Leverage: Part 1

What is Leverage?

Leverage[2] as an integral part of both an institutional and individual trading strategy, multiplies gains and losses. Utilising Leverage enables one to trade a higher volume of a financial instrument whilst not requiring any additional capital to be put up.

One form of leverage simply involves borrowing money against one’s capital. Another includes using derivatives to control a higher volume of e.g. stock vs. purchasing the actual stock.

“For example, say you have $1,000 to invest. This amount could be invested in 10 shares of Microsoft stock, but to increase leverage, you could invest the $1,000 in five options contracts. You would then control 500 shares instead of just 10.”[3]

The potential risks of leverage, especially over-leverage, have been well documented over the past 30 years, for example the speculative hedge fund Long Term Capital Management founded by John Merriweather, Robert Merton and Myron Scholes (the latter two joint Nobel Prize winners in Economics) collapsed in the ’90s partially due to a high leverage. LTCM had a peak leverage of 100:1, i.e. for every $1 of equity, they assumed $100 of ‘debt’.

[1] Margin is collateral that a customer must put up to cover the counterparty risk  assumed by, most likely, the broker providing the assumed debt. A ‘Margin Call’ occurs when the margin posted in the account is below the minimum requirement likely as a result of an adverse market movement affecting the trader.Therefore, the most apparent risk of leverage aside from, in my opinion over-leverging, is the magnification of losses. An investor who buys a stock on 50% margin will lose 40% of his money if the stock declines 20%.

[3] http://www.investopedia.com/terms/l/leverage.asp#axzz1jMVR7sm2


Daily Roundup

RBS Bankers Prepare for ‘Nuclear Winter’ as Hester Undoes Goodwin Empire
By Thursday lunchtime in London, the 18,900 employees in Royal Bank of Scotland Group Plc’s investment banking division will know whether they still have jobs at Britain’s biggest government-owned lender. Chief Executive Officer Stephen Hester, 51, decided to make the announcement, originally planned for later this month, because uncertainty in the ranks about jobs was undermining productivity, said one senior executive who declined to be identified because he wasn’t authorized to speak publicly. Hester is reversing a decade of expansion led by former CEO Fred Goodwin that included $140 billion of acquisitions. The Edinburgh-based lender plans to close its equities and corporate finance units globally, cutting as many as 5,000 jobs, said two people familiar with the situation. The cash equities, equity research, corporate broking as well as mergers and acquisitions units may also be shut, the people said. Limiting cuts to the equities unit may not be enough to boost profitability, said Raul Sinha, an analyst at JPMorgan Cazenove in London.

BofA Prunes Senior Ranks in Asia Investment Banking (Reuters)
Bank of America-Merrill Lynch, the second-largest U.S. bank by assets, is cutting around a fifth of its managing directors across its Asia investment banking division, sources said on Monday, in a bid to cut costs as the outlook sours in a once-booming region…Headhunters interviewed by Reuters said the bank’s reduction in its ranks of managing directors in Asia was a deeper-than-usual cull of senior bankers, but reflects the broad challenges the investment banking industry faces. “That sounds like carnage,” said Richard Broadhurst, who runs Hong Kong-based Initiative Recruitment.

Greek Bailout In Peril (WSJ)
Greece’s deteriorating economy is threatening the viability of a €130 billion ($165.2 billion) bailout for the country that European leaders agreed to in October. The bailout package, which followed an earlier aid deal for Athens that was agreed on in 2010, relies on Greece negotiating a 50% reduction in much of its outstanding bond debt. It also requires Greece’s government to make fresh efforts to cut its budget deficit. “The second Greece program has to be implemented soon, otherwise it won’t be possible to disburse the next tranche” of aid loans, Ms. Merkel told a joint news conference with Mr. Sarkozy after their meeting.

Credit Suisse Bankers Said to Bet Own $450 Million on Firm’s Risky Assets(Bloomberg)
Credit Suisse, selling riskier assets to free up capital, has found a ready buyer: its own employees. The same senior bankers who received part of their 2008 pay in illiquid loans and bonds contributed $450 million of their own money to buy more of the firm’s risky assets (CSGN), such as mortgage-backed securities, said two people with knowledge of the plan, who asked for anonymity because the deal is private. The bankers, some of whom have left since 2008, had been willing to put almost $500 million into the Expanded Partner Asset Facility, or EPAF, which closed Dec. 31, one of the people said. Banks are trying to divest illiquid loans and fixed-income securities because regulators would require the firms to hold more equity capital as a buffer against losses. Europe’s lenders have pledged to cut more than 950 billion euros ($1.2 trillion) of assets over the next two years to reduce the capital they would have to raise. “This is an advantage to the company, if priced correctly, in that it will reduce their capital charges and liquefy their balance sheet,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York. “The question is what goes into it, how is it being valued and are they using a third-party firm to value it? Because to do anything else is a transfer of value from the shareholders to the employees.”

Geithner In China To Discuss Yuan, Iran (Bloomberg)
Geithner is likely to encounter resistance in China, which disagrees with U.S. assertions that its currency is undervalued and is sparring with the Obama administration over trade in goods from chicken to steel. At the same time, he may seek to avert a public split at a time when a likely European slide to recession is already clouding the global economic outlook. “These are the world’s second- and third-largest economies and the two biggest holders of Treasury bills,” said Stephen Myrow, a U.S. Treasury official during the administration of George W. Bush and now managing director of ACG Analytics Inc., a Washington investment research firm. “These are relationships that need to be continually nurtured.”

Traffic Agent With Unpaid Tickets Is Arrested Over Tow (NYT)
A traffic agent who owed more than $450 in parking tickets was arrested Monday morning in Brooklyn, accused of trying to stop her S.U.V. from being towed, the authorities said. The agent, Olatakumbo Erinosho, 39, was charged with obstructing governmental administration, disorderly conduct and resisting arrest, the police said. City marshals went to Greene Avenue in Bedford-Stuyvesant before dawn on Monday to tow Ms. Erinosho’s 2007 Cadillac Escalade, the police said. But she “interfered with and resisted their lawful efforts to seize her personal vehicle” and “subsequently resisted efforts by police who were summoned by marshals to arrest her,” Paul J. Browne, the chief Police Department spokesman, said in a statement.

Fitch May Downgrade Italy, Not France This Year (Reuters)
Fitch Ratings does not expect to cut France’s triple-A credit rating this year, while countries under review such as Italy or Spain could be downgraded by one or two notches, the agency’s EMEA ratings head said on Tuesday. Fitch put Belgium, Spain, Slovenia, Italy, Ireland and Cyprus on negative watch late last year, with a conclusion expected by March. France has a negative rating outlook from Fitch, which normally means that it could be downgraded within two years. “On the basis of some current economic and fiscal trends in France… we wouldn’t expect to downgrade France this year, unless there is a material deterioration in the euro zone,” Ed Parker, head of EMEA sovereign ratings, told Reuters in an interview on the sidelines of a Fitch seminar.

Wife’s Trades Sink Banker (WSJ)
Swiss National Bank Chairman Philipp Hildebrand resigned Monday after emails appeared to undercut his assertion that he knew nothing of a currency trade worth more than $500,000 by his wife last summer. Mr. Hildebrand, who denied any wrongdoing, resigned just days after declaring that he wouldn’t step down in the wake of disclosures that his wife, who once worked at a New York hedge fund, exchanged Swiss francs for dollars Aug. 15, just weeks before the central bank made one of the boldest interventions in foreign-exchange markets in recent years to control the rise of the Swiss currency. The resignation brought an abrupt end to the two-year tenure of a central-bank chief who generated both controversy and plaudits from the international financial community. In a news conference, 48-year-old Mr. Hildebrand said he was resigning in part because it was impossible for him to prove that his wife, Kashya, acted alone in making the transaction last August. “My wife has a strong personality,” Mr. Hildebrand had said last week in discussing the trade. “She worked in the financial business and has her own thoughts.” Ms. Hildebrand worked at New York hedge fund Moore Capital Management between 1994 and 1999 in various roles, where she met her husband. She has managed an art gallery in Zurich since 2001.

Apple CEO Cook’s 2011 Package Worth $378M (Bloomberg)
The total includes $376.2 million in shares that will vest starting in five years, Cupertino, California-based Apple said yesterday in a proxy filing to shareholders. Cook’s base salary was $900,000 in 2011.

Romney tackles attacks on his business experience from GOP rivals (NYP)
There was no mention of “pink slips,” but Mitt Romney on Monday was already trying to counteract the perception that he was out of touch when he said there were times he feared getting fired. On Sunday, Romney told a crowd in Rochester, NH, “I know what it’s like to wonder whether you’re going to get fired. A couple of times I wondered if I was going to get a pink slip.” Speaking at a Nashua Chamber of Commerce breakfast Monday, Romney began by noting he did not always hold high-level positions. Rather, he said he started off “at the entry level.” “I was able over the years to work my way up and learn some lessons along the way,” Romney said.

Twinkies Maker Preparing For Chapter 11 Filing (WSJ)
Hostess Brands Inc. is preparing to file for Chapter 11 bankruptcy protection as soon as this week, said people familiar with the matter, a move that would mark the second significant court restructuring for the Twinkies and Wonder Bread baker in the past several years…Hostess also owes more than $50 million to vendors, which have been demanding payments on shortened time frames because of Hostess’s financial condition, one of the people said. Most of those goods and services were provided to Hostess within the past three weeks or so.

Santorum Takes Credit for Sweater-Vest Sales Boom (Daily Intel)
Appearing on Hannity Monday night as GOP rival Newt Gingrich did earlier, the former Pennsylvania senator held up an official Santorum sweater-vest and told the host that “This is the attire of the campaign. We’ve heard from several retailers that sweater-vests sales have gone up since I started displaying the sweater-vests.”

Weekly Video Highlight

Check out this video demonstrating a Long Short trading strategy.



Asset Classes – Part 1

There are many types of assets to invest or trade that can be chosen according to risk tolerance, market factors, capital available etc.

The most common classes are listed below:

Fixed interest securities e.g. Bonds: junk; government; corporate; foreign; convertibles; MBSs
Stocks: preferred; large-cap; mid-cap; small-cap; micro-cap; public; private; foreign; emerging
Real Estate: REITs
Commodities: agriculture; energy; water; precious metals; industrial metals
Derivatives: long; short; market neutral; options; futures; swaps; forwards; OTCs

Cash: If you are going to be using cash for your investments, you need to be aware of the various disadvantages associated with it. One of these is the fact that it does not earn any interest in itself. It can also lose its value in a period of high inflation, affecting its capability to be exchanged for services and goods.

Another disadvantage is that it can be difficult to handle or transport in large quantities. It is also subject to risks like fire and theft. However, using cash has many advantages, too. It is accepted by most people in exchange for goods or services. It is also the standard of value that is used in modern society. Furthermore, it is more efficient to use in purchasing items when compared to bartering because of its portability.



A bond is a debt security, similar to an I.O.U. When you purchase a bond, you are lending money to a government, municipality, corporation, federal agency or other entity known as an issuer.* In return for that money, the issuer provides you with a bond in which it promises to pay a specified rate of interest during the life of the bond and to repay the face value of the bond (the principal) when it matures, or comes due.

It is always prudent for an investor to maintain a diversified investment portfolio consisting of bonds, stocks and cash in varying percentages, depending upon individual circumstances and objectives. Bonds help you to diversify your portfolio, thereby, reducing your risk exposure.

Investing in bonds provides a predictable stream of income and repayment of principal.

Some of the negative aspects of investing in bonds are:

When interest rates go up, the price at which the bond can be sold goes down. If you are forced to sell the bond due to pressing circumstances, you may not back the entire amount invested resulting in losses.

Long-term bonds can tend to be volatile and can somtimes fail to keep up with inflation.


Dynamic Hedging

Dynamic Hedging is a risk management strategy in which one reduces risk by taking various positions in put options according to changing market conditions. For example, one may buy a put to hedge risk to one security in a portfolio thought to be particularly risky at one time, and then sell that put and buy another when matters change.

It is dynamic as it is a hedge that needs to be adjusted as the price (and sometimes other characteristics) of the portfolio or security it is hedging changes.

Some securities cannot be hedged with a static position. For example, the change in the price of an option is not linear with (in a constant proportion to) the change in the value of the underlying asset. This means that options can only be hedged using the underlying (or other simple securities) dynamically — options can be statically hedged using other options (e.g. an exotic option with a portfolio of vanilla options).

The description above implicitly tells us what is problematic about dynamic hedging. The root problem is that it requires constant re-balancing. Consider a simple delta hedge where the value of an option is hedged with a holding of the underlying asset. What happens when the value of the underlying asset changes? The amount of the underlying asset needed to hedge the option changes, and so the position has to be re-balanced?

What happens when change in price is a substantial jump? Not only is the position no longer be fully hedged, but it could even show a sudden loss. In the type of highly geared arbitrage like strategies where dynamic hedging is typically employed, this could be disastrous.

The answer would be to hedge against changes in the delta by gamma hedging. Of course this still does not cover really big jumps, because gamma also changes with price. In addition other factors may change such as changes in option value because (the markets perception of) the volatility of the underlying.

We can cover some possibilities by hedging using rho (to hedge changes in interest rates), and vega (to hedge changes in volatility). In addition hedging theta offsets the decline in option value as time passes.

Even after all this, a dynamic hedge would still not be perfect. A sudden jump in price often implies a sudden jump in volatility.

All this is, of course, why strategies that depend on dynamic hedging, even if they are basically arbitrage strategies, are risky.

For further info, check out this video: