dow Jones Newswires
  02-23-090817ET
  Copyright (c) 2009 Dow Jones & Company, Inc.

This is a slide presentation on the above, located on Columbia University's Department of Industrial Engineering & Operations Research website.

Original: http://www.ieor.columbia.edu/pdf-files/Ross_S.pdf

Local PDF: Ross_S.pdf

Topic: Siamese Twins and The Macroinvestment Function

 

Interesting Artifact:

Stephen Ross' Financial Hurricane Scale (Love this scale)

 

 

dail15661.pdf

Special FX: the asset class that thrives on volatility

"FX divisions are among the most profitable in the banks. Ultimately in 2008, FX was a significant contributor to profits," says Scott Wacker, managing director of foreign exchange sales at JPMorgan.

"Low volatility means a bear market for the foreign exchange industry and high volatility means a bull market," says Martin Wiedman, head of global forex sales at Credit Suisse.

"But if you still have a pulse, you are going to have the opportunity to make some serious money in FX over the next couple of years."

Full Story: 26b4d60c-f324-11dd-abe6-0000779fd2ac,dw.pdf

My Comments:

  Intraday Volatility---Prices move more during certain parts of the global day.

In foreign exchange, currencies get traded more or less in the regions where they are used as currencies of account, ie. JPY in Japan, GBP in the UK, etc.  USD is essentially the global currency used to measure value, with EUR becoming a closer second for this role.

FX Pairs move more when one of their currency's regions begin their day and, you get a distribution of volatility on pairs.

(Stole this from: http://i.investopedia.com/inv/articles/site/FX-3market2.gif)

Short & Long, 20pip stop / 40pip take. (meant to do 1 lot, but accidentally did 2 lots)

The market went almost straight down, $1080+, $540-, which is P/L $540+.

     

The risk is that the volatility drops off, and the market starts moving sideways again.  Worse even, the market moves against you and you pay spread, and lose your ante'd stop loss.

Take a look at the last 3 weeks or so.  Pay attention to the area under the Solid Blue (UK) boxes (and where they overlap with Solid Green boxes (US)).  This is typically the most volatile time of the day.  Since Lehman died, its a rare day that see daily range of less than a 100pips.

Depending on what the actual probabilities work out to be with whatever SL/TP I choose and the directionality from whatever point I initiate my trades turns out to be, the probability of working out might be less than 50% of the time.  With only simple TP/SL, if the trade only works out 45% of the time, that means that the break even on the game is...

[Scenario 1 x Probability 1] + ... + [Scenario n x Probability n] = 0, (Break Even)

[(Win Scenario) x 45%] + [Losing Scenario x 55%] = 0,

[((Profit Took Side) + (Stopped Out Side) ) x 45%] + [2 x (Stopped Out Side) x 55%] = 0, 

[(Take Profit - Spread) + (Stop Loss - Spread) ) x 45%] + [2 x (Stop Loss - Spread) x 55%) = 0,

[((91pips - 5pips) + (-20pips - 5pips)) x 45%] + [2 x (-20pips - 5 pips) x 55%] = 0

At 45% probability of win, 91pips is break-even,

At 50% probability of win, 80pips is break-even,

At 55% probability of win, 71pips is break-even.

Reducing loss, increasing win, and increasing winning probability are keys to any strategy.

When expecting a spurt of volatility, the fact that the trade has not won yet, indicates too little volatility for the strategy. A time-based narrowing of the exit range would probably be helpful at reducing loss. In this case, it would be good to start reducing losses by accepting a small loss on exit, which is better than waiting until the market starts moving against you and takes out the remenants of your trade.

Secondarily, there might be something to be said for a directional bias.  A risk-neutral bias, based on close historical prices seems like it might be of some value. However, care needs to be taken to only make the strategy risk neutral, otherwise the strategy starts becoming a directional play, as opposed to a volatility play.

With that said, with a well timed entry where volatility typically picks up, a well devised trailing stop, and a loss reduction strategy, there might be a potential on an above average volatile day of 200-250pips, to return a maximum of 2 to 3x the break even distance of 80pips.

Since this strategy runs on volatility, another helpful ingredient might be having the program look back several days and measure the amount of volatility there was, and make it revise it's own strategy parameters to increase win probability.  Even perhaps a simple implementation of a volatility model, GARCH, or something along those lines.

This leads me to thinking about a model that attempts to predict intraday volatility, and perhaps calculating win probabilities to size bets, maybe with the Kelly bet-sizing model, or a weakened form (as Kelly is known to be ultra aggresive.)  Alas, I shall leave this for another day.

PDF: 052cf48e-f08f-11dd-972c-0000779fd2ac,dw.pdf